CBPP Examines Cap and Trade, Carbon Tax

• Both cap and trade and a carbon tax create incentives to conserve energy, improve energy efficiency, and adopt clean-energy technologies.

The Center on Budget

Several northeastern states have already implemented a regional cap-and-trade system, the Regional Greenhouse Gas Initiative. In addition, the European Union has operated a cap-and-trade system since 2005. Last year, the U.S. House of Representatives passed the American Clean Energy and Security Act of 2009 (H.R. 2454), which would establish a national cap-and-trade system. The Senate is considering similar legislation, but could adopt a hybrid approach that uses cap and trade for some emissions sources and a carbon tax for others. If Congress fails to act, the Environmental Protection Agency (EPA) could step in and regulate greenhouse gases under the Clean Air Act.

How Does Cap and Trade Work?

Under cap and trade, lawmakers establish a limit (or "cap") on the overall amount of greenhouse gases -- mainly carbon dioxide from the burning of fossil fuels -- that can be emitted each year. The cap might be relatively loose in the early years as the economy begins to adjust, but it ultimately must become very tight to achieve the emissions reductions scientists say are needed to control global warming.

To ensure compliance with the cap, the government would require the firms that the cap covers to hold government-issued permits (or "allowances") for those emissions. Lawmakers would have to decide which entities were responsible for different kinds of emissions. For example, they could assign accountability for the carbon dioxide that coal-powered electricity plants generate either to the companies that own the power plants or to the coal mining operations that provide the coal. Similarly, lawmakers could assign accountability for the emissions that result from the burning of transportation fuels either to oil refiners or to oil producers and importers.

The government could initially auction off emissions allowances to the highest bidder or allocate them for free to firms that need them or, as was done in the House bill, to entities that would then sell them to firms that need them and use the proceeds to fund various public purposes. Subsequent to the initial allocation, firms that can reduce their emissions cost-effectively would be free to sell excess allowances to other firms that find it particularly expensive to reduce their emissions.

• Cap and trade specifies the amount of allowable emissions, while letting the market determine the cost of reducing them. A carbon tax, in contrast, specifies the price of allowable emissions.

By putting a "price on carbon," cap and trade would encourage businesses and households to look for ways to cut their fossil-fuel energy costs. That would reduce the demand for fossil fuels without the government needing to decide how to achieve that reduction.

How Cap and Trade Differs from a Carbon Tax or Regulatory Approach

Cap and trade specifies the amount of allowable emissions, while leaving the cost of reducing emissions to that level to be determined in the marketplace. If analysts underestimate how difficult it will be for businesses and households to adapt to higher prices for carbon-based energy, the cost (and hence the price of allowances) will turn out to be higher than anticipated, and vice versa.

A carbon tax is the obverse of cap and trade: rather than fixing the amount of allowable emissions, it specifies their price. Firms covered by the cap would weigh the cost of reducing their emissions against the tax they would pay if they kept emitting at their present level. If analysts underestimate how costly it will be for businesses and households to reduce their emissions, the amount of emissions reduction will turn out to be smaller than anticipated, and vice versa.

Put another way, if reducing emissions proves more difficult than analysts expect, the result under cap and trade would be higher compliance costs and less production of other valued goods and services, while the result under a carbon tax would be less emissions reduction and greater risk of damage from global warming. Policymakers trying to decide between the two approaches must weigh those potential outcomes.

If policymakers chose instead to leave responsibility for regulating greenhouse gases to EPA, they would sacrifice the flexibility of a market-based approach. As a result, it would likely cost more to achieve a given level of emissions reduction through a command-and-control approach than through cap and trade or a carbon tax. A regulatory rulemaking approach would likely tell firms how much they need to reduce their emissions and how to do it. That would discourage technological innovation and gives firms that can reduce emissions below the required level no financial incentive to do so.

Economists recognize that "market failures" can inhibit cost-effective investments in energy efficiency or clean-energy alternatives even when there is a price on carbon. Government policies that effectively address these market failures, such as investments in research on new technologies, can bring down the cost of meeting an emissions cap (or increase the reductions achieved under a carbon tax).