What's the Best Way to Price Carbon Emissions: Cap and Trade, Cap and Dividend, or Carbon Tax?

coal power plant photo
photo: Jeffery DelViscio via flickr

With all the talk about getting the United States off of oil, energy independence, creating a low-carbon future, et cetera, one of the key parts of that is reducing carbon emissions, whether they are from electricity, transportation or wherever they occur. Central to that is setting a price on carbon emissions. What options are there to do this?

Cap and trade may be the main option being considered, but both a cap and dividend approach, as well as a carbon tax have their vocal proponents. Let's take a look at each:paris traffic at night photo
While France recently tried to establish a carbon tax, it ultimately didn't win support due to loopholes in the proposal which allowed many large sources of pollution to go un-taxed. Photo: Nelson Minar via flickr.

The Goal of All These: Pricing Pollution

Before that though, let's detour into the wonk world for a few paragraphs. Whichever of these economic mechanisms is used, the goal is essential the same: Incorporating the price of externalized pollution (carbon emissions) into the price paid for goods--whether that good is something tangible like gasoline, a new computer, or food imported from thousands of miles away, or something less tangible like electricity.

By doing this you've made those goods which are less polluting to produce and use less expensive in comparison to those which are more polluting (i.e. emit more carbon in their manufacture and use).

Using electricity as the example: Provided the price on carbon is high enough, electricity produced from a source with high carbon emissions such as coal increases in price, while electricity from, say, solar power, doesn't see a price increase. This in turn encourages further development to make low-carbon sources less expensive and to find ways to make polluting sources less polluting.

These prices then filter down to all goods and services. While it won't happen overnight, items which are less polluting will naturally assume a greater role as those which are polluting become more expensive. For the average person, whether or not they are deeply concerned about the environment, choosing the more eco-friendly option becomes the norm based on price along.

Back to our options....

european union flag photo
Though there have been some well-publicized problems with it and some growing pains, the EU emissions trading scheme is cited as a robustly functioning system. That said, whether or not nations under the program meeting their Kyoto Protocol commitments have done so because of the scheme or because recession slowed economic activity more broadly is a debatable point. Photo: Rock Cohen via flickr.

Cap and Trade

In practice cap and trade is much more complex than in theory (what isn't?), but the idea is pretty simple.

A given amount of carbon dioxide permitted to be emitted by regulated sources is established by the government. Anything above that results in fines. That's the cap. This is set at a certain level to start with, below current levels, and then (in hopefully predictable intervals so that no one is caught off guard) lowered over time to further reduce pollution. Also hopefully, these levels are dictated by the best scientific recommendations and not by the polluting industries themselves.

Permits for emissions are created and distributed to industry. Each allows a certain amount of emissions. They can be either auctioned off, given aways for free based on historic levels of pollution, or some combination of these.

If a company can reduce its pollution below the amount of credits it has, it can trade (sell) those credits to companies who aren't doing as good a job in reducing their own emissions, thereby avoiding the fines for going over the cap.

In doing this you create a financial market which money can be made off trading the pollution permits--which hopefully can then be plowed back into further research and development--while at the same time providing a direct financial incentive for polluters to clean up their act.

WATCH VIDEO - Planet 100: Cap and Trade Explained

The great advantage of this system is perhaps more political than theoretical: Rightly or wrongly, cap and trade is often perceived as the most market-based solution to pricing carbon. Politicians and industry far prefer anything tarred with the 'market-based' brush than other options. Plus the creation of a emissions-trading market means there's money to be made by financiers.

This is also the exact reason why a number of high profile environmentalists and economists, not to mention activists, are opposed to cap and trade. There is the feeling that the creation of this sort of market is just more financial tinkering, is rife for exploitation by bankers and industry, and is too much of the same sort of thinking that resulted in the recession of 2008-2009. It's just a handout to big business.

The political realist counter to that is cap and trade is simply the only option that has even a small chance of passing in Congress, and setting a price on carbon is the most important thing.

san francisco traffic photo
Cap and trade may be in the ascendent, but cap and dividend proposals have come up at both the national and state level. One proposed in California would see 75% of the revenue being returned to state residents--up to $1000 a year for a family of four--with the balance being used by the state to help industry cut emissions and develop low-carbon technology. Photo: Wonderlane via flickr.

Cap and Dividend

Cap and dividend is similar to cap and trade with a couple very important distinctions.

First, all the pollution permits established by the government are auctioned off rather than given away to industry. Polluters have to purchase the right to pollute--again, based on levels that are initially slightly below current levels and then decreasing over time. If you can improve your production methods so that you have fewer carbon emissions, then it simply costs you less to do business.

Second, and this is the biggest difference, the money generated by the auction of pollution permits--either all of it, as proposed by some advocates of cap and dividend, or a portion of it, as has been considered by some state-level programs--is then returned to tax-payers as a dividend. This is intended to offset any initial increases in prices of consumer goods and services.

As Bill McKibben described it a year ago:

So the soundest proposal, probably, is to take that money, and write a check to everybody in the country every six months... Here's your climate check. Your share of the sky. Just the way that Alaska writes everybody a check every year for their share of oil revenues in the state. [...] It's not a perfect system, but if you game it out politically, it is probably the best chance we have.

maryland state flag photo
Not all carbon taxes have to be set at a national level. One Maryland county recently established a carbon tax, structured in such a way that currently only a lone 850 MW coal-fired power plant was affected. Because of the way it is structured, electricity rates are not expected to increase significantly. Money from the program is going towards energy efficiency programs in the county. Maryland state flag photo: Seth Sawyers via flickr.

Carbon Tax

A carbon tax is far more straightforward than either cap-and method, even if in the United States any proposal with the words 'carbon' and 'tax' in close proximity to one another is, bluntly, doomed from the start.

Recent research shows that it's semantics, not principle, that causes the problem. When psychologists presented a range of people with identical programs designed to reduce carbon emissions, one labeled as a 'carbon offset' and the other as a 'carbon tax', the 'tax' was opposed while the 'offset' was not. Again, same exact program, just named differently.

By any other name a carbon tax is the same. Activities which emit large amounts of carbon dioxide, be it production of electricity, refining of gasoline, or production of plastics, are subject to a tax collected by the government. This directly increases the price of polluting goods compared to those which are less polluting. Simple.

The less simple part comes in when you figure out what to do with the revenue of the program.

One solution would be for the government to use the funds to fund research and development of low-carbon energy (since that's where the most change is needed), to assist with jobs training for workers displaced from polluting industries, to build better public infrastructure so fewer people need to drive to work every day and can walk, bike or take better public transportation instead.

Another solution, sometimes labeled 'tax and dividend', is to take all the money raised by the tax and then give it back to taxpayers as a dividend to ease the financial burden during the transition towards low-carbon goods and services being the norm. This could be in the form of a check or some sort of tax credit--either, obviously, dependent upon the income of the taxpayer.

One big bonus of this method, its supporters will claim, is that it eliminates the potential for the type of financial speculation that in all likelihood will accompany the creation of a carbon trading market. It takes bankers out of the system. It also sends a powerful symbolic message about what is publicly tolerated in terms of pollution and what is not.

But for those people seeing financial speculation as something not necessarily bad, and believing that that carbon trading market will spur industry to clean up itself more quickly than being told to by government--the assumption being that the free market is inherently more efficient than government dictate--a carbon tax just doesn't do the trick.

Even if it tackles the problem most directly...

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More on Carbon Emissions:
Bill McKibben on Why Cap and Dividend is the Best Approach to Setting a Price on Carbon
Anything But a Carbon Tax! Psychology Reveals How to Better Price Pollution
A Cap and Trade System Could Save US Families $900 a Year
James Hansen Hopes Waxman-Markey Cap and Trade Bill Fails: Has He Lost the Plot?

Tags: Carbon Emissions | Economics | Global Climate Change | Global Warming Solutions | United States


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