Carbon Tax Vs Emissions trading

One of the most interesting public policy debates today involves addressing the issue of climate change. Governments across the world are faced with the challenge of reducing emissions of greenhouse gases, which depletes the ozone layer and thereby promotes global warming.

The two policy options available are the cap and trade emssions trading scheme and direct taxes on carbon emissions. The cap and trade scheme, which is already under implementation in the European Union and as part of the Kyoto Protocol, limits the carbon emissions and permits surplus emitters to purchase carbon credits from the market. It is argued that a system of cap on carbon emissions coupled with the creation of a market in carbon credits would result in efficient allocation of resources. Those carbon emitters who can reduce their emissions at the least cost can sell their saved carbon credits to those emitters facing higher marginal costs.

Ever since the cap and trade scheme became established, several distortions have crept into the market. It has distorted incentives and has not significantly reduced emissions. Some studies show that emissions by the biggest carbon emitters, involved in the trading scheme, have actually increased. It has also resulted in misallocated subsidies as projects which would have come through in the normal course have been subsidized on the grounds of energy efficiency. In many cases the caps have been placed at very high levels and allowances allotted very liberally thereby defeating the very purpose of such schemes. All these aforementioned problems have meant that while the cap and trade scheme has not made any significant dent on carbon emissions, its benefits too have been captured by vested interests and corporate groups.

Harvard Professor Greg Mankiw has described the cap and trade scheme as a "tax on carbon emissions with the tax revenue rebated to existing carbon emitters, such as energy companies". He describes it appropriately as

Cap and trade = Carbon tax + Corporate Welfare

The other option is of a carbon tax, originally proposed by AC Pigou, and called a Pigouvian Tax. The carbon emissions are a classic negative externality, and the carbon tax would internalize the costs inflicted by the externality producer. The electricity or fuel producer and its consumer will bear the cost of carbon emitted by their actions. Taxing the carbon content of the fuel, or the amount of CO2 emitted per unit of energy, would put a uniform price on carbon emissions. This would align the incentives by discouraging the carbon intensive fuels like coal and oil, and encourage low carbon fuels like natural gas. Further, with a carbon tax, some of the renewable energy sources start looking commercially attractive options.

Prof Mankiw has emerged as one of the foremost advocates of carbon taxes today. He lays out a case for carbon tax in his New York Times, Economic View column, One Answer to Global Warming: A New Tax . He advocates that the tax can be sold politically by sugar coating it with a proposal for lowering payroll or some other tax with a wide base. This tax would transfer the cost of global warming and climate change on to the carbon emission producers - the oil companies and the thermal electricity producers.

Update 1:
Thomas Friedman has thrown in his weight in favor of a Gasoline Tax, that would discourage oil consumption and thereby reduce and even partially reverse the flow of American consumers' money to the oil producers. He quotes Prof Greg Mankiw, “(a Gasoline tax would cause) the price of oil would fall in world markets. As a result, the price of gas to [U.S.] consumers would rise by less than the increase in the tax. Some of the tax would in effect be paid by Saudi Arabia and Venezuela.”

Update 2:
Joseph Stiglitz made a case for a Carbon Tax on the eve of the UN Climate Change Conference in Bali in December 2007, Carbon Taxing the Rich. He writes, "Economic efficiency requires that those who generate emissions pay the cost, and the simplest way of forcing them to do so is through a carbon tax. There could be an international agreement that every country would impose a carbon tax at an agreed rate (reflecting the global social cost). Indeed, it makes far more sense to tax bad things, like pollution, than to tax good things like work and savings. Such a tax would increase global efficiency."

"Polluting industries like the cap-and-trade system. While it provides them an incentive not to pollute, emission allowances offset much of what they would have to pay under a tax system. Some firms can even make money off the deal. Moreover, Europe has grown used to the concept of cap-and-trade, and many are loathe to try an alternative."