Social and Economic Policy,

Carbon Taxes vs. Emissions Trading: What's the Difference, and Which is Better?
By Kevin Baumert
April 17, 1998
There is a growing debate between two competing climate change policy instruments - carbon taxes and emissions trading. Along with a suite of other "flexibility mechanisms," emissions trading among industrialized and transitional countries (former Soviet bloc) was included in the Kyoto Protocol to the UN Framework Convention on Climate Change under Article 17 (formerly 16bis) and has thus been the subject of much international discussion since December. Although an international emissions trading system does not necessarily preclude the use of carbon taxes (domestically or internationally), the two are commonly seen as competing policy instruments to reduce greenhouse gases (GHG). This analysis attempts to clarify the two policy approaches and the respective advantages of each.
Carbon taxes, and all environmental taxes, are "priced-based" policy instruments. Taxes increase the prices of certain goods and services, thereby decreasing the quantity demanded. This is called the "price effect." Tradable permits, or emissions trading, is considered a "quantity-based" environmental policy instrument. Although both policy approaches are "market-based," they operate differently - carbon taxes fix the marginal cost for carbon emissions and allow quantities emitted to adjust, while tradable permits fix the total amount of carbon emitted and allow price levels to fluctuate according to market forces.
Emissions Trading Under an emissions trading system, the quantity of emissions is fixed (often called a "cap") and the right to emit becomes a tradable commodity. The cap (say 10,000 tons of carbon) is divided into transferable units (10,000 permits of 1 ton of carbon each). Permits are often referred to as "GHG units," "quotas" or "allowances." To be in compliance, actors participating in the system must hold a number of permits greater or equal to their actual emissions level. Once permits are allocated (by auction, sale or free allocation) to the actors participating in the system, they are then tradable. This enables emissions reductions to take place where least costly.
Carbon Taxes Carbon taxes are simply direct payments to government (collection body), based on the carbon content of the fuel being consumed. Given that the primary objective of the abatement policy is to lower carbon dioxide emissions, carbon taxes make sense economically and environmentally because they tax the externality (carbon) directly. Coal generates the greatest amount of carbon emissions and is therefore taxed in greater proportion than oil and natural gas, which have lower carbon concentrations (Coal contains .03 tons of carbon per million Btu of energy, while oil and natural gas contain only .024 and .016 tons respectively).
Which is Better?There is no simple yes or no answer, and the policies are not necessarily mutually exclusive. Several important advantages and drawbacks of the respective policies are outlined below.
The Case for Emissions Trading

A well functioning emissions trading system allows emissions reductions to take place wherever abatement costs are lowest, regardless of international borders. Since costs associated with climate change (e.g. coastal flooding, increasing incidence of violent storms, crop loss, etc.) have no correlation with the origin of carbon emissions, the rationale for this policy approach is clear. If emissions reductions are cheaper to make in Poland than in France, emissions should be reduced first in the former where costs are lower.

Emissions trading has the advantage of fixing a certain environmental outcome - the aggregate emissions levels are fixed, and companies/countries pay the market rate for the rights to pollute. This also makes emissions trading more conducive to international environmental agreements, such as the Kyoto Protocol, because specific emissions reduction levels can be agreed upon more easily than tax rates or policy instruments, which may vary in appropriateness and applicability between states.

Emissions trading is more appealing to private industry. By decreasing emissions, firms can actually profit by selling their excess greenhouse gas allowances. Creating such a market for pollution could potentially drive emissions reductions below targets. In general, transferring resources between private entities is more appealing than transfers to government.

Emissions trading is better equipped than taxes to deal with all six GHGs included in the Kyoto Protocol and sinks (e.g. trees which absorb and store carbon) in one comprehensive strategy. Each gas has a "greenhouse gas potential" (GWP, based on carbon dioxide). Thus firms emitting more than one GHG have more flexibility in making reductions.

Permits adjust automatically for inflation and external price shocks, while taxes do not. For example, the US has already experienced an extended period of stable greenhouse gas emissions levels from 1972 to 1985 because of high oil prices. Taxes would need to be designed to adjust for such external shocks.
The Case for Carbon Taxes

A carbon tax would offer a broader scope for emissions reductions. Trading systems can only be implemented among private firms or countries - not individual consumers (transaction costs would be prohibitively high if commuters needed permits to fill up their car with gas). Carbon taxes extend to all carbon-based fuel consumption, including gasoline, home heating oil and aviation fuels. Trading systems may not be able to reach parts of the transportation and service sectors which could account for 30-50% of emissions.

A system of tradable permits entails significant transaction costs, which include: search costs, such as fees paid to brokers or exchange institutions to find trading partners; negotiating costs; approval costs, such as delays or fees incurred during the approval process; and insurance costs. Conversely, taxes involve little transaction cost, over all stages of their lifetime.

Carbon taxes have dynamic efficiency advantages that trading lacks because taxes offer a permanent incentive to reduce emissions. Technological and procedural changes, and subsequent technology diffusion, will lead to reductions in permit price (i.e. since emissions goals will be easier to meet, there will be a decrease in permit demand, and hence, a decrease in permit price). Trading systems may not be able self-adjust in response to rapid change, and thus provide the permanent incentive of a tax system to reduce emissions. In short, emissions trading must have some method of removing permits from the system or other method of ratcheting-up permit prices.

Taxes are not susceptible to strategic behavior by firms or non-governmental organizations which may harm the contractual environment of the market. Non-governmental organizations or even private individuals that object to the concept of purchasing the "right to pollute" may purchase large numbers of permits to drive up costs of CO2 abatement. Likewise firms may hoard permits, driving up the prices for competitors.

Emissions trading proposals are highly complicated and technical, unlike taxes which are an extremely familiar instrument to policymakers. Many technical issues would need to be resolved before trading could begin, including treatment of sinks, different GHGs, monitoring, enforcement, etc. Ongoing costs are also low for tax systems because of the lack of monitoring and enforcement requirements.

Emissions trading may prevent meaningful domestic reductions from taking place. If the global climate system is to be stabilized, emissions reductions should take place sooner, rather than later, in the countries most responsible for the problem. This concern relates to profound equity issues among developed, developing and transitional economies.

Carbon taxes earn revenue, which can be "recycled" back into the economy by reducing taxes on income, labor and/or capital investment. This is often referred to as a "revenue neutral" tax and may be part of a broader program of "environmental tax reform" (ETR) which attempts to shift the tax burden from "goods" like labor, to "bads" like pollution. Evidence indicates that there can be profound employment, distributional and political benefits to such an approach. Permit systems have the potential to earn revenue, but only if permits are auctioned.
The Politics: Who likes which policy, and why? United States is the strongest proponent of emissions trading and fought hard to include trading in the Kyoto Protocol. The reasons are straightforward. Relative to other industrialized countries, the US is energy inefficient and has high per capita carbon dioxide emissions levels. Thus carbon taxes would penalize the US relative to other, less fossil fuel dependent nations. US industry is also strongly against any taxation measures to achieve GHG reductions. Trading would allow US firms to purchase emissions allowances from other countries, and avoid domestic reductions.
The European Union has traditionally been in favor of strong coordinated policies and measures, such as energy/carbon taxes, among countries. Because the EU is already relatively energy efficient (improvements have been made steadily since the late 1980s, through energy deregulation, taxes and agreements with industrial sectors), carbon taxes would be less of a burden than in the US. In Kyoto, the EU was against emissions trading, but was unable to overcome US support for trading. Therefore, EU efforts have been channeled into developing effective rules and guidelines for a trading system. For example, the EU has recently announced that at least 50% of countries' reduction targets should be achieved domestically.
The Russian Federation and the Ukraine are major supporters of emissions trading, and would stand to gain financially. Their emissions reduction targets are 0% reductions by 2008-2012 based on 1990 levels (i.e. to remain at 1990 levels through 2012). However, because of the economic collapse of the former Soviet bloc, and the closure of inefficient power plants, these countries are already 30% below 1990 levels. If they were allocated trading permits (based on their emissions target), they would be able to immediately flood the market and receive major cash inflows. The trading of allowances that represent past emissions reductions (which are not the result of climate considerations) is called "hot air."
Developing countries (known as G77/China in UNFCCC negotiations) are extremely cautious of emissions trading, and view it primarily as a "loophole" that the US and Japan can use to avoid their domestic responsibility. They are in favor of rules and guidelines that ensure equitable allocation of allowances and monitoring provisions. Currently, trading is being discussed only as a means for Annex 1 (industrialized and transitional countries), since developing countries do not have binding emissions reduction targets. However, if the system were to be extended globally in the future, developing countries would demand that permit allocations be based on population, rather than historic national emissions levels. This position is indicative of the strong equity concerns held by developing countries. Developing countries favor the principle of carbon taxes - as long as they are levied on rich countries and not poor ones.

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