Carbon Tax versus Carbon Trading: Implications for Climate Policy

Carbon Tax versus Carbon Trading: Implications for Climate Policy


Climate change has become a major priority in international relations. Embracing politics, economy and environmental conservatism, climate change is an increasingly complex challenge. To address current and potential future challenges of climate change resulting from carbon emissions, national and international efforts continue to inform climate policy. Given current policy landscape, a patchwork of national and international policies emerges which are overlapping, conflicting or divergent. Indeed, climate policy is informed more by each appears to be informed more by national considerations and less by a collective, international will to help mitigate negative effects of increasing carbon emissions. Moreover, although controlling carbon emissions depend on reduction of overall emissions at a global level, differential carbon emissions resulting from different industrialization and development needs has only made controlling carbon emission harder. The case for controlling carbon emissions at a global level becomes even more complicated when carbon-intensive industries relocate from more developed economies, under stricter climate policies, to less developed economies of lax or no climate polices at all. Two major climate policies emerge, however, as most widely adopted to control carbon emissions at national and international levels: carbon tax and carbon trading. While carbon taxing centers on applying taxes to carbon emissions produced by different industries under a national carbon emission policy, carbon trading is a system by which carbon emissions from developers are traded so that least polluters earn credit (usually in income tax form) and are able to trade credit for money with most polluters. Each policy has specific merits and disadvantages and is adopted differentially not only globally but within different areas of a given polity. To better weigh each policy, a proper investigation for each system is required. This requires, accordingly, a proper contextualization of each policy within a given polity. The United States is, for current purposes, selected to weigh merits and demerits of each climate policy. The choice of USA is justified by several reasons.

First, US is a major developed economy whose economic activity is one major contributor to carbon emissions globally. Second, although US has a diversified economy, which is increasingly knowledge-dependent, conventional industries, including oil and mining, still hold considerable influence on political decisions in so far as climate policy is concerned. (This is discussed in further detail in considering for lobbying to push forward one policy or another.) Third, recent developments and changes in policies, particularly under President-elect Trump, add more interesting “flavor” to climate policy both nation-wide and in connection to different major economies, particularly China. This paper aims, hence, to weigh merits and demerits of climate policy at national and international levels with particular focus of climate policy implications for USA.

This paper is made up of four sections in addition to Introduction: (1) Carbon Tax & Carbon Trading: Conceptualization, (2) Case Examples, (3) Carbon Tax vs. Carbon and Trading: Implications for US Climate Policy and (4) Conclusion. The “Carbon Tax & Carbon Trading: Conceptualization” section offers a brief overview of each climate policy. The “Case Examples” section offers case examples of applying carbon tax or carbon trading in specific countries in order to further highlight merits and demerits of each approach. The “Carbon Tax vs. Carbon Trading: Implications for US Climate Policy” section weighs merits and demerits of each approach in US context in order to recommend, if possible, best approach to adopt.


As noted above, while carbon tax approach relies on applying taxes, progressive or not, on end consumers or producers to help regulate price of carbon emissions, carbon trading applies limits on carbon emissions to regulate quantity of emissions. Generally, both approaches aim to encourage least-cost emission reduction. However, major differences emerge between both approaches. For carbon tax, economic feasibility outweighs political feasibility. More specifically, taxing carbon emissions incentivizes more optimized energy efficiency (by innovating new methods, usually “greener”, to generate energy in lieu of fossil fuel-based ones) and hence reducing carbon supply and demand for energy services. On another hand, political feasibility outweighs economic feasibility by enabling carbon developers to trade, under different schemes, carbon emissions without external intervention from regulators. In balance, while carbon tax approach has a major economic advantage of expanding state revenue (which can be re-distributed, for example, to reform “distortionary” taxes), carbon trading approach has a major political advantage of allowing for market forces to self-regulate carbon emissions in lieu of politically costly state intervention. The specific details for each approach should, ideally, decide which approach is optimum to one polity or another and/or at a global level.  To assess viability of each approach for US application, a closer look is required at specifics of each approach and, in next section, of pros and cons of each approach in specific polities.

As just noted, carbon tax approach is more economically feasible. This feasibility stems from carbon tax approach’s attractiveness as a revenue source. However, political cost of adopting carbon tax approach varies from one polity to another and is subject to a broad range of political lobbying, if jockeying, strategies which are, in turn, are responsive to complex internal and external influences. More specifically, by 2000, only eight countries – Finland, Poland, Sweden, Norway, Denmark, Latvia, Slovenia and Estonia – adopted carbon tax approach informed by regulations to minimize carbon content and energy products (Baranzini, Goldemberg & Speck, 2000). The slow pace of adopting carbon tax in different tax systems is attributed to considerations for competitiveness, tax design, revenue distribution and environmental impact. As is shown in next section, different weight of different countries on world stage, combined by national political and economic considerations, determine to a large extent whether carbon tax or carbon trade should be adopted partially or in full.

The case for carbon tax becomes more complicated when international regulations and agreements are factored in.  The Kyoto Protocol to the United Nations Framework Convention on Climate Change (UNFCCC) is, more specifically, one major international framework regulating carbon emissions from six greenhouse gases for industrialized nations (Zhang & Baranzini, 2004). More significantly, three flexibility mechanisms, supplemental to domestic actions, have been emphasized in Conference of the Parties (COP) to the UNFCCC in Bonn, July 2001 and at COP-7 in Marrakesh in November 2001 (Zhang & Baranzini). The consistent emphasis on domestic action has left open interpretations of UNFCCC’s supplementary provisions. Further, since carbon taxes are more likely to increase over years (and hence raising legitimate questions about how revenues should be distributed in each polity), economic and political impact of carbon taxes cannot be overemphasized. For US, as is shown in subsequent sections, carbon taxes are of significant implications for US economy.

For carbon trading, political feasibility is shown to outweigh economic feasibility. Then again, economic feasibility of carbon trading could be improved by more optimized taxation systems. Two major approaches to taxation include upstream taxation and downstream taxation. By “upstream” taxation is meant applying taxes to carbon developers. By “downstream” taxation is meant applying taxes to carbon consumers. These approaches are subject to comparative political power of carbon developers and consumers. Cramton and Kerr (2002) show, however, how both political and economic benefits could be balanced out in adopting a carbon trading approach. Taxes are primarily applied upstream on oil refineries, natural gas pipe lines, natural gas liquid sellers, and coal processing plants. This should minimize administrative costs required for processing tax schemas further downstream of carbon production process. This should be followed by financial measures ensuring that carbon permits are fully tradable and bankable. Tradability and bankability of carbon permits would create a free market for permits not restrained by interventionist measures, including distortionary taxes. The state is interventionist only in so far as conducting a quarterly auction is concerned. The auction, as supposed to grandfathering, is apt to reduce tax distortions, provide more flexibility in distribution of costs, provide greater incentives for innovation, and, not least, reduce the need for politically contentious arguments over rent allocation (Cramton & Kerr).

The next section contextualizes further carbon tax and carbon trading approaches by discussing each in specific jurisdictions. This should inform discussion on whether to adopt carbon tax or carbon trading in US context under “Carbon Tax vs. Carbon Trading: Implications for US Climate Policy” section.


To better understand approaches to climate policy, particularly ones centered on reduction of carbon emissions, specific case examples of EU, UK and China are discussed in further detail.

For EU, EU Emission Trading Scheme (EU ETS) can be said to be EU’s overarching policy for carbon emissions. The scheme is based on a carbon trading approach, applicable in 31 countries and limits emissions from more than 11,000 heavy energy-using installations (“EU Emissions Trading System,” 2017). The differentials in national carbon emission policies, tax design and revenue distribution makes EU ETS far more complex. More specifically, while EU ETS aims to place a cap on carbon emissions in 31 countries, economic impact is, predictably or not, different on each member state. This applies to a broad range of economic variables including, of course, energy prices. For instance, Bunn and Fezzi (2007) show that carbon and gas prices, under EU ETS, jointly impact on equilibrium price in UK electricity markets. Moreover, shocks in gas prices are shown to be passed on to electricity prices in UK. The implications for price interdependence between different energy supplies in UK electricity markets become even more complicated, if not unknown, when Brexit is factored in. Thus, although EU ETS is cap-and-trade based system, emphasizing quantity of emissions over price, energy prices cannot by any means be avoided as immediate “causalities” of carbon emissions supply-and-demand dynamics.

In UK, although carbon-intensive industries are shown to be most affected by a carbon price of £20 per ton, with small impact on UK overall competitiveness, UK climate policy mix is strongly recommended to be harmonized across different sectors in order to optimize economic efficiencies (Grover, Shreedhar & Zenghelis, 2016). More specifically, in order for UK to remain competitive over long run, as carbon taxes are more likely to increase, all economic sectors in UK should, ideally, face a “similar carbon price” by which impact of increased carbon prices should not undermine competiveness of carbon-intensive industries, as is shown in further detail in next section, when discussing a recent reversal in US carbon policy to support mining industry.  The recommendation to level UK policy landscape is consistent, moreover, with Hoel (1996) who shows that although imposing higher carbon tax on carbon-intensive industries might reduce emissions in more developed economies, doing so would shift production into countries which have lax or no climate policy. This would make a climate policy pointless since only all CO2 emissions from all countries are relevant for climate. Instead, Hoel proposes that carbon tax should not be differentiated across sectors. Similarly, in order for UK to have an effective climate policy, particularly in carbon emissions area, carbon taxes should not be differentiated across economic sectors. The case for an even carbon tax in UK cannot be overemphasized, particularly in light of recent Brexit developments if UK wants to retain revenues from carbon taxes in UK.

China, fundamentally different from EU and UK politically and economically, faces a different climate policy. Notably, while China is infamous for high pollution levels, particularly because of disregard for environment issues, at least at governmental level, international frameworks and legislations on climate change in general and carbon emissions in particular, including most notably Kyoto Protocol, are apt to pose serious challenges to China’s economy (Liang, Fan & Wei, 2007). More specifically, a carbon tax is most likely to limit China’s international competitiveness, particularly for carbon-intensive industries. To mitigate possible negative effects of a comprehensive carbon tax, a combination of subsidies for energy and trade-intensive sectors and tax breaks, or credits, for non-exempted sectors (Liang, Fan & Wei).

Overall, EU, UK and China offer insightful examples of how different approaches to a carbon policy could “spill over” well beyond specified aims. For EU, although EU ETS aims, ultimately, to limit carbon emissions within EU jurisdictions, EU ETS policy complications for UK, as shown, are apt to make EU ETS ineffective, if null, in light of recent Brexit. For UK, increasing although a carbon price of £20 per ton is shown not to impact negatively on UK’s competitiveness, including for carbon-intensive industries, increasing taxes, combined by non-optimized policy mix, is apt to impact UK far more negatively. For China, still in a late industrialization phase and is much dependent on mining for local development needs and international export purposes, faces an increasingly dimmer future as restrictions on carbon emissions increase. These policy complications offer an adequate policy backgrounder which informs US climate policy discussion in next section.


Policies are not created in void but are responsive to historical, present and future influences. Thus, in order to propose a proper climate policy mix for US, developments, past and present, should be properly contextualized. This section starts first by referring to a number of recent developments which are more likely to influence how a future US climate policy, if any, could be influenced. Then, a brief overview of current climate legislations and/or policies in US at large and in California in particular is offered.  This is followed by weighing pros and cons of each climate policy approach in US context backed up by policy literature. Finally, a policy proposal, informed by earlier efforts, is offered.


In recent months, a number of developments well connected to US climate policy has occurred, developments which are apt to influence current and future policy efforts. Recently, current US Administration has made a number of steps encouraging more coal mining on federal government lands (Lipton & Meier, 2017). These moves are interpreted as a business-friendly one which is consistent with current administration’s support for business community at a substantial expense of American public and, in mining industry’s case, at environment’s.

Early on in 2017, California’s cap-and-trade auction for greenhouse gas emissions raised only $8.2 million out of projected $600 million (DeVore, 2017). Having a public budget gap, California may be inclined more toward a carbon tax policy, reversing historical cap-and-trade policies.

On August 4, 2017, US State Department notified United Nations of US withdrawal from Paris Climate Agreement (Volcovici, 2017). The announcement has been justified by US President Donald Trump on grounds that Paris Climate Agreement would have cost America trillions of dollars and hampered growth in oil, gas, coal and manufacturing industries. Meanwhile, several US business leaders denounced US official move citing possible negative impact on emerging clean energy industry.

US Policies and Legislations

The US does not have, generally, a unified climate strategy. This can be justified, of course, by country’s economic and political diversity which makes an overarching climate strategy very costly politically and unfeasible economically. Indeed, different economic activities across US make local and state interests far outweigh federal ones. The recent consideration by California State, as noted above, to shift greenhouse policy from a cap-and-trade to carbon tax approach is only one example. The US, on another hand, has federal level organizations whose mission is to regulate sustainability practices of different economic activities, including for carbon emissions. The United States Environmental Protection Agency (EPA) is country’s most prominent environment protection organization. At a state level, California is probably country’s most progressive and leading state in environment policies in general and greenhouse emissions in particular.

Federally, EPA offers a detailed account of greenhouse gases which are regulated by law and are subject to cap-and-trade or carbon tax system depending on each state’s internal requirements. The main list of greenhouse gases regulated in US includes Carbon dioxide (CO2), Methane (CH4), Nitrous oxide (N2O) and Fluorinated gases (“Overview of Greenhouse Gases,” 2017). In order to ensure levels of greenhouse gases are within acceptable limits, EPA has established a Greenhouse Gas Reporting Program (GHGRP) (“Greenhouse Gas Reporting Program (GHGRP),” 2017). More broadly, environment protection in general and carbon emission in particular are areas of political contestation which is subject to executive orders by different presidents as is in recent presidential orders to reduce taxes on coal and mining interests by current US President, reversing his predecessor’s policy emphasis.

At a state level, California is one early adopter of cap-and-trade system. Indeed, California is country’s leading state in effective cap-and-trade practices, in spite of recent fall in revenue, as noted above, which has raised expectations of a possible shift to a carbon tax system to close state’s budget gap. California has a stated vision for greenhouse control of “Reducing Greenhouse Gas Emissions to 40% Below 1990 levels by 2030” (State of California, 2011-2017). Two strategies are, moreover, of particular interest for current purposes: Increase Renewable Electricity Production to 50% and Reduce Petroleum Use by 50% in Vehicles. While state governor’s first strategy reflects a broader national and international shift into “cleaner” energy sources, second strategy is a complementary one and is, of course, parallel to a successful implementation of first strategy.

Internationally, US has been, until recent notification of State Department to UN of country’s withdrawal, bound by Paris Agreement (“The Paris Agreement,” n.d.), an international accord which, by USA’s most recent action, highlights vulnerability of international agreements which emphasize national roles, as in Kyoto Protocol discussed above.

Carbon Tax or Carbon Trading?

The progress and regression in US climate strategy can be attributed, largely, to economic and political factors. Economically, California’s recent fall in revenues highlights actual realities of a cap-and-trade system which could generate lower revenues. Politically, recent moves by current administration, reversing earlier orders by outgoing administration, highlights power of corporate interests in a carbon trading system (Spash, 2010). The US withdrawal from Paris Agreement, combined by recent executive moves, further highlights how interactions between national and international climate policies might be conflicting only to result in defections (Sorrell & Sijm, 2003). This is not to mention price volatility in electricity markets when adopting a cap-and-trade system as opposed to a carbon tax one (Green, 2008).

On another hand, while steadily increasing carbon tax could lead to shifting production of carbon-intensive industries from developed to underdeveloped markets (Babiker, 2005) and would require broader public acceptability as one component of a proposed climate policy’s political cost (Bristow, Wardman, Zanni, Chintakayala, 2010) – a carbon tax system is consistently shown in literature to improve carbon emission reduction practices in terms of limits and prices provided that international cooperation is properly coordinated (Wittneben, 2009). Moreover, a carbon tax system is shown to lift many regulatory and administrative barriers required for a cap-and-trade system, let alone lending US more credibility on climate change challenge (Avi-Yonah & Uhlmann, 2009). Mo \rover, while increasing costs of a carbon tax system are much emphasized when weighing pros and cons of a carbon pricing strategy, Baranzini et al. (2017) show that, contrary to widespread misunderstanding, a carbon tax approach is apt to enhance environmental effectiveness and innovation (provided that taxes are progressive) and hence achieving a dual goal: generating public revenue (to be re-distributed on different public projects) and improving carbon emission reduction practices (by reducing demand for carbon-based energy products and enhancing environmental innovations).

US Climate Policy Proposal

The US has a successful record in energy taxation. Paradoxically, although taxes are generally avoided by consecutive US Administrations as politically costly, energy taxes in particular have shown to be successful (Metcalf, 2007). For instance, in 1982, a surge in gasoline excise tax occurred to fund Interstate Highway System to 9¢ up from 4¢ and in 1990, gasoline excise tax experienced another surge to 14¢ , half of which earmarked for deficit reduction – without much political and public brouhaha  (Metcalf). The resistance to energy taxes by consecutive administrations is justified by a greater emphasis on economic growth. Thus, building on US economic and political inputs Metcalf proposes a carbon tax at an initial rate of $115 per ton of carbon dioxide. To offset new carbon tax, Metcalf suggests implementing an environmental tax credit in personal income tax equal to employer and employee payroll tax on initial earnings up to a limit.

Building on Metcalf’s proposition and informed by current interactions of US climate policy with international climate frameworks and protocols, US has a carbon tax policy as most optimum policy option weighed against a cap-and-trade system provided that the US

  • Balances national and international interests in developing a carbon tax policy,
  • Provides evidence of credibility by investing in renewable energy sources funded from revenues of carbon taxes,
  • Emphasizes downstream taxation over upstream taxation, which is subject more to political jockeying and industry interests, and
  • Garner international cooperation by more international investments in renewable energy.

In balance, carbon tax and cap-and-trade are two most widely adopted approaches to control carbon emissions at national and international levels. While a carbon tax approach emphasizes prices for carbon emissions, a cap-and-trade policy emphasizes quantity of emissions. The two approaches are adopted with differential degrees of success in different nations. Generally, issues of revenue distribution (for carbon taxes), international competitiveness (which might influenced by applying carbon taxes and hence reducing overall production of carbon-intensive industries), lobbying, political cost, and international cooperation are most recurrent in weighing options of whether to adopt a carbon tax or a cap-and-trade policy. Ideally, an optimum policy mix would require proper balance between national and international policy interactions. As shown above, while EU, a developed market block, emphasizes limits on carbon emissions, China, an emerging economy, is most vulnerable to a carbon tax policy which might limit country’s international competitiveness, particularly in carbon-intensive industries. For US, a carbon tax policy is recommended based on country’s earlier, successful history in energy taxation, economic policies and political power balances. The US, in adopting a carbon tax policy, is best recommended to accommodate international climate protocols and frameworks as opposed to more recent actions which consider more for national interests.

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