Clearing the Air: Carbon Tax or Cap and Trade?

Carbon cap and trade and carbon taxation are two very different strategies to address the challenge of greenhouse gas emissions. A look at the political and economic issues that drive each.

Carbon taxation and carbon cap and trade have been implemented with varied success as greenhouse gas reduction strategies in recent years. Carbon taxes have gone into effect, seemingly counterintuitively, where the energy industry looms large. And cap and trade programs have operated broadly across Europe, and regionally in parts of the U.S. 

Energy Policy Now guest Jim Hines, professor of economics and law at the University of Michigan, provides insight into the workings of cap and trade and carbon taxation, and explains the unique set of factors that may make one policy more politically acceptable than the other.

Andy Stone: Good day and welcome to the Energy Policy Now Podcast brought to you by the Kleinman Center for Energy Policy at the University of Pennsylvania. I’m your host Andy Stone. As 2015’s Paris Climate Agreement demonstrated the challenge of global warming is broadly recognized in the developed and developing world alike. Nevertheless, strategies to reduce emissions have proven contentious and for a variety of economic and political reasons often difficult to implement.

Today we’ll take a closer look at two emissions reduction frameworks that have been considered by policymakers and implemented with varying degrees of success in recent years. Carbon taxes aim to reduce emissions by directly raising the price of fossil fuels like gasoline, coal, and natural gas, thereby discouraging their use. Carbon cap and trade, by contrast, targets pollution directly by setting a limit on carbon dioxide emissions such as emissions from the generation of electricity, and it also establishes a market where the right to pollute can be bought and sold. Here to shed light on details of carbon taxation and cap and trade. This today’s guest, Dr. Jim Hines. Jim, welcome to Energy Policy Now.

Jim Hines: Thank you Andy.

Stone: Jim is a Professor of Law and Economics at the University of Michigan and an Editorial Advisor to the Kleinman Center for Energy Policy at the University of Pennsylvania. His research is focused on various aspects of taxation. He is a Research Associate with the National Bureau of Economic Research and Research Director of the International Tax Policy Forum. So Jim, let’s just start out with a bit of background. What are the main tools each strategy uses to achieve reductions?

Hines: What carbon taxes do is they make carbon more expensive for those who use it. You know, either companies or consumers who consume the products that embody carbon. What cap and trade does is limit the quantities of carbon that industries are permitted to emit or consumers to use. That distinction makes them seem more different than they really are. What cap and trade systems do is try to restrict the quantity of carbon emissions in a highly efficient manner because doing so lowers the total cost of these emission reductions. In the process, they create markets for carbon emission permits that effectively raise the cost of emitting carbon and have many of the same effects the taxes do.

Stone: It sounds like one of these actually leads with carbon as the initial target of the framework. The other one is more of an economic lead in. Are they equally effective in reducing emissions?

Hines: They’re different and it really depends on the circumstance how effective they are. It depends how one thinks about effectiveness too. Cap and trade has the attractive feature that the government can set a specified limit to the amount of carbon that will be emitted. And if you have appropriate enforcement then you won’t get any more carbon emission than that. So the government might set a, you know, a target of a hundred million tons of carbon emission and then grant permits for that amount of emission. And then that’s what you will get. You won’t get any more than that.

With taxes, it’s a different control method that the government uses. With taxes, the government sets the tax rate, which is a higher price for emitting carbon than you otherwise would have. And thereby indirectly discourage emissions. The interesting thing is that taxes in concept can be just as effective as cap and trade. They won’t guarantee that you hit a particular numerical target, but what they do do is guarantee that emitters will face a higher price of emission. Cap and trade interestingly doesn’t guarantee how much higher a price emitters face. All it guarantees is that the total amount will not exceed as pre-specified target. So they’re both effective and they’re both largely effective in the same way by discouraging emissions, by making it more costly for emitters to emit carbon rather than the alternative. But they do it with different methods that depending on the situation, one might be preferable to the other. It’s not clear which one is better they just do slightly different things.

Stone: Now here’s one of the key questions. Who bears the cost in each of these?

Hines: That depends on exactly how the systems are set up. Generally speaking, with carbon taxes, more of the cost is bore by people in that market, be it either the companies or the ultimate consumers of the goods that they produce. With cap and trade, the cost depends on exactly how the allowances are allocated to market actors. The common method of handling cap and trade is to grant producers a certain allowance without having to pay for it. And then you have trading of those allowances. That has, from the standpoint of the producers, the attractive feature that they don’t have to pay for the allowances that they get.

Stone: And those allow us to say how much they can emit. Is that correct?

Hines: That’s right. So you know, and allowance might say, oh, based on your historical emissions, you know, this company gets to admit 5 million tons of carbon or whatever the number would be. And, but if they don’t use it, they can trade it to another company. Or if they, their emissions exceed 5 million, they have to buy allowances from others who have them. If you grant the allowances without making people pay for them, then that’s a lot better from their standpoint than having to pay taxes where you have to pay with every ton that you emit. There are cap and trade systems that don’t grant the allowances. That require you to buy them in an auction from the government. And not surprisingly, those tend to be less popular among the firms that need to buy the allowances.

Stone: Do we have any examples of successful taxes that have been implemented anywhere in the world in the past or a carbon cap and trade?

Hines: Yes, we do. And we have examples of both. Every country in the world has taxes on some carbon, typically gasoline taxes and taxes on various fuels for airplanes and ships and things like that. And they go back hundreds of years and were originally designed to raise revenue. You know, in the days before we understood some of the climate and environmental consequences. And the United States still has these taxes. In fact, there’s a federal 18.4 cent a gallon tax on gasoline that is used to fund the highway trust fund and states, counties and cities also have taxes on gasoline.

Cap and trade is much more modern system. But again, widely adopted. The European Union has caps on greenhouse gas emissions and tradable permits for that. The United States, to control sulfur dioxide and nitrogen dioxide, has in various regions implemented caps with tradable permits. And these have been effective. We have this sort of hybrid system right now in the United States where some places are putting on caps and we have taxes as well. There’s nothing to say that hybrid system of taxes plus caps isn’t a bad idea either. So the answer is that both work, they do slightly different things and have somewhat different consequences for the actors involved. But it’s simply a mistake to say that neither one works. It’s just they do different things.

Stone: What’s interesting, you said the cap and trade system that was put in place to reduce sulfur dioxide emissions and acid rain starting 1990s was actually very effective as you mentioned. On the gasoline tax, we haven’t seen any increase in quite some time.

Hines: No we haven’t. The last federal gas tax increase was 1993 and it was actually the product of, that was the first year of the Clinton administration, and that was the product of an effort to put a broader based energy tax on the U.S. economy based on BTU content, British Thermal Unit content. That failed in Congress. And instead of getting this broad based energy tax, the Clinton administration got a modest increase in the gas tax and that is where matters have stayed since then. There have been efforts to try to increase the federal gas tax in the last 26 years, but they have failed. And even though the federal highway trust fund has a revenue shortfall now, Congress nonetheless has been unwilling to increase the federal gas tax.

Stone: You just hit on a very interesting point about the income from the gas tax being used to maintain the highway system. We often think about these taxes and cap and trade as ways to address emissions and climate change. But there’s another side of this which is the government looks at these as sources of revenue. Can you explain that?

Hines: Sure. Taxes are sources of revenue. Of course. That’s where the federal money comes from is one tax or another. And the federal government has several taxes. We’re mostly familiar with the income tax. And of course companies are subject to a separate corporate income tax, but there are other federal taxes too on imports and on gasoline, on alcohol, on lots of outboard motor engines you know, there are lots of specific federal taxes. The gas tax does fund the highway trust fund. And as I mentioned, there is a revenue shortfall in that tax right now.

One of the complicating features of using carbon taxes to control greenhouse gas emissions or for other environmental purposes is that the taxes really do two things. They discourage the taxed activity. That’s true always. Every tax basically discourages whatever you’re taxing because you make it more expensive for people. The second thing that taxes do is they raise revenue and sometimes you want the tax to discourage the activity as we do with gasoline taxes or tobacco taxes, you know, that are intended to discourage smoking. And sometimes you want the tax to raise revenue as in the income tax. With income tax, we don’t really want to discourage income production, but the government needs the revenue. And so that’s why they have the income tax. And discouraging income production is an unwanted byproduct of the income tax. But that’s the way it goes with income taxation. And if you want to get your revenue, you know, you’ve got to get it somewhere.

In the environmental case, some of the politics around carbon taxes have to do with people who might otherwise support improving the environment and controlling greenhouse gas emissions nonetheless are concerned about the revenue generation aspect of the taxes. Either because they don’t want to pay the taxes or they’re concerned that the government won’t do good things with the revenue that it receives. And look, these are valid issues. You know, a reasonable minds may disagree on them, but it is true that carbon taxes raise revenue for the government. Most people in the tax community think carbon taxes are a pretty efficient way of raising revenue for the government compared to many of the alternative ways that the government uses. That many of the other revenue sources that the government has, like the personal income tax or the corporate income tax or some of the other taxes that they use, are far less efficient methods of raising revenue than carbon taxes are. And so in the tax community the use of carbon taxes just as a revenue source is often thought to be a pretty good way of raising revenue because it’s efficient. Because it tends not to discourage economic activity as much as many of the alternative taxes do. The cap and trade type way of regulating greenhouse gas emissions really is just discouraging the activity and not so much raising revenue except if you auction off the permits, which most systems don’t do.

Stone: Well, in California for example, they’re relying on cap and trade income to fund some of their public transportation initiatives.

Hines: That’s right. And you will get some states that increased the gas tax and dedicate the additional revenue to education spending, for example. Sure. I mean, when you get more revenue, you can use it for whatever purpose you know, you have for revenue. There are examples where the system started with cap and trade and then morphed to raising more revenue with it. And the classic example of that is the control of the chlorofluorocarbons. There was this concern in the late seventies and early 1980s that release of these chemicals chloroflurocarbons that were in aerosol sprays, unknown to people, was depleting the ozone layer in the stratosphere above the Earth and causing too many ultraviolet radiation waves from the sun to strike the Earth. And the concern was that people would get, you know, sunburns and skin cancer and that it would hurt agriculture as well. But the main, you know, thing that people were worried about was the effect on humans.

In order to control the chlorofluorocarbons, there was an international agreement, the Montreal Protocol, and this is in the 80s, and countries really wanted to reduce release of these chlorofluorocarbons. The United States was the biggest releaser because we had the most industry, you know, of anybody else. So the United States put a strict limits on release of chloroflurocarbons and had and had cap and trade. But then we also put taxes on. The reason in that case for the taxes was the government realized that when you limited the production, part of what you were doing was creating kind of a monopoly situation for industry. Their profits were actually going up by the restrictions because they could charge higher prices for the very limited chloroflurocarbons that they were permitted to release.

Stone: Basic supply and demand.

Hines: It was basic supply and demand. Look, this is what a monopoly does, is it limits the amount that it sells in order to bid up the price. Normally industry when it competes with each other, can’t do that because one firm has an incentive to undercut the other. And so even if you start out with high prices, it’s hard to maintain that when you have competition among firms. What was happening with the cap and trade in the case of the chloroflurocarbons was that the government, by restricting the amount that firms were allowed to release was kind of, it was as if they were coordinating their actions the way a perfectly collusive agreement would have done and making the industry, believe it or not, more profitable.

So people didn’t like that very much. And so what they said was, okay, we will limit the quantities, but we will also impose taxes to basically extract the greater profits that the firms were getting out of this restriction on the quantities. This is in the 80s. And so we wound up with this hybrid system of strict limits on emissions and very high taxes on the firms that emitted chlorofluorocarbons. So it’s true, they were making profit in the marketplace, but then they were paying it all back to the government in the form of taxes. Just in case listeners are worried. The Montreal Protocol was very effective at reducing chloroflurocarbons emissions. And according to our measurements, the ozone layer in the stratosphere has grown back because the world is emitting far fewer of these chemicals. So you know, it’s safe to go to the beach in the summer now.

Stone: Recently the Province of Alberta Canada implemented a carbon tax. It’s a very resource rich part of Canada and one of the tools that the government has used is revenue neutrality, returning some of the proceeds from the taxes back to various constituencies. Does that make this generally more palatable? And what does it do then to the incentive to reduce consumption if the net of this is zero financially?

Hines: It’s certainly, returning the revenues to taxpayers inlays some of the concerns that might otherwise be raised by a carbon tax. It also, to some advocates, will reduce some of the benefits of the carbon tax. So there’s no political free lunch here. As I mentioned earlier, one of the concerns about carbon taxes is that it does augment government revenues and some will view that as a good thing and some will view it as not a good thing. The Alberta system where they rebate many of the revenues to individual taxpayers, you know, will obviously be more attractive to some of those individual taxpayers than just a tax system without those rebates.

The industry in Alberta will bear costs of this carbon reduction that they’re putting on and the carbon taxes. Alberta is a major petroleum producer and that tends to be a very carbon intensive activity. It’s not only that it produces, you know, obviously an output with a lot of carbon content, but it uses a lot of carbon in the process of all this refining and processing of their activities. So there will be some costs and some of those costs are absorbed by the people in Alberta because if your big local industry incurs costs, it will slightly change its operations, make them more expensive. And some of that costs will be borne by local workers in the form of fewer job opportunities or smaller raises than you otherwise would have had or things like that. So the rebate definitely makes it more palatable. It does mean that Alberta isn’t using the additional resources for education or infrastructure or other things that government might do. And you know, again, reasonable minds will disagree about priorities for that.

This scheme was clearly designed to try to patch together a broad political coalition in support of the policy. And part of getting the coalition together was the tax rebate which makes sense because liberals are going to like this policy because it improves the environment and conservatives are going to be in favor because they get a lot of the money back. And I think conservatives also want to improve the environment. They just have slightly different ideas about how to do it.

Stone: So if done correctly, this is palatable to everybody.

Hines: It’s hard to find major policies that are actually palatable to everybody as we know in the United States and they know around the world. But Alberta was remarkably able to put together a pretty broad coalition of support in favor of this policy, which frankly is a model for the United States and probably other countries.

Stone: Today’s guest is Jim Hines, Professor of Law and Economics at the University of Michigan. We’re taking a look at the politics of carbon taxes and cap and trade. Jim, one of the issue that often comes up is the issue of economic competitiveness. A province, like in Canada, a state, a country, will adopt a carbon tax or cap and trade. And the fear is that the products and services will more expensive and less competitive due to that.

Hines: Look, it’s a serious concern. It can’t be brushed aside. I would take it one step further. You can have an odd situation, what’s called in the business leakage where suppose the United States were to adopt a broad based climate policy that involved significant increases in carbon taxes. And as a result, some industries left the United States or shrank or didn’t grow because things got more expensive. And their place was taken by the same industries in other countries with much more lax standards. Suppose that happened. You could have an odd outcome where actually by tightening environmental standards in the United States, you make things worse around the world because you have shunted the activities to other places with even lower standards than ours or dirtier industries than ours.

The United States does not have very high carbon taxes is the truth. But the United States has advanced industries and advanced industries tend to be cleaner than the alternatives in many parts of the world. If you go to developing countries, even China, and look at how carbon-intensive their industries are, it’s more so than the United States for the same activity. Because they are in the earlier stage of economic development and you know, the United States is more advanced. It is a concern, competitiveness, and I want to emphasize it’s a concern not only for the country adopting the policy, but due to this leakage phenomenon you could have the odd situation where you actually, if you get enough leakage into the wrong places, wind up worsening the worldwide problem that you’re trying to address.

So, what do you do about this issue? Well, the effort of the international community has been to try to coordinate actions so that you don’t have as significant a problem with leakage as you might otherwise. And that’s the whole idea behind the Paris Agreement, and it’s precursor the Kyoto Agreement, to try to get all the major emitting countries together to jointly engage in this activity, so that mitigating carbon emissions, in order not to get these unwanted consequences and in order not to make any one country make itself uncompetitive relative to others. It makes a lot of sense, but it only makes sense if countries don’t cheat on the agreement or if they, you know, agree to join in the first place. If they don’t, then the whole system, you know, is clearly not going to work.

One of the problems with greenhouse gas emissions is that it truly is a worldwide issue. It really, as far as we can tell from the science, it matters very little where the carbon comes from, whether it comes from India or America or the Southern hemisphere or it’s sort of mostly doesn’t matter. The climate scientists, you know, will tell you maybe in some small detail that matters, but mostly it doesn’t because it all gets mixed together in the atmosphere eventually anyway. As a result, any one place has an incentive to cheat on the agreement because most of the cost is born by others. And obviously if every country in the world feels that way, then you’re never going to have reductions at all. So unless you think it’s a good idea not to have any reductions, there has to be some kind of cooperative international agreement.

You know, you asked the competitiveness question, it’s the right question to be asking. And the problem is that if one thinks about competitiveness without thinking about the consequences for the whole international system, then you can easily talk yourself into the idea that my country or my city should not participate or should cheat on the agreement. And then before you know, it probably a lot of places will do the same.

Stone: Well, correct me if I’m wrong, a few years ago the European Union implemented a carbon tax on the airline industry and wanted to, I guess, address this issue of leakage by imposing those taxes on flights that came from overseas as well. That didn’t go too well.

Hines: No, no it didn’t because it’s always easy to impose taxes on somebody else and the people on whom, if they’re foreigners and, it always sounds attractive and, you know, politically of course it’s got a certain resonance. The difficulty, there really two difficulties with that. One is the foreigners don’t like it. And the second is that a lot of that comes back to bite you, afterwards as the Europeans discovered. There’s a separate issue that under the World Trade Organization that’s a different international agreement, basically not to try to put tariffs on others that, you know, would burden them and, or to limit the tariffs that you can put on. And so the European Union ran afoul of, you know, how the rest of the world felt about their policy. It’s certainly true that airplanes, you know, are big carbon consumers, and therefore CO2 emitters. But it’s probably also true that the best way to handle that is through a cooperative agreement among all countries.

Stone: Let’s just bring this back to the United States for a moment and taking into account the new administration here in the U.S. What is the outlook for a carbon tax or cap and trade here? It was tried six or seven years ago, but where are we right now?

Hines: That’s anybody’s guess of course, with the new administration and we have a new Congress too. The people are not talking about a lot of new taxes other than perhaps a new tariffs on imported goods. But there hasn’t been a lot of talk about new taxes and it’s hard to know how to interpret that. Presidential campaigns tend not to talk about new taxes because that doesn’t make you very popular with the voters. And everybody wants to get elected. So that doesn’t mean we never get new taxes it just means they don’t talk about them.

What are the prospects now? People believe that the Trump administration is skeptical about many international efforts to control greenhouse gas emissions, again, remains to be seen what they’re actually going to do. I would say that there’s quite a bit of skepticism that the Trump administration is going to be out front on these issues, either with taxes or with cap and trade. We do have American states that have been making some aggressive gestures in this regard. And it may be that they go to Congress into action, more than Congress might have done, you know, without the states.

Stone: What do you mean the states would go the Congress into action? What exactly do you mean by that? We’re talking about California, Massachusetts?

Hines: Sure. If New England or California, you know, adopt these carbon emission caps, which they have, then it is odd to have a portion of the country doing that and not the rest of the country. And Congress may feel like it’s better to have it uniform throughout the country. And a lot of people would agree with them on that. Now that’s conjecture. Congress might alternatively say, if they don’t do anything, then maybe California will back off or New England will back off. So we’re guessing what Congress might do.

It’s also the case that as the evidence accumulates about the potential harm of global warming, that may change people’s attitudes too. That has already clearly had some effect. And, you know, as time goes forward, there’ll be more evidence accumulating more, you know, icebergs melting and hot summer days and things like that. The final thing I would say is they do need revenue in Washington and we’re currently spending more than we’re pulling in. The administration and many members of Congress campaigned on a promise to cut income taxes and to cut state and gift taxes and to cut business taxes and things like that. Okay. They certainly have the authority to do that and they may do a portion of what they campaigned on. If they do, they will find that the budget deficit is growing and when the budget deficit grows, they are going to look for alternate sources of revenue. Carbon taxes are sitting out there as a very realistic and very effective way of raising money.

Again, the federal gas tax is very low. We have one of the lowest gasoline taxes in the whole world and ours hasn’t been changed since 1993. At some point, as the difficulty of funding government operations continues, at some point as the highway trust fund gets further into the red and there just isn’t money to maintain federal highways and do other infrastructure things that the government seems to want to do, it may be that just the revenue implications of carbon taxes may start to look sufficiently attractive. Even to those who are not that in climate change that they might come around to them eventually. They certainly have made no noises about that so far. Congress has so far proved quite unwilling to increase the federal gas tax. But let’s see what they do when they realize that the choice is either a gas tax or some income tax increase or cutting, you know, favored spending programs. There’s no easy budget math for this administration or any other, you always have unattractive alternatives in front of you. Again, the gas tax might start to look a little better when they think about some of the alternatives.

Stone: I imagine the politics will be very tricky in any event. One, final question here that I just want to ask is, are there any teaching moments from any of these experiences we’ve seen anywhere, carbon taxes and cap and trade, that might be helpful and understanding where we might be going?

Hines: With the cap and trade, we have had experience with cap and trade for these sulfur dioxide and nitrogen dioxide emissions in the United States. We’ve had experience in other countries, including many European countries. And one of the things we have found over time is that prices of the permits can be very volatile and that can be a hardship for some of the firms involved in the relevant industries. One of the advantages of taxes is that the cost is pretty predictable to the market players. Look, if you put a $10 a ton tax on, then everybody knows there’s a $10 a ton tax and they can try to plan their business operations. If instead you need to buy permits in order to keep your business going, but you don’t know what the price of the permits will be, you now face an additional source of business uncertainty that may be a problem for you.

Bill Nordhaus at Yale has done a calculation that the sulfur dioxide permits in the United States over the history that we’ve had them, their prices have been as volatile as world oil prices over the same period. They are steady for many times. And then you had enormous spikes at different times when there’s been untoward weather events or economic events that have caused the prices to go way up and then they fall back down again. You know, it’s an issue.

Stone: That’s been very successful.

Hines: It has been very successful at limiting emissions and it has, by everybody’s calculation, been more cost effective than some of the older style ham-handed regulatory alternatives of just forcing every emitter to do the same thing. So it’s very attractive, but it does have this downside that it’s hard to plan around the cost of the permits. To many of us in the tax community, we are just saying, you know, our experience with permits is good, but our experience with taxes is better.

Stone: Jim, thanks for appearing on Energy Policy Now.

Hines: My pleasure. Thank you, Andy.

Stone: Our guest has been Jim Hines, Professor of Law and Economics at the University of Michigan and an Editorial Advisor to the Kleinman Center for Energy Policy. And a sincere thanks to all of our listeners for tuning into Energy Policy Now. If you found that today’s podcast shed light on one of the complex issues in energy policy, please tell a friend or give us a five star rating on iTunes. You can follow the latest research, news, and events at the Kleinman Center by visiting our website, www.kleinmanenergy.upenn.edu.

James Hines

Professor, University of Michigan
James Hines is a professor of law and economics at the University of Michigan and an editorial advisor to the Kleinman Center. His research is focused on various aspects of taxation.

Andy Stone

Energy Policy Now Host and Producer
Andy Stone is producer and host of Energy Policy Now, the Kleinman Center’s podcast series. He previously worked in business planning with PJM Interconnection and was a senior energy reporter at Forbes Magazine.