March 10, 2008

Energy – Emissions Cap and Trade

These systems draw on the power of the marketplace to reduce emissions in a cost-effective and flexible manner. In practice, cap-and-trade systems create a financial incentive for emission reductions by assigning a cost to polluting. First, an environmental regulator establishes a “cap” that limits emissions from a designated group of polluters, such as power plants, to a level lower than their
current emissions. The emissions allowed under the new cap are then divided up into individual permits—usually equal to one ton of pollution—that represent the right to emit that amount.


Plant A emits 600 tons of CO2 each year, and Plant B emits 400 tons, for a combined annual total of 1,000 tons. An environmental agency then establishes a CO2 emissions cap of 700 tons per year (a 30 percent reduction).

Under a traditional approach, both plants could be ordered to reduce their emissions by 30 percent, which would force Plant A to reduce its annual emissions to 420 tons (a reduction of 180 tons) and Plant B to reduce its emissions to 280 tons (a reduction of 120 tons). The cost for each plant to make emission reductions depends on factors such as plant efficiency and the type of fuel used (e.g., coal, natural gas); in this example, it would cost Plant A an average of $50 per ton and Plant B an average of $25 per ton to meet these reductions, for a total cost of $12,000.

Under a cap-and-trade system, each plant seeks out the lowest-cost way to reduce emissions. Initially, Plant B is able to reduce its emissions at a lower cost than Plant A, so it can sell permits to Plant A. However, the more Plant B reduces its emissions, the more expensive it becomes to make further cuts. Eventually, both plants reach a point where their cost to reduce an additional ton of pollution is equal.

The end result of the cap-and-trade system is that the two plants are able to reach the emission reduction goal set under the cap, but at a lower cost. In our example, we calculate a total cost of $9,000—a savings of 25 percent compared with the traditional approach.


There are cases in which other emission reduction approaches are preferable to cap-and-trade. For example, less flexible regulations are more appropriate when the negative impact of pollution is direct and localized (as with asthma) rather than indirect and global (as with climate change). Cap-and-trade systems are also not very beneficial if the polluters have identical costs for reducing emissions, or if policy makers prefer to be more certain about how much the program will cost rather than how much the environment will benefit.

What’s A Carbon Tax?

A carbon tax is a tax on the carbon content of fuels — effectively a tax on the carbon dioxide emissions from burning fossil fuels. Thus, carbon tax is shorthand for carbon dioxide tax or CO2 tax.

Tax vs. Cap - and -Trade

Note: The New York Times’ Nov. 2 on-line piece, The Real Climate Debate: To Cap or to Tax?, is a superb primer on the carbon-pricing debate. CTC’s Charles Komanoff is quoted for the carbon tax side.

  1. Carbon taxes will lend predictability to energy prices, whereas cap-and-trade systems will aggravate the price volatility that historically has discouraged investments in less carbon-intensive electricity generation, carbon-reducing energy efficiency and carbon-replacing renewable energy.
  2. Carbon taxes can be implemented much sooner than complex cap-and-trade systems. Because of the urgency of the climate crisis, we do not have the luxury of waiting while the myriad details of a cap-and-trade system are resolved through lengthy negotiations.
  3. Carbon taxes are transparent and easily understandable, making them more likely to elicit the necessary public support than an opaque and difficult to understand cap-and-trade system.
  4. Carbon taxes can be implemented with far less opportunity for manipulation by special interests, while a cap-and-trade system’s complexity opens it to exploitation by special interests and perverse incentives that can undermine public confidence and undercut its effectiveness.
  5. Carbon taxes address emissions of carbon from every sector, whereas cap-and-trade systems discussed to date have only targeted the electricity industry, which accounts for less than 40% of emissions.
  6. Carbon tax revenues can be returned to the public through progressive tax-shifting, while the costs of cap-and-trade systems are likely to become a hidden tax as dollars flow to market participants, lawyers and consultants.


A key advantage of a cap-and-trade system compared with other emission reduction strategies is that it gives companies flexibility in the manner in which they may achieve their emission targets. Another advantage is that it sets a clear limit on emissions. Traditional approaches often focus on emission rates or require the best available technology, but do not always require that specific environmental goals be met. For example, an emissions tax penalizes polluters but does not guarantee the degree to which the environment will benefit, because some companies might find it easier to pay the tax instead of reducing emissions.

Cap-and-trade systems do, however, exert constant pressure on polluters to reduce emissions while allowing flexibility in the process. This encourages companies to meet (or exceed) their emission targets in the most innovative and cost-effective way possible. By promoting innovation, cap-and-trade systems can help slow the pace of global warming while spurring the development of new technologies and industries that will contribute to the long-term growth of the U.S. economy.

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