Carbon taxes and cap-and-trade programs are both touted as economically sound approaches to reducing carbon emissions. Cap-and-trade systems are being promoted by some large corporations and several major environmental organizations. Why is a carbon tax preferable?

Carbon taxes are superior to cap-and-trade programs for six fundamental reasons:

1. Carbon taxes will lend predictability to energy prices, whereas cap-and-trade systems will do little to mitigate the price volatility that historically has discouraged investments in less carbon-intensive electricity generation, carbon-reducing energy efficiency and carbon-replacing renewable energy.
2. Carbon taxes can be implemented much sooner than complex cap-and-trade systems. Because of the urgency of the climate crisis, we do not have the luxury of waiting while the myriad details of a cap-and-trade system are resolved through lengthy negotiations.
3. Carbon taxes are transparent and easily understandable, making them more likely to elicit the necessary public support than an opaque and difficult to understand cap-and-trade system.
4. Carbon taxes can be implemented with far less opportunity for manipulation by special interests, while a cap-and-trade system’s complexity opens it to exploitation by special interests and perverse incentives that can undermine public confidence and undercut its effectiveness.
5. Carbon taxes address emissions of carbon from every sector, whereas cap-and-trade systems discussed to date have only targeted the electricity industry, which accounts for less than 40% of emissions.
6. Carbon tax revenues can be returned to the public through progressive tax-shifting, while the costs of cap-and-trade systems are likely to become a hidden tax as dollars flow to market participants, lawyers and consultants.

Carbon Taxes Will Lend Predictability to Energy Prices. With carbon taxes ramped up through a multi-year phase-in, future energy and power prices can be predicted with a reasonable degree of confidence well ahead of time. This will make it possible for literally millions of energy-critical decisions — from the design of new electricity generating plants to the purchase of the family car to the materials used in commercial airframes — to be made in full recognition of carbon-appropriate price signals. In contrast, the primary virtue of cap-and-trade systems — that future levels of carbon emissions can be known ahead of time — is of questionable value, since there is no agreed-upon trajectory of emissions that can achieve climate stability and prevent disaster. The real target for which the U.S. must aim is to reduce carbon emissions as much as possible, and then more.

Carbon Taxes Will Provide Quicker Results. The taxes themselves can be designed and adopted quickly and fairly. Cap-and-trade systems, by contrast, are devilishly complex and will take years to develop and implement. Key issues must be addressed intellectually and resolved politically; the proper level of the cap, timing, allowance allocations, certification procedures, standards for use of offsets, penalties, regional conflicts, the inevitable requests for exceptions by affected parties and a myriad of other complex issues must all be resolved before cap-and-trade systems can be implemented. During this time, polluters will continue to emit carbon with no cost consequences.

Carbon Taxes Are Transparent and Easier to Understand than Cap-and-Trade. A carbon tax is transparent and easy to understand; the government simply imposes a tax per ton of carbon emitted, which is easily translated into a tax per kWh of electricity, gallon of gasoline or therm of natural gas. By contrast, the prices for carbon set under a cap-and-trade system will vary with market fluctuations and be impossible even for big business (let alone small businesses or consumers) to predict. A cap-and-trade system will require a complex and difficult to understand market structure in order to balance the many competing interests and ensure that the trading system minimizes abuse and maximizes real carbon reductions.

A Carbon Tax’s Simplicity Inoculates it Against the Perverse Incentives and Potential for Profiteering that Will Accompany Cap-and-Trade. In contrast to the simple and straightforward process of implementing a carbon tax, the protracted negotiations necessary to implement a cap-and-trade system will provide constant opportunities for the fossil fuel industry and other invested parties to shape a system that maximizes their financial self-interests as opposed to an economically efficient system that maximizes societal well-being. If allowances are allocated based on some type of baseline reflecting past pollution (which has been the practice with NO_x and SO₂trading programs), rather than being auctioned, polluters will have perverse incentives to maximize emissions before the cap-and-trade system goes into effect in order to "earn" those pollution rights. (The voluntary carbon cap-and-trade system currently operating has already been criticized for questionable offsets that have produced huge profits but little environmental benefit. See Outsize Profits, and Questions, in Effort to Cut Warming Gases, New York Times, Dec. 21, 2006.)

Carbon Taxes Address All Sectors and Activities Producing Carbon Emissions. Carbon taxes target carbon emissions in all sectors — energy, industry and transportation — whereas at least some cap-and-trade proposals are limited to the electric industry. It would be unwise to ignore the non-electricity sectors that account for more than 60% of U.S. CO₂ emissions.

Carbon Taxes Can Produce a Far More Equitable Result than Cap-and-Trade. As discussed in our Issue Paper Softening the Impact of Carbon Taxes, carbon taxes can be used to fund progressive tax-shifting to reduce regressive payroll or sales taxes. The costs of cap-and-trade systems, both implementation and the costs incurred as more expensive technologies replace older and less expensive coal-fired combustion, are far more likely to be imposed upon consumers with less possibility of rebating or tax-shifting. Moreover, because cap-and-trade relies on market participants to determine a fair price for carbon allowances on an ongoing basis, it could easily devolve into a self-perpetuating province of lawyers, economists, lobbyists and other market participants bent on maximizing their profits on each cap-and-trade transaction. As Holman W. Jenkins, Jr. stated in his Jan. 24 Wall Street Journal "Business World" column (subscription only):

General Electric, DuPont, Alcoa, Caterpillar and other industrial pigpens this week endorsed cap-and-trade limits on carbon dioxide, which would turn their established habit of using the atmosphere as a free waste disposal into a property right, worth billions. Talk about a low-hanging fruit. They are accustomed to treating carbon dumping as a gimme. Now they’d at least be in a position to get paid for dumping less.

The dollars that will be funneled into making the market work could be better spent reducing regressive taxes, protecting poorer households and/or helping consumers use less energy.