Carbon tax or Cap-and-Trade? ___________________________________________________________________________

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Economists argue that, if the market is left to operate freely, greenhouse gas emissions will be excessive, since there is insufficient incentive for firms and households to reduce emissions. As such, they recommend applying the polluter pays principle and placing a price on carbon dioxide and other greenhouse gases. This can be implemented either through a carbon tax or a cap-and-trade scheme. Climate change, a case of market failure Many economists have described climate change as an example of a market failure. The adverse effects of greenhouse gases are 'external' to the market, which means there is usually only an ethical, rather than an economic, incentive for businesses and consumers to reduce their emissions. As a result, the market fails by over-producing greenhouse gases. Economists concerned about this market failure argue for policy intervention to increase the price of activities that emit greenhouse gases, thereby providing a clear signal to guide economic decisionmaking and in the same time as stimulating innovation of low carbon technologies. Carbon tax or cap and trade? In order to ensure that emissions cuts are distributed across the economy as inexpensively as possible, economists tend to favor policies that ensure that everyone faces the same price on carbon such as a tax on carbon emissions or a cap-and-trade system. A carbon tax gives firms an incentive to reduce pollution through a tax on each unit of greenhouse gas emissions.

As such, the quantity of pollution reduced depends on the chosen level of the tax. Find the right tax level is a key: too low and firms and households are likely to opt for paying the tax and continuing to pollute. Too high and the costs will rise higher than necessary to reduce emissions, impacting on profits, jobs and end consumers. By contrast, a cap-and-trade system (as the carbon market) sets a maximum level of pollution, the cap, and distributes emissions permits among firms that produce emissions. Companies must have a permit to cover each unit of pollution they produce, and they can obtain these permits either through an initial allocation, or through trading with other firms. Since some firms inevitably find it easier or cheaper to reduce pollution than others, trading takes place. While the maximum pollution quantity is set in advance, the trading price of permits fluctuates, becoming more expensive when demand is high relative to supply for example when the economy is growing) and cheaper when demand is lower (for example in a recession). A price on pollution is therefore created as a result of setting a ceiling on the overall quantity of emissions. Which one is better? There is much discussion about whether a carbon tax or a cap-and-trade system is the best way to put a price on greenhouse gas pollution. The simple answer is that it depends on how each system is designed. The design will determine the environmental and economic effectiveness. Key elements of the design can be for example, to which emission sectors does the system apply and how strong is the

economic incentive (meaning the carbon price). Therefore, both cap-and-trade programs and carbon taxes can work well as long as they are designed to provide a strong economic signal to switch to cleaner energy. Carbon tax has one key advantage: It is easier and quicker for governments to implement. A carbon tax can be very simple and therefore be implemented in just a few months while cap-and-trade systems are much more complex and require more time to develop the necessary regulations, and they are more susceptible to loopholes. However, Cap-and-trade also has one key environmental advantage over a carbon tax: It provides more certainty about the amount of emissions reductions that will result and little certainty about the price of emissions. A tax ensures everyone knows the price being paid for each unit of carbon dioxide emitted, but uncertainty remains about the actual quantity of emissions. A lively debate All the economists agree that it is possible to influence the price of a commodity or its quantity, but not both [3]. Those who supports the cap-and-trade system argue that it is the best solution to establish a quantifiable, legally enforceable limit on emissions which will ensure that essential climate change targets are met at the lowest possible cost. Such a program will accelerate global emissions reductions and provides the private sector with the flexibility required to reduce emissions while stimulating technological innovation and economic growth. Cap-and-trade is already the policy instrument of choice in many US States, the EU, New Zealand and Australia, and has proven to be effective in the US Acid Rain Program. In the other side, the tax system defenders argue that the climate change issue is now such an urgent one that we

need an approach that has an immediate impact on the carbon price and that pollution increase comes from market failure Reliance on the market through a cap and trade-based emissions trading scheme system to solve the greatest market failure ever seen would be the triumph of hope over experience. Cap-and-trade could contribute to a solution, but would have a slower and less certain impact than a carbon tax. Although some critics claim a carbon tax would damage the economy, Sweden's carbon tax is $140 per tonne of carbon pollution. The Swedish Ministry of Environment estimated the carbon tax has cut emissions by an additional 20%. Since the carbon tax was introduced, Sweden's economy has grown by more than 100% and the country recently ranked fourth in the world on economic competitiveness. Decision making are too slow The immediate needs of economic growth seem to push the less short-term need to restrict greenhouse gas emissions into the background. The relevant sanctions will be hard to enforce against any sovereign country that does not wish to comply with the targets. Whichever of these policies is favored to place a price on carbon, they represent just one of a number of policies needed to cut greenhouse gas emission. References [1] US Department of Agricultural and Resource Economics Externalities (1999): Market Failure, and Government Policy. [2] European Commission (2012): The state of the European carbon market in 2012. Retrieved from http://ec.europa.eu/clima/policies/ets/ reform/docs/com_2012_652_en.pdf [3] International institue for sustainable development (2012): Markets, Mmitigation

and Climate Change. Retrieved fromhttp://www.iisd.org/climate/markets/ [4] International Energy Agency (2012): MAKING MARKETS: UNPACKING DESIGN AND GOVERNANCE OF CARBON MARKET MECHANISMS. Retrieved from http://www.oecd.org/env/cc/%28201 2%294%20%20Market%20Mechanisms_AE%20%28 2%29.pdf [5] The Carbon Brief (2013): Warsaw climate talks: Is a carbon market 'toolbox' a precursor to a global deal, or just a waste

of time? Retrieved from http://www.carbonbrief.org/blog/201 3/11/what%E2%80%99s-the-point-of-aglobal-carbon-market%E2%80%98toolbox%E2%80%99/ [6] International Emission Assiciation (2013): Why Emissions Trading is More Effective Than a Carbon Tax. Retrieved fromhttp://www.ieta.org/index.php?option =com_content&view=article&catid=54%3 A3-minute-briefing&id=207%3Awhyemissions-trading-is-more-effective-thana-carbon-tax&Itemid=135

Carbon tax or Cap-and-Trade? -

tax on carbon emissions or a cap-and-trade system. A carbon ... It is easier and quicker for governments to ... 2%29.pdf. [5] The Carbon Brief (2013): Warsaw climate talks: Is a carbon market 'toolbox' a precursor to a global deal, or just a waste.

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