Carbon tax v Cap and Trade

1 - Full cost accounting

Under current conditions, the price of energy reflects supply and demand, the costs of discovery, transportation, refining, and retail.

The use of fossil fuels has other costs to society (pollution, economic insecurity) that are not reflected in current markets - environmental externalities.

For markets to work properly, there must be an accurate and comprehensive accounting of all costs associated with any energy purchase choice.  It will be necessary to describe and monetize as many of the costs in energy consumption as possible in order to send appropriate signals to consumers.

Full Cost Accounting is a necessary development for long term energy policy.

Carbon Tax and Cap and Trade are the two most commonly cited mechanisms to effect Full Cost Accounting.

2 - Carbon tax

A carbon tax would be applied to fossil fuels at the point of sale like a sales tax.  The objective of a carbon tax is to use markets to reduce fuel consumption by increasing the price of the fuel.

2.1 - Pros

·         It’s fast.

·         It provides revenue for government.

2.2 - Cons

·         It’s arbitrary and political.

·         It’s regressive.

2.3 - Where does the money go?

·         Conservative - debt retirement

·         Liberal - reduce income tax - the Green Shift

·         NDP - social programs

·         Best environmental practice - invest in improving energy productivity

Establishing a carbon tax is a political process (rather than a market process) driven by experts and interest groups.  It is an imperfect but useful first step in attaching a market cost to emissions.  It is a stop gap pending the development of a market that can attach a tradable value to emissions credits.

Revenues from any carbon tax should be spent locally to improve the efficiency and productivity of the taxed fuel.

3 - Cap and Trade

Government sets an upper limit (Cap) on the total amount of permitted emissions.  The total allowances are divided among the emitters.  A firm that produces more emissions than are permitted must either make investments to reduce emissions or buy credits (Trading in permission to pollute beyond the cap).

A carbon credit can be created by a company reducing emissions below the cap.  The difference between the allowed emissions and the actual emissions becomes a “carbon credit” that can be sold to a company that must reduce emission but faces very high costs to do so.

3.1 - Example

Company “A” is required to reduce emissions to come under the cap.  It can make investments to reduce its own emissions, or it can buy someone else’s surplus reductions.  If company “B” can reduce emissions below the cap, at a lower cost than company “A” can, those surplus reductions can be sold by “B” to “A” at a profit. 

3.2 - Pros

A fully liquid market in carbon credits is the Holy Grail of energy efficiency and emissions management. 

Carbon credits become a product that can be manufactured by improving energy efficiency and sold at a profit.  Energy management is funded by institutional investors driven by profit, not by regulation and subsidy.  Huge amounts of investment capital will develop emissions reductions, least cost first.  Cap and Trade is less regressive than a carbon tax.

Cap and Trade is a great idea and it should be supported.  It is a longer term alternative.  As the market develops, it may replace a carbon tax.  A functional cap and trade market can bring vast amounts of money into improving energy efficiency and doing so at the lowest cost.

3.3 - Cons

For this to happen, there will need to be a credible regulator, a market with stable rules and clearing systems that will allow institutional investors to have confidence in the legitimacy and liquidity of carbon credits.  There has to be a way of certifying credits so they can be traded in multiple markets.  There has to be enforceable caps. Will the caps be by sector? by country?  Will industry be treated the same as consumers?  What will be eligible to be an internationally traded credit?

Since emissions know no borders, there must be an international market.  Who runs the central bank of carbon credits?  Who decides (and can make stick) the levels of the Cap?  Is this ultimately going to the UN?

A fully liquid global carbon credit market will take years to develop.