cap-and-trade or carbon tax

Human activity is unequivocally responsible for the warming of the planet. Over the last century, the average temperature has gone up by 1 degree Fahrenheit. Although this might not sound like much, it is half the average increase from the end of the last ice age up until the beginning of the 20th century. Sea levels have risen and will continue to do so. Ecological habitats are strained and unable to adapt quick enough to the temperature. Agricultural systems are becoming more and more strained. In short, we need a solution.

The two most common policy proposals circulating are a carbon tax and a cap-and-trade system. A carbon tax simply levies a tax on carbon output. Different taxes measure carbon emissions in different ways, but the tax generally works by charging per ton or per kilogram of carbon output.

A cap-and-trade system allows firms to trade carbon emissions allowances on the market. The government sets an overall emissions ceiling for the entire economy, prints the equivalent amount of emissions allowances, and then lets firms buy and sell them. A lower-emitting firm can sell its allowances to a higher emitting firm. The amount emitted is still at the set level, but the distribution is based upon needs and determined through the market. The U.S. successfully adopted a cap-and-trade system to limit the emissions responsible for acid rain in the 1990s.

As said previously, a cap-and-trade system sets a ceiling for emissions but there will never be any incentive for firms to emit, in sum, less than the ceiling. Imagine firm A emits less than their share and sells their emissions passes to firm B who emits more. This system is efficient since there is no cash left on the table, as it were; no firm could make any more money by selling emissions permits and no firm could emit more. But imagine that the sum of firms emit less than the ceiling. This will mean that there is cash on the table; there are emissions permits with economic value that are going unused. On the assumption that firms would economically prefer to emit than not, it will be to a firms advantage to emit more until equilibrium is reached at the ceiling. This is traditional supply-and-demand reasoning. Any total emissions point below the ceiling which is the government-set equilibrium point will be economically inefficient.

Now consider a carbon tax system. The government can set a tax rate for which firms will want to lower their emissions until the benefits and costs of emitting and paying the tax are roughly equal. This will be different for different firms. The government can perform market research to find the market equilibrium for a carbon tax and set the rate so that the emissions level will be sufficiently low.

In effect, the level of emissions can be capped just the same through a cap-and-trade system as with a carbon tax system.


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