Carbon Tax and Cap-and-Trade System

Introduction

The problem of carbon emission into the atmosphere is highly associated with the greenhouse effect that has become a paradox in the world’s environmental economics. Carbon dioxide gas is one of the heat trapping gases that cause the greenhouse effect in the world. The impacts of carbon emission based on the resultant greenhouse effect include the rising of world temperatures, acid rains, and penetration of ultraviolet rays that are harmful to both human beings and animals. In fact, greenhouse effect is also resulting in floods, storms, and melting of the world snowcaps as witnessed in the Arctic.

Climate patterns of the world are therefore changing with the increase in carbon emission, especially by the industrialised nations such as the US, China, and the European Union. This problem brings the need for controlling of how industries and countries manage their carbon emission. Several intervention measures have been put up to control carbon emission. Some of these measures include carbon tax, cap-and-trade, carbon pricing, carbon credit, emission trading, personal carbon trading, and carbon diet. This paper explores the first two approaches to carbon emission, namely carbon tax and cap-and-trade. Specifically, it will evaluate them and show how they compare.

Carbon Tax

According to Metcalf, carbon tax refers to any tax that is levied on fuels according to their carbon content¹. Carbon tax is charged depending on carbon evaluation results. Hence, it varies per fuel. Carbon tax is one form of carbon pricing that has been adapted by most of the industrialised countries in an effort to regulate carbon emission. Metcalf observes that all hydrocarbons contain carbon². Therefore, all fuels that come from hydrocarbons emit carbon dioxide gas into the environment upon combustion. Since the gas causes a greenhouse effect, environmental scientists recommend carbon tax as an intervention measure. According to Strand, carbon tax is aimed at preventing global warming³. It provides a cost effective method of minimising the emission of greenhouse gases. The greenhouse gas that is emitted by fossils as they burn is an indicator of the amount of carbon that a particular fossil fuel contains. Carbon tax is levied at any stage of its cycle.

Cap-and-Trade

Cap-and-trade is also referred to as emission trading. According to Hasegawa and Salant, cap-and-trade refers to the placing of legal limitation on the amount of pollutants that an industry can emit⁴. Cap-and-trade offers economic incentives to industries or economies that are able to minimise their pollutant emissions. Cap-and-trade has been adapted by various countries of the world in their effort to contribute to the reduction of greenhouse gasses that their industries emit to the atmosphere. Individual governments of different countries carry out regulation of pollutant emission. Governments are charged with the responsibility of setting the cap on pollution amount within their jurisdiction. This cap regulates the amount of pollutants that different industries can emit into the environment.

For example, Conefrey, Fitz, and Malaguzzi affirm that the government of California has its own scheme on carbon emission⁵. Moreover, the government of New Zealand has its own scheme of pollutant production. After setting the cap on pollutants emission, the governments of respective countries then sell the units in the form of emission licenses to different industries. Cap permits are also sold as secondary markets. In this form of cap and trade, firms purchase emission permits either directly from the government or through financial bodies such as banks. In the trading of emissions, permits are also granted to industries that intend to carry out higher emissions than their cap purchase emission credits can allow as opposed to industries that have lower emission levels. Hasegawa and Salant claim that trading of emission credits can also occur across international borders⁶. For example, in the European Union foreign emission permits are traded. In this trade, the seller earns money for reducing his or her pollutant emission while the other seller pays money for his or her increased or higher emissions. Cap trading is common in the European Union under the European Union Emission Trading Scheme (ETS).

Evaluation of Carbon Tax

Metcalf affirms that David Gordon first proposed carbon tax in 1973. Since this period, many countries have moved to implement carbon tax in their industries⁷. As a form of tax that is levied on pollution, carbon tax requires countries that levy it to enact laws that guide the process of their implementation. Carbon tax is therefore considered a Pigouvian tax since it constitutes an externality that affects third parties. Such tax is charged according to the marginal damage that is done to the third party, which in this case is the negative externality of carbon dioxide to the environment. Various evaluation approaches have been adapted across the world.

Assessing the social cost of carbon

Strand asserts that carbon tax can be estimated using the social cost of carbon⁸. In this approach, estimations are made on the marginal cost of every one ton of carbon dioxide that is released to the environment at a certain time. Elliot et al. confirm that evaluation begins by analysing the amount of carbon in the atmosphere at a given point together with its effects on climate⁹. This assessment will indicate the effects of every ton of carbon dioxide that is released into the environment at a given time on climate change. Although a discount on the impact of carbon emission is allowed due to time variations, comprehensive and market-compliant social cost of carbon estimations can be used in the setting of carbon tax. However, various scholars have challenged the social cost of carbon approach with the argument that it is affected by market variation. With effects of variations in markets, the social cost of carbon estimation is therefore unstable and an erroneous method of basing carbon tax.

Calculation of the quantity of pollution that emanates from carbon dioxide is estimated by measuring its mass. Scientists will therefore measure the mass of carbon dioxide molecules that are emitted into the environment. The results give a quantity of carbon dioxide that is referred to as a ton of carbon dioxide. Estimations of the amount of carbon dioxide to be taxed are therefore made per ton. Elliot et al. observe that some scientists only calculate the population of carbon atoms that are present in pollution¹⁰. This process involves calculating the weight of carbon molecules whilst eliminating oxygen atoms. The resultant amount is a ton of carbon that is equal to four tons of carbon dioxide. However, scientists and environmentalists continue to debate about the accuracy of the SCC as a basis of carbon tax.

A wide standard deviation is observed between the actual values and the estimated values of the total amount of carbon that is emitted into the environment by a particular industry within a given time. The wide disparity is associated with lack of consensus by environmental scientists on various aspects of climate change. For example, scientists continue to differ on the amount of carbon that can eventually cause climate change. In addition, different countries accord varying discount rates on carbon emission, thus making the calculations inconsistent. However, efforts to regulate and standardise social cost of carbon evaluation are ongoing. They are expected to develop better results. Countries that apply the social cost of carbon evaluation in levying tax on carbon emission are more focused on the impact of carbon emission on their environment than on the accuracy of the method. Environmentalists also claim that social cost of carbon is more accurate within a country than across international borders since the environment is relatively similar.

Assessment of Carbon Leakage

Elliot et al. assert that the international community is also concerned with carbon leakage¹¹. Carbon leakage refers to the impact that regulations of carbon release in one country can have on another when there is a difference in regulation. Strand further asserts that carbon leakage has both negative and positive impacts¹². For example, spill over results in a drop in the overall effectiveness of reducing the total emission. According to Barclay, in the evaluation of carbon leakage, the total impact should be arrived at through an analysis of both short-term and long-term effects¹³.

The impact of short-term leakage, for example in the developing countries, may seem minimal. However, when combined with the increased emission from industrialised countries, short-term leakage causes a lot of harm. In the developing countries, there may be positive leakages since such countries have a low demand for fossil fuels compared to developed nations. Developed nations are also able to meet their energy demands through substituting fossil fuel with coal. This plan reduces their carbon emission significantly. Developed nations are therefore required to give incentives to developing nations to cover for carbon leakage.

Use of Border Adjustments, Tariffs, and Bans

According to Luo and Tang, there has been an outcry by the international community for border adjustments, tariffs, and bans since there is a variation in carbon tax¹⁴. Some countries are keen to levy carbon tax while others do not. Barclay observes that the international environmental concern groups have therefore called for the application of tariffs, tax, and trade bans on countries that do not exercise carbon tax¹⁵. The premise is that if border tax is levied, it can cover carbon emissions that result from imported goods that come from countries that do not levy carbon tax. Carbon tax can also be pushed through trade bans or enactment of tariffs on countries that have not enacted policies on carbon tax. However, such acts can be strenuous to a country that does not levy carbon tax, especially at a point where the World Trade Organisation (WTO) has not enacted any laws on how taxes on climate pollution should be levied.

Taxing Petroleum Products

Luo and Tang further assert that carbon emission can also be evaluated directly through the amount of petroleum products that are consumed in a country¹⁶. Products such as gasoline, diesel, jet fuel, and petrol are taxed. Each product is charged according to the amount of carbon in it. However, the effectiveness of taxation on petroleum products is questioned since prices of petroleum have not deterred people from consuming more of these products. Development of lower energy consuming vehicles can work better.

Evaluation of Cap-and-Trade

Hasegawa and Salant affirm that cap-and-trade is the most applicable method of controlling carbon emission, which is the major cause of global warming¹⁷. In the emission trading system, every member country assesses the carbon emission level in its environment. Besides, it assigns a cap as a starting point that is used as an indicator of the expected carbon production reduction for a country. Industries are then required to buy carbon emission limits as licenses from the government. Nishida and Hua confirm that industries and countries are allowed the option of reducing their carbon emission to earn more credit¹⁸.

Besides, they can allow their carbon emission to remain high above the cap, although they will have to continue buying carbon credits from other industries or nations, which have an excess of such credits. The checkpoint for the cap-and-trade is that every participant should always have carbon credit for its emission at any one point, regardless of whether a party acquires it directly from the government or purchases it from other nations or industries. A uniform and targetable carbon emission can therefore be arrived at and maintained through this regulation since it can be calculated to a total of all the issued caps. Caps are then lowered continually by individual nations in efforts to reduce total emissions. There are various methods of evaluating the cap-and-trade.

Market-based and Least-cost

According to Nishida and Hua, cap-and-trade is one of the market-based methods of controlling carbon emission that is recommended by environmentalists¹⁹. Emission trading is preferred due to its ability to incorporate technological development levels of a country and its geographical location. The use of trade caps gives the freedom of choice to individual companies. For example, after the government set the cap to be followed by industries in particular areas, the industries have had the choice to reduce their emission and/or comply with the license they buy. They have also had the option to remain at a higher level by purchasing carbon credit from others. In a market-based evaluation, if a company fails to comply with the regulation, governments or regulatory bodies must punish it. It can have its cost of production increased. Firms that have lower emission credits are at an advantage since they can gain income from the sale of extra credits to companies that have higher carbon emissions tickets.

Emission Markets

According to Repetto, emission credit trading is common in carbon trading systems²⁰. In this trade, one carbon emission credit is equivalent to one ton of carbon dioxide. These credits are also referred to as Kyoto units or certified emission reduction units. Individual industries are allowed to sell them either within the country or across borders. Yakao observes that when carbon credits are transferred from one country to another, they have to comply with the regulation of the United Nations Framework Convention on Climate Change (UNFCCC)²¹. However, transfer of carbon credits by nations that lie within the European nations must also be compliant with the framework of its commission. Carbon credits are priced in terms of Euros per carbon ton. It is now easy for nations or industries that want to purchase carbon credits since there is a spot market that provides contacts for industries that want to sell their carbon credits. This accessibility ensures a balance of carbon emission in the world.

Various organisations have cropped up to facilitate carbon credit trade under the United Nations. They include NASDAQ OMX commodities Europe, European energy exchange, commodity exchange Bratislava, European climate exchange, and PowerNext. Online markets are also available where traders can access buyers and sellers, for example in CantorCO2e. In fact, the sale of emission permit has grown rapidly in Europe and the United States. It is also estimated that trade in carbon will be one of the biggest areas of trade in the future. It is important for countries to adopt the cap-and-trade approach since carbon dioxide emission into the atmosphere will eventually have a detrimental effect on human beings.

Cap-and-trade helps in predicting, analysing, and protecting the world environment from excessive pollution. Carbon is one of the major greenhouse gases. Greenhouse gases cause the weathering of the Ozone layer of the stratosphere, thus resulting in the penetration of ultraviolet rays to the earth. These rays have detrimental health effects. For example, they may cause skin cancer, aging, destruction of immune system, and damaging of the eyes. If the world will be able to reduce the amount of carbon gases that are emitted into the atmosphere, there will be a reduction of these health effects. According to Yakao, the cap-and-trade method of reducing carbon emission has been given credit since the Ozone layer is already recovering²². In fact, by 2060, it is projected that the layer will be back to the size it had before the 1980s.

Comparison of Carbon Tax and the Cap-and-Trade

Similarities and differences between carbon tax and the cap-and-trade are evident. In some cases, the two methods of reducing carbon dioxide emission into the environment are applied concurrently. According to Conefrey et al., carbon tax involves levying taxes on all carbon fuels according to the amount of carbon dioxide they emit into the environment²³. This process ensures that all industries and imports that have emitted carbon are taxed. Carbon tax system also charges carbon-emitting substances at any stage of their cycle. Carbon tax method is preferred by some governments due to its ability to raise government revenue. For example, the government is able to levy taxes to all fuels such as petrol, diesel, jet fuel, and other products that emit carbon upon combustion. Imports that contain carbon are also subjected to carbon tax, thus earning the government huge revenue.

Carbon tax is criticised for its inconsistence with the technological development of the environment in which it is levied. The economic development level of a country is important in determining the amount of carbon tax that can be levied in an environment. However, carbon tax ignores all other factors. It institutes a standard tax for all products that emit equal amounts of carbon dioxide into the environment. Barclay asserts that the carbon tax method does not also consider the needs of individual industries in levying tax²⁴. For example, a higher amount of carbon products that a company uses implies that it will also pay a higher amount of taxes. This plan only benefits the government but not the individual players in the industry. Environmental scientists also debate on the calculation of carbon molecules in a particular fossil that is used in levying carbon tax across the world.

On the other hand, the cap-and-trade is implemented by setting a limit on the amount of carbon dioxide that an industry can release into the environment. The government then sells the cap limits as licenses to industries that emit carbon into the environment. This method has been preferred by most of the countries in the world since it considers individual industrial players as compared to carbon tax. A company that has low economic turnover can buy carbon credits that are equal to its carbon emission. Repetto asserts that industries that release more carbon dioxide than their licenses permit can trade and buy more carbon credits from companies that have extra credit²⁵. This plan benefits small emitters and buyers. Lower carbon dioxide emitters gain income from the sale of extra Kyoto credits to higher emitters. This trade benefits individuals. Moreover, the government also earns revenue through the selling of license. The use of emission trading is also pivotal in estimating, calculating, and regulating global carbon levels since they are predictable.

Conclusion

One of the major problems that are facing environmental economics is the control of carbon emission. Increase in industrialisation across the world has amplified the need to control carbon emission. Methods such as the cap-and-trade and carbon taxes have been implemented to counter negative effects of carbon emission such as global warming. Carbon tax involves tariffs on all carbon dioxide emitters. The approach is implemented though the evaluation of social cost of carbon, carbon leakage, border adjustments, tariffs and bans, and taxing petroleum products. Cap-and-trade involves the placement of limits on the amount of carbon that an industry can emit. If an industry wants to emit more, it has to purchase carbon credits from industries that emit less. This method is implemented through market-based, least-cost, and emission markets.

Bibliography

Barclay, Richard. “Regulatory Economics: Saved by the Carbon Tax?” Natural Gas & Electricity 29, no. 4(2012): 31-32.

Conefrey, Thomas, John Fitz, and Laura Malaguzzi. “The impact of a carbon tax on economic growth and carbon dioxide emissions in Ireland.” Journal of Environmental Planning & Management 56, no.7(2013): 934-952.

Elliot, Joshua, Ian Foster, Sam Kortum, Todd Munson, Fernando Pérez, and David Weisbach. “Trade and Carbon Taxes.” American Economic Review 100, no. 2 (2010): 465-469.

Hasegawa, Makoto, and Stephen Salant. “Cap-and-trade programmes under delayed compliance: Consequences of interim injections of permits.” Journal of Public Economics 119, no. 1(2014): 24-34.

Luo, Le, and Qingliang Tang. “Carbon tax, corporate carbon profile and financial return.” Pacific Accounting Review 26, no. 3(2014): 351-373.

Metcalf, Gilbert. A Green Employment Tax swap: Using a Carbon Tax Swap to Finance a Payroll Tax Relief. Washington, DC: World Resources Institute, 2007.

Nishida, Yuko, and Ying Hua. “Motivating stakeholders to deliver change: Tokyo’s Cap-and-Trade Programme.” Building Research & Information 39, no. 5(2011): 518-533.

Repetto, Robert. “Cap and Trade Contains Global Warming Better Than a Carbon Tax.” Challenge 56, no. 5(2013): 31-61.

Strand, Jon. “Strategic climate policy with offsets and incomplete abatement: Carbon taxes versus cap-and-trade.” Journal of Environmental Economics & Management 66, no. 2(2013): 202-218.

Yakao, Yasuo. “Policy learning and diffusion of Tokyo’s metropolitan cap-and-trade: making a mandatory reduction of total CO 2 emissions work at local scales.” Policy Studies 35, no. 4(2014): 319-338.

Footnotes

1. Gilbert Metcalf, A Green Employment Tax swap: Using a Carbon Tax Swap to Finance a Payroll Tax Relief (Washington, DC: World Resources Institute, 2007), 4.
2. Metcalf, 7.
3. Jon Strand, “Strategic climate policy with offsets and incomplete abatement: Carbon taxes versus cap-and-trade,” Journal of Environmental Economics & Management 66, no. 2(2013): 204.
4. Makoto Hasegawa, and Stephen Salant, “Cap-and-trade programmes under delayed compliance: Consequences of interim injections of permits,” Journal of Public Economics 119, no. 1(2014): 25.
5. Thomas Conefrey, John Fitz, and Laura Malaguzzi, “The impact of a carbon tax on economic growth and carbon dioxide emissions in Ireland,” Journal of Environmental Planning & Management 56, no.7(2013): 934..
6. Hasegawa and Salant, 26.
7. Metcalf, 6.
8. Strand, 203.
9. Joshua Elliot, Ian Foster, Sam Kortum, Todd Munson, Fernando Pérez, and David Weisbach, “Trade and Carbon Taxes,” American Economic Review 100, no. 2 (2010): 465.
10. Elliot et al., 467.
11. Elliot et al., 467.
12. Strand, 206.
13. Richard Barclay, “Regulatory Economics: Saved by the Carbon Tax?” Natural Gas & Electricity 29, no. 4(2012): 31.
14. Le Luo, and Qingliang Tang, “Carbon tax, corporate carbon profile and financial return,” Pacific Accounting Review 26, no. 3(2014): 353.
15. Barclay, 32.
16. Luo and Tang, 354.
17. Hasegawa and Salant, 25.
18. Yuko Nishida, and Ying Hua, “Motivating stakeholders to deliver change: Tokyo’s Cap-and-Trade Programme.” Building Research & Information 39, no. 5(2011): 519.
19. Nishida and Hua, 520.
20. Robert Repetto, “Cap and Trade Contains Global Warming Better Than a Carbon Tax,” Challenge 56, no. 5(2013): 34.
21. Yasuo Yakao, “Policy learning and diffusion of Tokyo’s metropolitan cap-and-trade: making a mandatory reduction of total CO 2 emissions work at local scales,” Policy Studies 35, no. 4(2014): 322.
22. Yakao, 323.
23. Conefrey et al., 952.
24. Barclay, 32.
25. Repetto, 42.