cap-and-trade vs. carbon tax in canada

The environment is turning out to be a big issue in the current election campaign. The Liberals, Conservatives, New Democrats (NDP), and the Greens all have a climate change action plan as part of their platforms, and notwithstanding the Conservatives, all parties are proposing that Canada lower emissions by putting a price on carbon. In terms of environmental economics, the two established methods of doing this are to implement a carbon tax or a cap-and-trade system. I’ll assume you know the basics of each approach.

In Canada, The Liberals and Greens both propose a carbon tax while the NDP proposes a cap-and-trade system. So, what’s a better way to put a price on carbon: a carbon tax or a cap-and-trade system? Regardless of the political rhetoric, strictly speaking, the two methods are economically equivalent. They are both taxes on carbon emissions. I think it’s important for Canadian voters to understand this.

Professor Willem Buiter of the London School of Economics explains this equivalence best on his Financial Times blog:

Every cap & trade scheme with an efficient secondary market for [CO2-equivalent] emission permits and a given way of allocating these permits is, from an economic perspective, equivalent to a tax on [CO2-equivalent] emissions and a given way of allocating the revenues from that tax.

Equivalent from an economic perspective means that they have the same effect on incentives and wealth distribution and therefore supports the same allocation of resources.

I also think it’s important for Canadian voters to understand the differences between cap-and-trade and a carbon tax in terms of policy implementation. I’ve done a bit of research on this lately and I’ve summarized some of the main arguments on each side below.

Unknown Variables

Each approach has different unknown variables when it comes to implementation. In a cap-and-trade system, the maximum emission level (the cap) is defined by the regulator and the price of carbon is determined by the market. The price of carbon is unknown in advance of the policy implementation. In a carbon tax system, the price of carbon (the tax) is defined by the regulator and the emission levels are unknown in advance of the policy implementation.

So there are clearly trade-offs in each approach: the maximum emission level defined in advance by the cap-and-trade approach is desirable, as is the predictable price of carbon in the carbon tax system.

Implementation Cost

A disadvantage of cap-and-trade is that it requires creation of a new, secondary market for trading emissions permits. It also needs to be an efficient market for the system to function optimally, which isn’t guaranteed. Furthermore, a cap-and-trade system requires negotiation of an initial allocation strategy for emissions permits, which is likely to be protracted and tedious.

A carbon tax would be easier to implement in this regard: all you have to do is slap a tax on carbon-based fuels. The downside is that a policy with the word “tax” is a hard sell to an uninformed electorate, which makes a carbon tax decidedly more difficult to legislate. I’m quite sure that this legislative difficulty is the reason why both Barack Obama and John McCain advocate a cap-and-trade approach.

Influence of Special Interests

Negotiating the formation of a new market for trading emissions permits and an initial allocation strategy creates ample opportunities for special interests — Canada’s oil sands, for example — to influence a cap-and-trade policy and limit its effectiveness in reducing emissions. The relative simplicity of the carbon tax approach offers little room for such influence.

Regressive or Progressive?

Contrary to a popular belief, one that is held even by some Canadian MPs, a carbon tax is not necessarily a regressive tax. Under a vanilla carbon tax implementation, yes: the tax is regressive because lower income consumers pay a disproportionate amount of their income toward the tax. The key is how the revenues from the tax are invested. If revenues are invested progressively, through rebates for low income earners and personal income tax reductions, for example, the regressive nature of the tax is offset. Carbon tax revenues that are shifted to personal income tax reductions are said to be revenue neutral, which both the Liberals and Greens propose in their platforms.

The same regressive vs. progressive issue applies to a cap-and-trade system: a vanilla cap-and-trade system will effectively impose a regressive tax on consumer goods. If the system involves a public auction of emissions permits, how those revenues are invested determines the progressive or regressive nature of the effective tax on carbon. The NDP cap-and-trade proposal distributes the proceeds of an initial public auction to “green investments”.

The Final Word

Given the time and cost of implementing a cap-and-trade system and the potential influence of special interests that might undermine its effectiveness, I’m inclined toward a carbon tax. In the long run, perhaps a combination of the two schemes will offer an optimal system to reduce emissions in Canada, but in my opinion, we’re already playing catch-up. A carbon tax can be implemented right now and we should have been on this at least 6 years ago when Jean Chrétien’s government ratified the Kyoto Protocol.