Cap and Trade vs. Carbon Tax. Which System Would be Better

The topic we're gonna discuss is the difference between a cap-and-trade policy and a carbon tax. Both of these policies are intended to address a negative externality which is a situation where the marginal private cost to the firm is lower than the marginal social cost. So there's a negative externality, the firm is producing lots of pollutions but it's not internalizing all of the social costs which are costs of people like me and you. The firm should be producing where the marginal benefit is equal to the marginal social cost so this would be our efficient level of carbon emissions. However, the firm is over-producing, it is producing at a higher level because it's not internalizing the external cost of carbon emissions.


So each cap-and-trade and carbon tax are both intended to reduce the amount of carbon and get it to the socially efficient level. However, the carbon tax uses a price mechanism in the sense that it's creating a tax on this amount which is the difference between the Marginal social cost and Marginal Private Cost. Here the external cost otherwise known as tax is adjusting the price and then assuming the firm will naturally adjust the quantity downward because they're facing a higher price. Whereas cap-and-trade you're not setting the price what you're actually doing is you're setting the quantity and saying "We're just gonna set the socially efficient quantity and then the price will naturally adjust. So the carbon tax is a price mechanism that leads to the efficient quantity whereas the cap-and-trade is a quantity mechanism that ends up yielding the efficient price but in each case we're trying to get to the socially efficient level of carbon emissions.


Pro's of Cap-&-Trade

There are some pros and cons to cap-and-trade. With cap and trade, the nice thing is you can set the quantity based on science. So you could say "Look scientists have told us that 200 million tons of carbon are the efficient level" whatever the efficient level is I have no idea but you could set that and you are setting that in advance but with the carbon tax you set the price and you hope that it will go to this efficient level of 200 million tons but it might not right. You might have set the price incorrectly and firms end up producing more than what you thought in terms of carbon emissions. With the cap-and-trade the advantage is you get to set that quantity and you could do it based on science. Now as things change over time, that the cost of abatement that's the cost of cleaning up and reducing carbon emissions that abatement may change over time, it may become cheaper and cheaper to do that and so you can adjust the amount of permits that you give out to firms for polluting. If you previously allowed the firm to do 50 thousand tons of carbon but now abatement has become cheaper so we'll only allow them to do 25 thousand this year. So as the cost of abatement changes you can adjust the amount of permits that you give out. Another thing is that these marketable permits that you're giving out for pollution, they create a unit of exchange that can go beyond just your country. Ultimately it could be harmonized internationally where these credits could be traded on an international basis and so forth. So we could think about a world in which we have the cap and trade. Also if you allocate the credits based on an auction like if you say "Look here's the amount of carbon, we're gonna auction off the credits. We're not just gonna give them out" then you could actually raise revenue.


Con's of Cap-&-Trade

There are some drawbacks to cap and trade and one is that assuming you don't use auctions to allocate the credits then you have the issue that "How do we determine the initial allocation of the initial credits?" because we might say "This firm A they produce 200 million tons and firm B produce 600 million tons of pollution last year, so we'll give firm B more credits. But is that fair? What if firm B basically are producing a lot more pollution because they haven't invested in clean technology and maybe firm A they're producing less carbon because they've been investing in clean technology. So if you give more permits to firm B and say they need the permits more you're really rewarding bad behavior. 

So then there's an issue of politicians are getting involved. They're allocating the credits and now you've got issues or maybe they're pressured to give certain credits to firms they back them and so forth. Also, you have to set up a market with cap and trade. We're setting up a market where people can buy and sell credits and also you've got to regulate the market and there could be issues with the market that could be manipulated. One major drawback to cap and trade is that can't be used for all types of pollutions, if you think about your's car it's easier just to say "We're just gonna have a rigid rule for emission standards for your car" we're not gonna set up some cap-and-trade market where you and your next-door neighbor are buying and selling credits from one another about how much emissions you get. It's will be too difficult, there are just too many people with too many vehicles and in terms of heating, your home things like that is harder to set think about setting up a cap-and-trade system for that.

Pro's of Carbon Tax

Now the carbon tax is easier to administer in the sense that you don't have to set up a market. So you don't have to create a market and say "Here's this market we're gonna set up the quantity and people can buy and sell" you just implement a tax. Of course, it's not easy to get a tax passed with legislation and stuff and there'll be arguments over what the tax rate should be and so forth but it's easier to administer than setting up an entire market. Also, it's going to avoid the volatility of having a market, and firms will particularly like that but also a nice thing about the carbon tax it can generate a lot of revenue. Billions of dollars in revenue can be generated that can instead be used on different programs and stuff. Not only by doing this price mechanism of the carbon tax are you getting the socially efficient quantity of carbon emissions but you're getting that money raised that you could invest in R&D for new types of technologies and for reducing emissions in the future. You could use it in early childhood education you get this money beyond just getting hopefully the socially efficient quantity of carbon produced.


Con's of Carbon Tax

Now some drawbacks to the carbon tax and the major one are it doesn't actually cap the emissions level. We said in theory by using this as a price mechanism by adjusting the price and forcing firms to internalize the external cost of carbon emissions. It will adjust to the efficient quantity however there's no guarantee. If you didn't set the tax to the right level or did any number of things would happen and you end up with more emissions, more carbon emissions than what is socially efficient. So the cap-and-trade has the nice thing of leaders say "look I've just kind of set it at 20 million tons or whatever the amount is and then it's not going to exceed that cap" but with the carbon tax you're using this price mechanism and ideally theoretically you can get to that which is socially efficient quantity but there's no guarantee. 


Also even though it's easier to administer the tax than it is to set up an entire market for cap-and-trade and stuff there's still the issue of legislative battles of people fighting over what the tax rate should be, who should be exempt, and so forth. Really the important thing to remember is that both the carbon tax and cap-and-trade er are both trying to bring about the socially efficient quantity of emissions and in theory, they can both do that but the question of which one is better might depend on the particular context. Sulfur dioxide, for example, they actually have set up basically a cap-and-trade and that's worked pretty well but in some other cases you might say "Look it's a bit too difficult to administer cap-and-trade, we should set up a carbon tax." So the ease of administration can dictate which system would be better because ultimately they're equivalent in terms of what they're trying to achieve