Among advocates of carbon pricing, there is a long-running disagreement about whether a carbon tax or a cap-and-trade system is preferable. Among economists and environmentalists, there is generally a preference for a carbon tax. Politicians terrified of the electoral implications of creating a new ‘tax’ tend to favour cap-and-trade schemes (partly, because it is easy to give away permits to influential industries under such a scheme).
Economists frequently argue that the trade-off is between price and emissions certainty. With a tax, you know exactly how much more any particular carbon-intensive activity will cost, making planning easier. With a hard cap, you know exactly what your emissions will be. With a tax, you can try to tweak the level to get the emissions volume you want, but you can never be entirely sure. Conversely, a cap assures the emissions outcome selected, but does so at a cost that cannot be known in advance.
A recent letter to The Economist does a good job of laying out some of the advantages of a cap-and-trade approach, arguing that economists and environmentalists have been too eager in throwing their support behind a tax:
First, a “one size fits all” tax requires an impossible calculation of the average cost of reducing emissions over a given period of time. Compare this with an emissions-trading system that works on the free-floating marginal cost of abating emissions. Second, carbon taxes would be levied locally and so impossible to properly administer on a global scale. A global carbon-market price is perfectly pervasive. And third, taxation cannot guarantee a reduction in greenhouse-gas emissions; emitters could opt to pay the tax and continue emitting at will. Conversely, a cap-and-trade solution introduces a carbon ceiling and the price acts as no more than a useful barometer of how close we are to achieving that goal; prices will tend to zero as the requisite level of emission reductions is achieved.
Personally, I think the choice of instrument is less important than the level of genuine political will, reflected in the care taken in regulatory design. Either approach can be set up in a dodgy way, intended to produce the impression of action without actually constraining carbon emissions effectively. A well-designed tax is better than a cap-and-trade system full of giveaways and dodgy offsets. A well-designed cap-and-trade scheme is better than a tax that is too low to be effective, or one where exemptions and rebates undermine the incentive effect. Those concerned about climate change should be willing to support either policy approach, while being energetic in ensuring that the system that is ultimately designed is a fair and effective one where polluters pay for the cost of their damaging activities and the long path to carbon neutrality is started upon.