Comparison Between Pigouvian Carbon Taxes And Cap-And-Trade

Notwithstanding unequivocal scientific evidence that human pursuits are bringing about climate change, there has been little response by Congress, but there has been some response by the President. In 2006, the Environmental Protection Agency (EPA) made a finding that carbon dioxide (CO2) and other greenhouse gases (GHG) endanger public health and welfare, and in 2010 designated CO2 a pollutant that had to be regulated under the Clean Air Act. , Around the world, policy makers are considering options: command-and-control technology mandates, performance standards, and market-based emissions pricing. Theoretically, emissions pricing – carbon taxes and cap-and-trade – can achieve emissions reductions more efficiently at lower costs than

Unless social marginal costs of externalities are internalized, market equilibrium is not optimal, and the market quantity of output producing emissions will be greater than the socially optimal quantity. By establishing a price for carbon emissions, both carbon tax and cap-in-trade policies induce firms to alter production processes to reduce carbon emissions toward the socially optimal level. Theoretically, covered firms – firms subject to the tax or required to hold emission allowances – face the same emissions price under either tax or cap-and-trade. Under a tax, the emissions price is set directly by the government equal to the marginal external cost. Since the tax is equal to the difference between the firm marginal cost and the marginal social cost curves, profit-maximizing firms choose the efficient socially optimum output. Under a cap-and-trade system, the government sets a limit on economy wide carbon emissions allowed by the most important sources (electric power plants, coal, natural gas, oil, transportation, cement, large manufacturers). That “cap” is dropped over time to reach the target, at the same time coverage expands. The government holds the property right to clean air on behalf of the people, so the government quarterly auctions or gives away allowances to covered firms and others (brokers or traders in the market to speculate for profit, even environmentalists buying allowances to withhold). The secondary market is “critical” to cap-and-trade because it “promotes the emergence of a single market price” so all firms face the same price, which should be the Pigouvian tax rate. As illustrated in Figures 2A and 2B, cost-minimizing firms will reduce emissions up to the point where the marginal cost of emissions abatement equals the price of emissions. Distributional impacts of cap-and-trade