The Truth About Carbon Pricing

Mirror images: carbon taxes and cap-and-trade.
This post is part of the research project: Putting a Price on Carbon

These are exciting times for carbon pricing in the Pacific Northwest. Under the auspices of the Climate Legislative and Executive Workgroup (CLEW), state leaders are, right now, engaged in the first serious look at the subject in years. (Please be sure to attend the hearings on October 23 in Seattle, and December 6 in Olympia!) The work is heavily informed by a recently released report commissioned by the state. It sets a foundation for the important work ahead, but we fear that it makes a few missteps that are unhelpful to policymakers. Our aim is to set the record straight about the benefits (and perils) of carbon pricing.

The truth about carbon pricing—a term that encompasses both carbon taxes and cap-and-trade systems—is that those two policies are two sides of the same coin. Unlike “command and control” policies that directly regulate the economy, “market-based” policies use the power of capitalism to protect the environment. Putting a price on carbon gives businesses and households a powerful financial incentive to reduce their consumption of fossil fuels and other greenhouse gases.

Although there are some (mostly subtle) differences between carbon taxes and cap-and-trade systems, they are more alike than they are different. In this context, efforts by some conservatives to re-label cap-and-trade as “cap-and-tax” makes perfect sense: the point of both of these policies is to make polluting more expensive. For the most part, whatever you do with one you can do with the other. (In particular, you can do either one well, and you can do either one badly.)

And that brings us to the state task force report, produced by the consulting firm SAIC. (Our comments refer to the original SAIC report, which can be found here, but they are also relevant to the updated report released more recently.)

First, the good news about the report: the treatment of carbon taxes is pretty reasonable. The analysis notes that carbon taxes will increase fossil fuel costs for households and businesses, but also points out that carbon tax revenues can be “recycled” by reducing property taxes, sales taxes, and B&O business taxes in a way that will help offset impacts on households and businesses. This kind of “revenue-neutral tax swap” was pioneered in British Columbia in 2008 and the result has been widely recognized by economists as the best climate policy in the world. Carbon emissions have fallen faster than in the rest of Canada, the provincial economy has grown faster than in the rest of Canada, and British Columbia now has some of the lowest personal income tax rates in Canada and some of the lowest corporate income tax rates in the rich world. The BC carbon tax is not a free lunch—as intended, fossil fuel prices have gone up—but it is good value for money, and the evidence shows that it’s a win-win for the environment and for the economy.

Now the bad news: the SAIC treatment of cap-and-trade ignores the fundamental similarities with carbon taxes.

The report notes that “revenue generated by the state [through permit auctions] can be invested based on state priorities,” just as carbon tax revenue could. But the report is less straightforward about where that revenue will come from, asserting in one place that “many of these costs can be passed on to customers” and in another that “there is no consensus among studies as to whether cap and trade would increase or decrease personal income.” Without wading too far into the complexities of the many possible flavors of cap-and-trade programs, let’s just state the obvious: if the program generates revenue, that revenue has to come from somewhere. And that somewhere—just like with a carbon tax—is going to be a combination of households and firms who will pay more to pollute.

In a few other places, too, the SAIC report seems to give the two policies unequal treatment in ways that we find concerning. For example, the authors estimate that a $50 per ton carbon tax would reduce CO2 emissions by 5 million tons in 2035. They also estimate that a cap-and-trade system would reduce emissions in that same year by over 17 million tons, yet they neglect to mention what permit prices would have to be in order to achieve such a reduction. Clearly, the figure would have to be much higher than the $50 per ton that SAIC uses as a high-water mark in the report.

Elsewhere, in a discussion of “complementary policies”—regulations independent of the core market-based pricing system—SAIC categorizes them as “complements” to cap-and-trade systems but as “partial diminishments” to carbon tax systems. This doesn’t make much sense. In reality, complementary policies in sectors of the economy covered by a cap-and-trade program will not yield additional emissions reductions. That’s because a binding limit on emissions can be both a ceiling and a floor: you won’t get more emissions than the cap specifies, but as long as the cap is binding you won’t get fewer emissions either unless the program is specifically designed to withhold permits if demand falls to very low levels. (Complementary policies can, however, reduce cap-and-trade permit prices, potentially making the program cheaper if those complementary policies are smart and lower-cost than market-based options.) On the flip side, complementary policies added to a carbon tax can yield additional emissions reductions, even in the sectors of the economy subject to the tax.

We think that, done correctly, either cap-and-trade or carbon taxes could be an effective tool for Washington to reduce greenhouse gas emissions in a way that creates a win-win for the economy and the environment. Yet we are concerned that the SAIC findings may oversell some aspects of cap-and-trade and do not pay sufficient attention to the success story next door. British Columbia’s carbon tax legislation was passed in February of 2008 and went into effect in July of 2008. It was implemented by a right-of-center party and now enjoys support from both major parties, in part because eliminating it would mean rolling back the reductions in personal and corporate income taxes that are financed by the carbon tax. BC’s carbon tax is now $30 per ton of CO2, among the highest carbon prices in the world. They’re waiting for the rest of us to catch up.

Governor Inslee has said he wants Washington to give serious consideration to joining forces with California’s young cap-and-trade program. We think that a well-designed cap-and-trade program can make for a worthy climate policy, but we also think that the Governor and Washington State should give serious consideration to following BC’s lead by adopting a revenue-neutral carbon tax.


Eric de Place leads climate policy for Sightline Institute; he was instrumental in the development of several cap-and-trade proposals, including the Western Climate Initiative. Yoram Bauman is a long-time climate activist with a PhD in economics; he is a Carbon Tax Fellow at Sightline and (separately) is a leader in the carbon tax effort. They don’t see eye to eye on all aspects of carbon pricing programs, but they agree that using a market-based system to put a price on carbon is the single most important thing we can do to reduce greenhouse gas emissions.

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  1. sarger says:

    This is just another tax that Inslee wants to push. According to the EIA’s carbon emission report release in May 2013, Washington State is one of the lowest in the nation in per capita emissions already and …. our overall carbon emissions have dropped 8.1% in the last decade WITHOUT this. Why do we need this? It is ANOTHER tax on citizens. It is purely a feel good thing and Inslee is looking at having California be our guide to poverty.

  2. Clark Williams-Derry says:

    A friendly amendment: you guys say that a carbon cap is both a ceiling and a floor. But in theory, emissions could fall below the level specified by a carbon cap — driven, perhaps, by an economic downturn or rapid technological progress. But in that case the permit price for carbon would fall somewhere close to zero (unless there were a price floor of some sort).

    • Yoram Bauman says:

      Good point, Clark, but we say a “binding cap” is both a ceiling and a floor. Binding is econ-speak for non-zero, so I think we’re on the same page.

      PS. Eric would know for sure, but my belief is that price floors only apply to the initial sale price of permits, eg at an auction. There’s no price floor in the secondary market as far as I know.

      • Eric de Place says:

        It depends how c&t is structured. If permits are auctioned with a reserve price — as virtually all federal legislation proposed — it’s possible for demand for the permits to fall below the level of the reserve price. In that case, emissions actually do fall below the level of the cap.

        I’m going to amend the post slightly to correct for this.

  3. Carolyn Gastellum says:

    Thanks Eric. I am about to send in my public comment to the CLEW and I do support carbon taxing. Your article provides needed clarity on the benefits and differences between carbon taxing and cap/trade. I like the win-win situation in B.C. and was not aware of that until today. It makes a lot of sense and is an example of the kind of policy that absolutely should be a priority to reduce greenhouse gas emissions.

  4. andyg says:

    Seems like a carbon tax is a potentially simpler policy that puts the same pressure on all sectors of the economy using fossil fuels, while cap-and-trade is potentially more effective at achieving reductions from large centralized emitters (i.e., cap-and-trade doesn’t directly tie to personal transportation). Does that seem like a fair characterization?

    • Eric de Place says:

      Either program can be designed to touch all fossil fuel sectors (or, of course, restricted to partial coverage of the economy). When CA’s cap-and-trade program is fully mature it will cover transportation fuels by requiring oil refiners and importers to pay for carbon permits. The oil companies will absorb a portion of that cost as a hit to their bottom line and they will pass through as much as they can to drivers and other end-use consumers.

      In that sense, it works exactly like BC’s carbon tax, which is applied “upstream” to the firms that introduce fuel into the province’s economy.

  5. Paul Birkeland says:

    Good piece, Eric. I attended the CLEW’s hearing last night in Seattle, and commented that, as an energy strategies consultant, I have rubbed shoulders with carbon emissions verifiers and carbon offset verifiers in California. They will tell you that their cap-and-trade system is definitely producing results, it is definitely effective. But they will also tell you it is an overly complex and convoluted system. It is spawning its own little industry of verifiers and advisors and tools for addressing the requirements of the system. These are of questionable societal value. A carbon tax will not expend resources meeting cap-and-trade system requirements. It will focus directly on the carbon reduction.

    Also, the kind of innovation a cap-and-trade system motivates tends to be the Wall Street kind of innovation. (Read Wall St Exploits Ethanol Credits and Prices Spike.html for an example of the kinds of innovation we are talking about.

    A carbon tax, on the other hand, drives organizations and society to deal with the cost of carbon directly. We tend to get innovation that makes our businesses and society more efficient and competitive in the global market. This is a much preferable dynamic to me.

    • Eric de Place says:

      Good thoughts, Paul. Thanks.

      I agree that real-life cap-and-trade systems do have some level of complexity that may seem unreasonable. And I think there are some real pluses to carbon taxes, but I have to confess I’ve never understood the “complexity” advantage they are supposed to have.

      I mean, holy smokes, has anyone looked at the federal tax code? Or at state tax policy? There is (almost literally) not a single real-life tax in the US that is not rife with complexity, carve-outs, giveaways, verifications, and monitoring systems, etc.

      That doesn’t mean there’s anything wrong with the taxes necessarily; it’s just a reflection of the fact that tax policy-making happens in the context of a democratic system where some special interests are skilled at acquiring preferential treatment. It’s not like carbon taxes have magical powers of immunity from that.

      • Paul Birkeland says:

        Oh, yes. There will be complexities in a carbon tax system. (How shall we take into account the natural gas that leaks from the source and that never enters the market? Will it be different for a fracked well and a conventional well? How finely do we articulated the energy and carbon content of different coal seams?)

        But, still and all, it seems to me that a carbon tax regime has a lot more opportunities for ‘bright lines.’ Cap-and-trade has too much gray area, and requires constant adjudication.

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