Cap and Trade vs. Carbon Tax: Which one should we choose and why?

By Franny Connors

Wildfires that span continents. Floods that submerge countries. Rising sea levels consuming cities. All of these and many more extreme weather events are symptoms of the climate crisis humanity is currently facing. While they may have differing impacts, they all have one thing in common: they were caused by increases in carbon dioxide in the atmosphere. 

The most undisputed fact of the climate crisis is that society needs to drastically reduce carbon emissions. However, the jury is still out on the best way to achieve this goal. Two common methods to reduce carbon emissions are the implementation of a carbon tax or a cap and trade system. These systems are similar in the way that they work with economic markets to incentivize companies to emit less carbon, but they have key distinctions.

A carbon tax sets a flat tax rate on greenhouse gas emissions, typically by taxing the carbon content of fossil fuels. For example, Japan has a carbon tax rate of $2.65/tonne of carbon emitted. Carbon taxes make it more expensive to produce fossil fuels which disincentives producers from making it and consumers from buying it. It instead incentivizes consumers and producers to find alternative energy sources or reduce overall energy consumption, both of which reduces carbon emissions.

A cap and trade system sets a limit on the total amount of carbon the market can emit. Every company gets an allowance for how much carbon they can emit through a carbon credit system. If certain companies want to emit more carbon they can buy carbon credits from other companies or other carbon offset methods.

A key distinction between a carbon tax and cap and trade is how they interact with the market. A carbon tax increases the price of carbon which decreases the demand for carbon by some amount. Ultimately, the government sets the price of carbon, but the free market, producers and consumers decide the quantity of carbon emissions based on how much they value being able to emit, so if the tax isn’t aggressive enough, there could be little change in emissions. On the other hand, a cap and trade allows the government to set the quantity of carbon emissions, and it allows the market to decide the price or value of carbon emissions. In this case, the government has more direct control over the amount of carbon emitted.

Carbon taxes have the potential to be very effective policy tools. The IMF estimates that if the US implemented a $35/ton carbon tax it could meet its emission reduction commitment set at the Paris Climate Agreement. A more aggressive carbon tax starting at $50 and increasing 5% annually would reduce emissions by 26-47% compared to 2005 levels according to a Brookings Institution Report. Another added benefit of the carbon tax is the large tax revenues it generates that can be reinvested into clean energy projects. Brookings estimates that a carbon tax could generate $1.4 trillion in revenue. This money is a huge advantage of a carbon tax over cap and trade since cap and trade does not generate any money for the government.

Cap and trade has been effective at reducing carbon emissions when implemented. California saw a 13% drop in carbon emissions between 2004 and 2016 during its use of a cap and trade system. However, while California companies may have had net reductions of 13% this does not necessarily mean that this reduction happened in California. Because companies can buy carbon offsets from other locations, Berkeley found that there was actually an increase in local pollution in California specifically in disadvantaged communities. Because these companies complied with the cap and trade system, they were not penalized for polluting in the state.

While both carbon taxes and cap and trade systems have the potential to reduce carbon emissions, carbon taxes are the clear winner in most effective policies. That being said, it will take many combinations of policies to reduce carbon emissions and stop the climate crisis.