Cap and Trade Policy Paper

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Cap and Trade Policy Paper


The issue of carbon emissions is an important one not only from an environmental perspective but also an economic one. While reducing carbon emissions is an important one for the health of human beings as well as that of the environment, the larger question is what type of policy strategy is best for both reducing such emissions which might have an impact on efforts to mitigate the effects of pollution on climate change.

While ther are options to consider which does not rely on economics– technological or output standards achieved by command and control regulations–they are often fraught with political resistance by industry because they do not allow industry to make any choices or play a role in solving the problem of excessive emissions and the burden that these emissions place on others. Instead of such draconian measures based on fiat, the preferred options rely on economic tools instead to provide incentives to industry to police itself by either incenting investment in emission-reducing and/or energy saving technologies or to reduce production in line with the total/social-costs rather than just the private/ producer-costs of production. Two such economic policies to consider in this regard are emission taxes and cap-and-trade policies.

Overview of Policy Problem: Carbon emissions reduction

Consider a company that faces an increasing marginal pollution abatement cost curve as in the Figure 1. Left unregulated it will choose not to reduce its carbon emissions (a.k.a abate carbon emissions) and avert facing the costs of abatement represented by the area underneath the marginal abatement cost curve represented by area (B + C + D) in the diagram below. Figure 1: Marginal Costs and Marginal Benefits of Reducing Carbon Emissions [pic]

Source: Econ 101: Carbon Tax vs. Cap-and-Trade, 2012, n.pag. Suppose that policy analysts have determined that the economically efficient level of pollution abatement occurs at the point where marginal benefits of abatement equal the marginal cost costs of abatement as is suggested in economic theory. The resulting level of carbon emissions is e* (reduction in emissions is measured from the far right in the diagram above to the pointe*). The question is what policy to follow to achieve e*: either some type of fiat policy involving either some type of output restriction or requiring use of a particular pollution-control technology or some type of policy that involves financial incentives to reduce emissions. This paper hypothesizes that policy options involving economic incentives are preferable to those options that involve regulatory fiat.

Specification of Economic Policy Models:
1) A Carbon Emissions Tax:

One policy instrument that can be used to achieve this level of abatement is to set a tax where marginal benefit equals marginal cost — represented by the horizontal “tax” line in the Figure 2 below. Under such a scheme, the polluter will find that it is cheaper to reduce carbon emissions so long as the marginal cost is lower than the tax. Since the tax bill (A + B) is great than the marginal abatement cost bill (B) to the left of the point e*, the firm will choose to reduce emissions up to the level of C with the remaining emissions level indicated in figure 2 measured from the right in the diagram. To the right of e*, the marginal abatement costs, represented by areas C + D, are greater than the tax bill (area D) so the firm will choose to pay the tax and continue to emit pollutants beyond e*. Figure 2: The Carbon Emissions Tax


Source: Econ 101: Carbon Tax vs. Cap-and-Trade, 2012, n.pag. So long as the marginal costs and benefits of abatement can be known with certainty, an emissions tax can be set at the point of intersection of these two measures resulting in an efficient level of pollution emissions at e* with total abatement costs (including taxes paid) to the polluter of area B+D and providing the government with revenues represented by D (Econ. 101: Carbon Tax vs. Cap and Trade, n. pag.). It is when these marginal costs and marginal benefits are either not measurable in their entirety or when there is uncertainty about the figures obtained that leads to added questions as to whether this would be the best policy to follow.

2) A Cap Policy:

An alternative policy to an emissions tax to achieve reductions in emissions through the tools of economics is to set a cap at the point where marginal social benefit equals marginal social cost of reducing emissions/abatement — represented by the vertical “cap” line in Figure 3 below. The polluting firm must reduce its carbon emissions to e* where the marginal social cost of reducing emissions equals the marginal social benefit of the products produced by the polluter.

Such a policy–if the social costs and social benefits can be measured accurately—results in an efficient level of emissions produced/reduced at e* with an abatement cost borne by

Figure 3: Cap Policy for Each Firm

Source: Econ 101: Carbon Tax vs. Cap-and-Trade, 2012, n.pag. the polluter equivalent to area B (Econ. 101: Carbon Tax vs. Cap and Trade, n. pag.). The issue is whether total social costs can be measured and measured accurately in order to set such a policy at the correct or efficient level of emissions for each firm. Normally such policies do not result in efficiency even though an efficient level of overall emissions can be attained since it does not account for different costs of abatement in different firms. That is, a level of emissions can be attained that is equivalent to that achieved under an economically efficient policy but the level is not achieved at the lowest overall cost.

One way of obtaining individual caps is for the government to auction off emission permits that total the pre-set amount of emissions that it feels is optimal. Firms with higher costs of reducing emissions will bid higher than firms with lower cost structures. Again, the only problem is determining what the total amount of emissions should be reflecting all social costs and benefits of reducing carbon emissions.

3) A Cap-and-Trade Policy

An added twist on the cap policy allows firms to trade emission allotments between themselves based on the buyer of allotment bargaining with the seller over the proper price to pay for the extra allotment. A two-panel diagram is needed to better understand the logic of trading emission allotments. Figure 4 illustrates the marginal cost of reducing emissions of two firms. One firm is run on older technology with high abatement costs that goes from right to left with zero costs represented at the lower right-hand corner of the diagram. The other firm has newer technology in its plant with lower abatement costs that goes left to right with zero costs represented at the lower left-hand corner of the diagram. The width of the horizontal axis is the reduction in emissions that must be achieved overall to an efficient level.

The intersection of the two marginal cost curves is where economic efficiency is achieved. That is, the value achieved

Figure 4. Cap-and-Trade Between Firms Policy

Source: Econ 101: Carbon Tax vs. Cap-and-Trade, 2012, n.pag. from the last dollar expended on abatement must be the same across all firms in the market. This is known as the equimarginal principle (Boyes and Melvin, 2011,122). The total cost of attaining the efficient abatement/emissions level is equal to the area C + G + K. At the efficient level of emissions, e*, the low cost (of reducing emissions) firm should reduce more emissions than the high cost (or reducing emissions) firm. Such a policy can be implemented by issuing carbon permits to different firms and allowing them to buy and sell their permits in the open market. Normally, equal amounts of permits are issued to each firm since it is difficult to assess the true abatement cost a priori. In the end, the marketplace will help determine the differences in cost structure depending on how high a firm is willing to bid for an extra permit or two (Econ. 101: Carbon Tax vs. Cap and Trade, n. pag.).

As with the individual firm cap policy, the cap-and-trade policy is predicated on the government being able to determine the optimal level of total emissions desired reflecting social costs and benefits of reducing carbon emissions. Combining the different economic policy options together, it is obvious that it is possible to achieve the same level of reduction in emissions by setting a tax at the same level as where the marginal costs of reducing emissions is the same between firms which is at the level represented by the horizontal line in Figure 4 above. As above, the polluting firms will notice that it is cheaper to abate carbon emissions as long as the marginal abatement cost is lower than the tax. The firms with the higher cost structure will reduce emissions to e* when measured from right to left and incur abatement costs equivalent to area K and pay taxes equivalent to area B+C+F+G. The firms with the lower cost structure will reduce emissions to e* when measured from left to right and incur abatement costs of C+G and pay taxes equivalent to areas J + K in Figure 4.

Setting a cap on each individual firm will produce the same level of reduction in emissions, but given that it is difficult, if not impossible, to individualized caps based on different cost structures of abatement, an efficient outcome is difficult to achieve under such a policy even though emissions are reduced to the same overall level. Regarding the market failure due to the negative carbon externality, both a carbon tax and carbon cap-and-trade will achieve the same level of increased efficiency–assuming that measurements of costs and benefits can be measured accurately– by reducing emissions to the optimal level at minimum cost. The real difference in these policies is due to differences in the distribution of costs.

In the carbon tax policy, the government receives added revenues while in the cap and cap-and-trade policies when permits are simply handed out to firms, the firm has no additional outlays other than the cost of abatement to stay within the cap or to purchase additional allotment from other firms. If the permits are initially auctioned off by the government, the additional revenues to the government should be nearly the same as with a tax scheme if marginal social costs and benefits have been measured accurately. However, the economics-based policies are preferable to policies based on fiat where specific technologies (e.g., smoke-stack scrubbers) or a uniform cap on emission outputs across all firms since these other policies fail to take into account social costs and benefits. With regard to the economics-based policies, the following added impacts may also occur.

First, in addition to static efficiency–efficiency occurring within a single period of time–there may also be dynamic efficiency within these policy schemes whereby firms have an incentive to adopt new technology over time to reduce their marginal costs of reducing carbon emissions (Econ. 101: Carbon Tax vs. Cap and Trade, n. pag.). Secondly, carbon emission taxes and/or auctioning permits will generate additional government revenue that might be used to offset various distortionary taxes on labour and/or capital (Econ. 101: Carbon Tax vs. Cap and Trade, n. pag.).

Evidence and Analysis:

There are various problems associated with the design of emissions tax regimes warranting discussion. First, if such a tax were placed on individuals rather than firms without any offsetting changes in other taxes or government transfers, a carbon tax might be regressive suggesting that the highest tax burden would be placed on the poor (Poterba, 1991, 11). This is mostly applicable to gasoline taxes where a flat emissions tax would make up a higher percentage of the income of poorer over wealthier taxpayers; thus, an issue of equity arises here. Likewise, firms with higher profit margins would shoulder less burden from the tax than firms with lower profit margins given a similar costs of pollution abatement. Poterba (1991) suggests that this regressiveness could be offset by changes in either the direct tax system or in government transfers.

Second, as the population grows and production totals continue to increase to meet the demands of this growing population, emission taxes will need to rise to keep emissions at a particular level; this may lead to a set of distortions in terms of domestic vs. foreign production whereby firms can transfer production to other jurisdictions that do not have such taxes in place. Thus, international trade leads to an opportunity to get around the tax scheme and the higher the taxes instituted, the higher the incentive to engage in such behaviour.

Thus, if emission taxes differ significantly between two neighbouring jurisdiction–for example, the State of New York and Connecticut or even New York and one of its neighbouring Canadian provinces–there is an inherent incentive to move production outside of the jurisdiction with the highest taxes and import products from elsewhere. Third, a central issue regarding the design of carbon emissions taxes to harmonize such polities with other fiscal instruments designed to mitigate the effects of climate change. For instance, it is important to ensure that taxes on chlorofluorocarbons and emissions from fossil fuels are comparable to avoid distortions in consumption that may lead to a worse outcome for the environment than in the absence of such policies (Poterba, 1991, 27).

Bosquet (2000) conducted a review of the evidence regarding the impact of carbon emissions taxes on the environment and the economy. She claims that environmental taxes involve the shifting of tax burden from employment, income, and investment to resource depletion and waste. She asks the general question of whether such tax reform can produce a double benefit by helping the environment and the economy simultaneously.

Based on her reviews of the literature and available evidence, she concludes that when emissions taxes are instituted, they are generally associated with reductions in payroll taxes, and–if wage-price inflation is prevented–they often result in significant reductions in pollution and small gains in employment (Bosquet, 2000, 19). Also associated with the implementation of such environmental taxes are also marginal changes–gains or losses– in production in the short to medium term, while investments decease marginally and prices increase. However, she cautions that the results of such environmental taxes in the long-term are less certain (Bosquet, 2000, 29).

With regard to cap and cap-and-trade policies, the evidence is also available regarding the effectiveness and consequences of such policies. Stavins (2008) describes a graduated cap-and-trade scheme that involves initially just Carbon gasses with 50% of permits issued to polluters in the market free of charge and other half auctioned off. Over 25 years, the percentage auctioned off annually will gradually increase to 100% and other greenhouse gas emissions will be included over this time span. The idea is to implement a gradual iterative policy with a slow trajectory of emission reductions. As time goes on, other emissions are included in this scheme and the system provides for harmonizing this scheme over time with effective cap-and-trade systems and other emission credit reduction programs in other jurisdictions. This harmonization effectively addresses the issue raised with emission tax policies that are unilaterally established in one jurisdiction without consideration for the policies in neighbouring jurisdictions.

If there is an effective way to dovetail policies in different jurisdiction, then this would level the playing field between domestic and imported products. Regarding actual cap-and-trade policies already in place, Colby (2000) analyzes a cap-and-trade policy for limiting Sulfur Dioxide emissions. The changes stemmed from the Clean Air Act of 1990 which allowed for a nationwide cap-and-trade policy for industrial firms emitting sulfur dioxide into the atmosphere. Marginal costs of reducing emissions fell substantially duringn the 1990s due to reduced costs of installing scrubbers, reduced costs of flue gas desulfurization, and falling costs for low sulfur coal all due, to a large extent, to an active program of trading/buying allowances between firms that emerged after a few years of experience after the program was initiated.

As Colby (2000) states, “The allowance trading market enhanced competition among the different methods that firms use to control emissions, adding impetus to cost reductions” (Colby, 2000, 642). Low allowance prices and falling marginal costs associated with reducing emissions produced earlier-than-predicted cutbacks in sulfur dioxide emissions. Allowance prices rose from lows of $80-90/unit in 1996 to about $215/unit in mid-1999 spurring further conservation efforts.

Colby (2002) does mention that design and implementation of cap-and-trade schemes involves some important policy tradeoffs: equity among the players, balancing use levels with resource conditions, facilitating transactions between firms wishing to trade allowances, accurate accounting for externality costs, assuring adequate monitoring of emissions levels, and documenting welfare gains due to the policy. She says that efficient trading mechanisms can be more easily implemented when there is a strong political or legal mandate to cap resource use and trading allowances are sensed by all parties involved to be a way to ease adjustment to limits on emissions (Colby, 2000, 638).

In choosing between the various policies, it is inevitably important to sense the level of uncertainty over measuring the items of interest. With regard to emissions taxes, it is important to have fairly accurate estimates of marginal social costs and benefits and with regard to cap-and-trade schemes, there needs to also be a fairly accurate means of estimating the optimal level of emissions given all the costs and benefits involved in reducing emissions.

If it becomes difficult to measure these items accurately, then the expected deadweight loss and associate probabilities of various miscalculations needs to be assessed and compared across the different strategies to determine the policy that produces the smallest expected deadweight loss which is key from an economic perspective. Since policies based on fiat, such as technology mandates and non-economically based output standards, are not set with regard to these types of measures, it is likely that the deadweight economic loss associated with these policies will be greater than for either emissions taxes or better yet, cap-and-trade policies.


The evidence suggests that economics-based emissions policies are preferred over policies based on fiat. Moreover, the strongest evidence for promoting investment in pollution control equipment and reducing emissions that mitigate the effects of climate change appear to involve cap-and-trade policies. Partially, this might be due to the flexible design of such policies which—through the auctioning and/or trading of allowances—account for changing market conditions. This policy, even more so than emission taxes, forces the industry to face current market conditions through the use of auctions and trading for emission allowances. As a result, the parties are forced to make choices based on strong economic criteria to obtain efficiencies over time.

Works cited:

Bosquet B. 2000. Environmental Tax Reform: Does It Work? A
Survey of The Empirical Evidence. Ecological Economics. 34, 19-32,

Colby G. 2000. Cap-and-Trade Policy Challenges: A Tale of
Three Markets. Land Economics, 76, 638-658.

Econ. 101: Carbon Tax vs. Cap-and-Trade. 2012. Website.
Retrieved on June 5th, 2012 from

Melvin W. Boyes M. 2011. Microeconomics. 9th ed. Marion, OH: South-Western, Cengage Learning,

Poterba JM. 1991. Tax Policy to Combat Global Warming: On Designing a Carbon Tax. NBER Working Paper. MIT-CEPR 91-003WP. Retrieved on June 7th, 2012 from

Stavins RN. 2008. Addressing Climate Change with a
Comprehensive U.S. Cap-and-Trade System. Nota Di Lavoro 67.2008 Fondazione Eni Enrico Mattei. Retrieved on June 7th, 2012 from


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  • University/College: University of Chicago

  • Type of paper: Thesis/Dissertation Chapter

  • Date: 12 November 2016

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