A Brief Comparison of Two Climate Change Mitigation Approaches: Cap-and-Trade and Carbon Tax (or Fee)

A Brief Comparison of Two Climate Change Mitigation Approaches: Cap-and-Trade and Carbon Tax (or Fee)

Updated January 12, 2021
A Brief Comparison of Two Climate Change Mitigation
Approaches: Cap-and-Trade and Carbon Tax (or Fee)
Almost all climate scientists agree that greenhouse gas
At the end of each established compliance period (a
(GHG) emission increases have contributed to observed
calendar year or multiple years), covered sources submit
climate change and that continued increases in GHG
emission allowances to an implementing agency to cover
emissions will contribute to future climate change.
the number of tons emitted during the period. Generally, if
Although a variety of efforts seeking to reduce GHG
a source did not provide enough allowances to cover its
emissions are currently underway on the international level
emissions, the source would be subject to penalties.
and in individual states or regional partnerships, federal
policymakers and stakeholders have different viewpoints
Under an emissions cap, covered sources would have a
over what to do—if anything—about GHG emissions,
financial incentive to make reductions beyond what is
future climate change, and related impacts.
required, because they could (1) sell unused emission
allowances to entities that face higher costs to reduce their
For policymakers considering actions to reduce GHG
facility emissions, (2) reduce the number of emission
emissions, various policy options are available. Over the
allowances they need to purchase, or (3) bank emission
last 15 years, many of the legislative proposals have
allowances—if allowed—to use in a future compliance
involved market-based approaches, such as a GHG
period.
emissions cap-and-trade system or a carbon tax or
emissions fee. These particular approaches may be
A cap-and-trade system would create an emissions trading
considered in the 117th Congress and are discussed below.
market. Depending on program design details, emission
The information below provides an overview of two
allowance trading could involve not only sources directly
approaches while briefly addressing their similarities and
subject to an emissions cap but also a range of brokers and
differences.
intermediaries. The federal government oversees existing
emissions trading programs (sulfur dioxide and nitrogen
What Is a Cap-and-Trade System?
oxides) and would likely oversee a GHG program.
A cap-and-trade system is a policy tool that creates a cap on
GHG emissions from selected emission sources while
What Is a Carbon Tax (Emissions Fee)?
providing the sources with flexibility—on-site reduction or
A carbon tax or emissions fee is a policy tool that provides
emissions trading—when complying with the emissions
a financial incentive to reduce GHG emissions by attaching
cap. The cap could apply to the primary GHG emitted by
a price to GHG emissions (CO2 emissions or multiple
human activity, carbon dioxide (CO2), or it could apply to
GHGs) or their emission inputs, namely fossil fuels. The
multiple GHGs, such as methane, nitrous oxide, or
choice of terminology between a tax or fee may have
fluorinated gases. Covered sources in prior legislative
procedural consequences, particularly in terms of
proposals have included major emitting sectors (such as
congressional committee jurisdiction, which could
power plants and specific industries), fuel producers and/or
potentially influence the policy’s design. As many
processors (such as coal mines or petroleum refineries), or
policymakers, stakeholders, and academic journals use the
some combination of both.
term carbon tax, this is the default term in this document.
An emissions cap is partitioned into emission allowances
A central policy choice when establishing a price on GHG
(or permits). Typically, in a GHG cap-and-trade system, an
emissions is the rate of the carbon tax (measured in dollars
emission allowance represents the authority to emit one
per ton of emissions). Several factors could be considered
metric ton of CO2-equivalent—a measure that accounts for
when setting the rate. For example, Congress could set the
different GHG global warming potentials.
rate at a level or pathway—based on modeling estimates—
that would achieve a specific GHG emissions target.
Policymakers may decide to (1) sell the emission
Congress may also consider whether the tax rate should
allowances through periodic auctions, which would
increase over time and, if so, by how much.
generate a new federal revenue stream; (2) distribute
allowances to covered sources at no cost (based on, for
A carbon tax would generate a new revenue stream. The
example, previous years’ emissions); or (3) use some
magnitude of the revenues would depend on the scope and
combination of these strategies. Given that emission
rate of the tax, the responsiveness of covered entities in
allowances have a market value, the distribution of
reducing their potential emissions, and multiple other
emission allowances would likely be a source of significant
market factors. A 2018 Congressional Budget Office study
debate during a cap-and-trade program’s development, as
estimated that a $25/metric ton tax on energy-related and
discussed below.
other GHG emissions would yield approximately $100
billion each year during the first 10 years of the program.
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A Brief Comparison of Two Climate Change Mitigation Approaches: Cap-and-Trade and Carbon Tax (or Fee)
The distribution of this new revenue stream would likely be
Coverage Decisions
a source of significant debate, as discussed below.
Under either approach, policymakers would face a similar
debate regarding scope and applicability. For example,
Similarities Between Approaches
questions such as which emission sources should be subject
Cap-and-trade and carbon tax instruments are market-based
to the program or which GHG emissions to include would
approaches that may be used to reduce GHG emissions. In
be raised with either approach. Policymakers may consider
many ways, a cap-and-trade program and carbon tax would
multiple factors when debating these issues, including
produce similar effects. Both would place a market price on
environmental effectiveness, economic efficiency, costs,
GHG emissions (directly or indirectly), and both would
measurement, available technology, and administrative
increase the relative market price of more carbon-intensive
concerns.
energy sources, particularly coal, which generate greater
emissions per unit of energy. This result could lead to the
Role of Emission Offsets
displacement of these sources with lower carbon-intensive
Many existing cap-and-trade programs allow for the use of
sources, including renewables; spur innovation in emission
emission offsets as a compliance option. In a carbon tax
reduction technologies; and stimulate actions that may
program, policymakers could allow for tax credits for
decrease emissions, such as efficiency improvements.
offset-type projects. An offset is a measurable reduction,
avoidance, or sequestration of GHG emissions from a
Distribution of Allowance Value and Tax Revenue
source not covered by an emission reduction program.
When designing either program, policymakers would likely
Economic analyses have found that offset treatment could
face challenging decisions regarding the distribution of the
have a substantial impact on overall program cost, because
new emission allowance value (which includes both auction
these projects can often reduce emissions at a lower cost
revenues and distribution of no-cost allowances) or tax
than many typically covered sources. However, in existing
revenues. Policymakers could apply the allowance value or
cap-and-trade programs, offsets have generated some
tax revenue to support a range of policy objectives but
controversy and raised concerns, including the credibility of
would encounter trade-offs among objectives. The central
emission reductions from particular offset projects and
trade-offs include minimizing economy-wide costs (often
environmental justice issues more generally.
measured in terms of gross domestic product); lessening the
costs borne by specific groups, particularly low-income
Price Control Versus Quantity Control
households and displaced workers or communities; and
A primary difference between a cap-and-trade system and a
supporting a range of specific policy objectives, which may
carbon tax program is that the former provides emissions
or may not be related to climate change.
certainty, while the latter provides price certainty. In one
sense, preference for a price (carbon tax) or a quantity limit
Economic Impacts
(emissions cap) depends on one’s preference for
A primary concern with either approach regards their
uncertainty—either uncertain emissions or uncertain
potential for economy-wide impacts and disproportionate
program costs. Policymakers can include multiple design
effects on particular demographic groups and specific
elements, such as a price safety valve or auction reserve
industries. The degree of these potential effects would
price, with a cap-and-trade program that may blur the
depend on multiple factors, including the scope of the
distinction between price and quantity control. Similarly, a
program and the use of allowance value or tax revenues.
carbon tax program could include a mechanism by which
policymakers could alter the tax rate if they determine that
Policymakers may have different perspectives on whether
emission reductions are not proceeding at a desirable pace.
estimated economy-wide costs—often measured in terms of
U.S. gross domestic product—are significant. In addition,
Concluding Observations
some would argue that these costs be compared with the
Discussions of cap-and-trade and carbon tax approaches
climate benefits achieved from the program as well as the
often center on their potential advantages in terms of
estimated costs of taking no action. Estimates of climate-
emissions uncertainty and price uncertainty, respectively.
related benefits and costs often contain considerable
The degree to which one approach has an advantage in a
uncertainty and have generated debate in recent years.
particular context, such as transparency or administration,
Either approach may yield disproportionate impacts on
would depend on the designs of the programs being
certain demographic groups, particularly lower-income
assessed. In many cases, these differences may be
households, which spend a greater proportion of their
addressed with specific design elements.
income on energy needs. Congress could address these
Although recent attention has largely focused on market-
impacts by distributing some of the allowance value or tax
based mechanisms, policymakers can address emissions
revenues back to households in some fashion.
with other policy tools, including performance-based
While some domestic industries may thrive, a price on
regulations, which currently apply to motor vehicle
GHG emissions could create a competitive disadvantage for
emissions, or promotion of mitigation technologies, such as
other industries, particularly emission-intensive, trade-
carbon capture and sequestration. These tools could support
exposed industries. Policymakers could address some of the
market-based programs or function independently.
potential concerns, for example, by including a border
adjustment mechanism and allocation of no-cost emission
Jonathan L. Ramseur, Specialist in Environmental Policy
allowances or tax rebates to selected industries.
IF11103
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A Brief Comparison of Two Climate Change Mitigation Approaches: Cap-and-Trade and Carbon Tax (or Fee)

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