Economics for Today 9th Edition by Irvin Tucker

Exercise 3

HOW SHOULD CARBON EMISSIONS BE REDUCED: CAP AND TRADE OR CARBON TAXES?
Applicable Concepts: emissions trading and effluent taxes
With the great success that was enjoyed until recently in sulfur dioxide trading and the more modest success of trading in nitrous oxides, we may eventually turn to emissions trading to reduce carbon emissions in the United States. In fact, Europe has already instituted such an exchange. In 2005, the European Union instituted a carbon permit system for electric utilities and other major emitters such as steel companies. However, smaller emitters such as smaller industries and nonpoint sources such as automobiles are not covered.
In some ways, carbon would seem ideally positioned for emissions trading. To the extent that it contributes to global warming, the effect is the same regardless of where that emission takes place. Whether carbon is emitted in France, Spain, or for that matter the United States or China, its effect on the global atmosphere is the same. In this way, carbon is a better candidate for trading than is sulfur, which has a greater impact in the vicinity of its release.
But there is increasing questioning of whether or not carbon trading is preferable to a tax on carbon. One contributing argument is the initial European experience was disappointing. Early projections anticipated that carbon contracts would trade for about $50/ton, given the high cost to industry of reducing carbon. By mid-2006, the price of contracts had collapsed to €8/ton (approximately $12). The primary factor for the lower-than-expected price was that numerous national governments had issued enough permits that covered producers did not find it necessary to buy permits. In fact, carbon emissions increased in many countries during the first year of the carbon trading regime.
Since that time, there have been reforms in the trading system, and prices have risen. While price jumped to €30 by the end of 2007, it is now back down to €6 (US $7.25). The possibility that an emissions trading system might not reduce carbon emissions has given impetus to those who argue for a carbon tax.
For those who prefer the tax approach, perhaps the most widespread reason is that the tax will raise revenue. The revenue could provide a double dividend, if it is used to reduce taxes that discourage productive activities, such as the income tax. Of course, the revenues could go toward research and development into carbon-reducing technologies or reduction of the national debt. (Or tax opponents would point out it could simply be wasted on pork barrel projects.) While permits could raise revenue if they were auctioned off, rather than given away, the auction would negate one of the main reasons for favoring permits-that industry is willing to support the permit approach because they do not have to pay for the permits.
Other reasons to favor the tax approach include its ability to be more comprehensive, covering all carbon emissions, rather than being limited primarily to large point sources. It could also be fashioned to include other greenhouse gases, such as methane; farmers, for example, would pay a tax based on the number of cows they owned and perhaps on other animals that emit methane. 1. Jonathan A. Lesser, "Control of Greenhouse Gases Difficult With Cap-and-trade or Tax-and-spend," Natural Gas and Electricity , December 2007, Wiley Periodicals Inc., http://www3.interscience.wiley.com/cgi-bin/jhome/105559587.
Some prefer the carbon tax on equity grounds. Particularly if coupled with a reduction in income taxes, the tax could offer relief to lower-income households. In contrast, the main beneficiaries of giving away permits are stockholders, which may represent wealthier citizens.
The latest twist is that cap and trade has been spurned by the United States with its opponents calling it a disguised tax that will show up in higher prices for all carbon-emitting goods. In a recent court decision, carbon was declared a pollutant, giving the U.S. Environmental Protection Agency the right to regulate carbon emissions. New regulations aimed at carbon will likely mean the end of new coal-fired electric plants. But existing plants will still pour carbon into the air unless there is a program that imposes a cost on all carbon emissions.
What are the advantages and disadvantages of a tax system, as compared to carbon trading?