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Carbon Tax vs. Cap and Trade

The best way to start addressing climate change is to yank subsidies from fossil fuels and put a price on carbon dioxide emissions from them. Of the two methods widely discussed for pricing carbon -- cap and trade, and a carbon tax, which is better? Economist Gilbert Metcalf argues his case for a tax.

The January-February 2008 issue of Technology Review has two interesting articles about renewable energy and smart grids. Sandwiched between them is a Q&A with Tufts University economist Gilbert Metcalf about how best to price carbon emissions.

Metcalf argues in favor of a carbon tax over a cap-and-trade system. A tax would be levied on the production of fossil fuels -- coal at the mine, and petroleum at the refinery. An initial tax of $15 per ton of carbon should be used to create a tax credit for individuals, he says, to offset the higher prices they'll pay for goods and services as a result of the tax.

Metcalf admits that a direct carbon tax would not be very effective at reducing transportation emissions. Motor fuel use contributes only about 20 percent of this country's carbon emissions. A tax would add 25 to 40 cents to the cost of a gallon of gas, he says. The impact would be neglibible.

The cheapest place to get initial emission reductions will be from the electric utility sector and from industry, Metcalf says. At $20 per ton, a tax would double the price of coal and add 40 percent to the cost of coal-generated electricity -- bringing renewable energy closer to cost parity.

Metcalf may be right about a tax, but his argument is weak on many points. The basis of his case is that a tax is simpler to administer than a cap-and-trade system. As long as he thinks of the United States as an isolated economy, he's right. But when energy imports (including energy embedded in products) come into the picture, it gets more complicated.

He also argues that a tax is better for utilities because "they need to know what price they are going to face to make [new] plants competitive." But utilities have never known the future prices of commodity fuels. Enron based its business on that fact. The cost of a percentage tax is no more predictable than the price of coal, natural gas, or uranium. Tradable carbon allowances, though, are a commodity -- an uncertainty that utilities know how to deal with -- and a globaly compatible, tradable instrument.

Finally, he says that a cap-and-trade system creates unfamiliar, complicated financial instruments. "I think some of the bloom is off the rose in creating these kinds of instruments," he says, referring to the recent financial and mortgage crisis. "It could make the tax that much more politically attractive."

Tradable carbon allowances can't any get less politically attractive than a new tax. Dr. Metcalf should instead examine ways to repeal tax subsidies that have been granted in perpetuity to fossil fuel industries.

Comments

Cap and trade is no where near as opaque as the "financial instruments" created by Wall Street. Cap and trade worked for SOX and NOX and can work for carbon. Look at the Chicago Climate Exchange as a program that works.

Can someone explain how the Chicago Climate Exchange's business model might be impacted by a Cap and Trade vs. Carbon Tax approach? Is one more favorable than the other in terms of the value of its business model?

I agree: Carbon tax achieves the objective post-haste and seriously.
C&T is more subject to manipulation.

I can find no compelling reason to support "Cap-and-Trade" over a direct carbon tax at source, and many reaons to be against "C&T". Trading adds a huge overhead to the cost of emissions which is essentially a transfer of wealth from energy ratepayers to brokers and speculators (who are the ones promoting it, SURPRISE!). Small generating entities will have no means to participate in a trading scheme (If I eliminate the CO2 emissions from my gas hot water heater by installing a solar water hater, where do I go to get or trade the credits which should be due? With a tax system, I would immediately benefit by no longer buying the fuel.

C&T is a SCAM promoted by traders and brokers, and their captive politicians.