Cap and Trade vs Carbon Tax – 6 Myths Busted

In the midst of the debate over exactly what commitments will come out of the Copenhagen Accord follow-up discussions, and how a cap and trade system to incorporate those might work, we asked long time carbon trader Olivia Fussell, the CEO of Carbon Credit Capital in New York, to opine a bit on myths on cap and trade v carbon tax for the layman.  Cleantech Blog has written lots on this topic, but it always needs more. 

Myth 1: A Carbon tax provides much greater price stability than emission trading under a cap and trade system.

This argument is valid only when an emission trading system is designed without banking and borrowing options which allow firms to smooth emissions over time. This in turn contributes to leveling of the price of allowances and creates certainty in the market and thus spurs investment.

Moreover, tax regimes can easily be changed by legislative bodies which in turn can also introduce instability.

Myth 2: A carbon tax is a preferable option because the revenues from taxation can be used to invest in low carbon technology and/or used to offset potential regressive effects of carbon taxes on poorer households.

This argument is valid only with the assumption that allowances are grandfathered in an emission trading scheme. One solution to this potential problem is the auctioning of allowances which can potentially generate the same revenues as a tax.

In addition, governmental funding tends to “pick a winning” technology, whereas technological innovation is needed in many areas (renewable energy, energy efficiency, energy storage, etc). A cap and trade system provides an important incentive for the development of these technologies by providing a price signal that enables firms to capture the value of new technologies. Because cap and trade is not technology specific, it can encourage and accommodate any emerging GHG control technologies or practices.

Myth 3: The introduction of a carbon tax is simpler than an emission trading scheme under cap and trade.

True, an emission trading scheme is much more complicated than taxation. The introduction of a new tax does not require setting up a new system with additional administrative costs attached to it. However, having an international agreement on a global tax is highly unlikely if not impossible. This statement is supported by an example of the unsuccessful attempt to impose carbon tax in the 1990s within its multi-national European Union’s structure. Also the Clinton administration unsuccessfully tried to introduce an energy tax in the mid 1990s but encountered strong opposition in Congress.

Myth 4: A Cap and trade system creates market and environmental uncertainty.

Not true, a tax does not set a quantitative, legally enforceable limit on emissions. On the other hand, a cap and trade system measures, monitors, and achieves a specific environmental objective.

Myth 5: Cap and trade doesn’t work because the European Union Emissions Trading (EU ETS) Scheme did not prove that significant emissions reductions were achieved.

The fact that Phase I of the EU ETS achieved only small reductions in emissions was not due to the embedded flaw in the cap and trade but because the emission cap was set too high. In addition, the EU over allocated allowances. This was mainly due to many countries lacking reliable data monitoring and information standards of GHG emissions when the scheme was first introduced. Since then the EU has solved the problem of monitoring and reporting and tightened the cap for Phase II.

Myth 6: A Cap and trade system allows for ‘windfall profits’ for regulated firms.

It is true that implementation of the trading scheme in the EU led to the increase in retail electricity prices. However, this situation can occur under any type of regulation and it’s not cap and trade specific. The determining factor is not the type of regulation but the ability of a company to pass through the costs to consumers. Based on the EU ETS example, electricity generators were able to make profits because they were able to reflect the value of allowances in prices of electricity, even though they received the allowances for free (‘grandfathering’). This problem can be addressed through the mechanism of allocating allowances and more specifically through auctioning. Regulators would require companies to purchase allowances, and this could ensure that the companies incur direct costs, thus reducing their profit margin. However, this does not solve the problem of passing costs onto consumers. One can solve this by passing the revenues from the auctioning of allowances back to the consumers.

You can reach Olivia for comment at http://www.carboncreditcapital.com/

7 replies
  1. James
    James says:

    Cap/trade is a hidden, volatile and regressive carbon tax. Offsets (horribly difficult to verify) belie the myth that caps "guarantee" emissions reductions. When will the cap/trade crowd take their proposal off life support so we can move on?Why not an explicit, predictable and progressive "net zero carbon tax" with all revenue returned to households?See http://www.carbontax.org

  2. Warren S
    Warren S says:

    The Cap-and-trader has made a good case, but the fact remains that this mechanism is a full-employment scheme for lawyers, acccountants and wall streeters. A carbon tax is sooo much simpler.

  3. Anonymous
    Anonymous says:

    The EU ETS has its problems, but the critics all seem to use the same logic that environmental sceptics use – identify one negative, ignore all the positives and focus on that to throw away the whole scheme. Not to mention that most of the criticisms arise from people not understanding the scheme in the first place.The biggest problem most critics have is that it allows people to make money, and to some people that is a bigger crime than destroying the world. It is nice to see an artical that explains the positives of the scheme in a logical manner, dealing with the criticisms one by one and accepting where they are fair. p.s. you forgot to mention that the awarding for free allowances to companies allows them to sell them in advance, raising capital to invest on green technology at a time when banks are reluctant to load – thus providing a carrot as well as a stick, where a tax would only provide a stick.

  4. Michael
    Michael says:

    Let's get on thing straight. Has there ever been a simple tax? There is no such thing. Look at the French example. Sarkozy's efforts to implement a tax were thwarted by exceptions!I also disagree that a carbon tax is simpler to implement. The same issues of measurement and verification apply to both a cap and trade and a carbon tax. Both require departments of skilled people to regulate the scheme.The biggest difference, not highlighted here, is that a cap and trade allows the market to determine where and at what price carbon emissions will be reduced.Think of the alternative – a government fixed price (Ie a tax). When the times were good nobody would mind paying up for the extra cost of carbon (bad signal for reducing CO2), when economic times were bad the fixed, insensitive price could send an economy into deep recession. Think about the global financial crisis with oil prices fixed at $140. It's likely we would have had a longer and tougher recovery!Visit http://www.climakind.com to see how you can help reduce the cap to help stop damaging climate change!

  5. Bo Tanque
    Bo Tanque says:

    While the writer makes some valid points about cap and trade, addressing its shortcomings with the tools inherent to the system, it ignores some realities. Auctioning in particular is such a case where energy interests have been able to wrest an unbelievable amount of free allowances. Though they are suppose to go down over time, the costs then are passed on to consumers.However, there is one component that the blogger has not addressed about a carbon tax. A well-designed tax would be much more effective in changing consumption behavior, which has been a missing piece of the carbon reduction equation. Particularly for countries where per-capita emissions are high (most developed nations) this would directly link consumption patterns and carbon emissions with a penalty, thus reducing high-emissions consumption.Cap and trade hasn't shown any significant evidence that it has changed consumption behaviors at all. However, it has given rise to a robust wind-powered energy sector as well as other never-quite-there technologies such as CCS. However, so long as we are convinced of the need for perpetual growth and base that growth off of consumption, any new sources of energy generation will be quickly gobbled up.

  6. Mitra
    Mitra says:

    Thanks for this … key point to draw attention to is the part about allowances – if those are allowances are auctioned off, then there is immediately a price on carbon, that supports renewable energy development, and some of the inherent subsidies in allowing polluters to go on polluting are removed. If the allowances are given away then as suggested its a way to give the people who got us into this mess a chance to make even more profits (as in how much do I have to pay you NOT to throw the cigarrette butt on the ground). Instead of giving away allowances we should start asking the question of how much polluting industries should be charged for the cleanup of PAST pollution.

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