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Pricing carbon: Part one

Hydrocarbon Engineering,

A recent report by Charles Frank of the Brooking Institute discusses the pro and cons of a tax on carbon emissions in the US versus cap-and-trade.

Frank explains that, in June of this year, former US Secretary of the Treasury Henry Paulson published an opinion piece in the New York Times, calling for a price on carbon dioxide emissions. According to Frank, Paulson correctly asserted that ‘putting a price on emissions will create incentives to develop new, cleaner energy technologies’.

It will also create incentives to make coal-fired power plants more efficient, reducing the amount of carbon dioxide that they emit. More importantly, Frank accentuated, it will encourage a switch of electricity production from inefficient coal-fired power plants to more efficient natural gas-fired power plants, reducing carbon dioxide emissions by up to two-thirds/MWh.

Tax versus cap-and-trade

In his article, Paulson used the words ‘putting a price on carbon dioxide emissions’ and ‘carbon tax’ interchangeably. Frank holds that he was incorrect to do so because although carbon tax is one way to put a price on emissions, cap-and-trade represents another.

Frank explains that a carbon tax and cap-and-trade are opposite sides of the same coin. A carbon tax sets the price of carbon dioxide emissions and allows the market to determine the quantity of emissions reductions. Cap-and-trade sets the quantity of emissions reductions and lets the market determine the price.

Greater uncertainty, increased risk

According to Frank, with cap-and-trade the market price of carbon dioxide allowances may be less or more than the estimated benefits per ton of CO2 abatement. In contrast, the amount of abatement generated by a carbon tax may be less or more than the amount required to equate the cost of abatement with the benefit of abatement. Therefore, both entail risks.

However, cap-and-trade has the advantage of reducing some of the uncertainty about benefits. The benefit of carbon abatement is a function of the rise in global temperature, which in turn is a function of the quantity of CO2 emissions. Cap-and-trade sets the allowable quantity of emissions, which can then be used to estimate the decline in the rise of global temperature and the resulting benefits. One cannot know in advance the effect that any particular carbon tax level will have on emissions and therefore on estimated benefits.

Frank explained in his report that while cap-and-trade and a carbon tax are both subject to uncertainty about costs, cap-and-trade has the advantage of making clear, through a market price for emissions, the actual cost of a stipulated quantity of emissions reductions. Furthermore, the market price for CO2 allowances under cap-and-trade automatically and continuously adjusts for changes in abatement cost over time as changes take place in prices of fossil fuels, the demand for electricity and the rate of technological change.

But frequent changes in a carbon tax to adjust the tax level to the changing cost of abatement are likely to be administratively difficult and politically divisive. Read more about these challenges here.

Adapted from a report by Emma McAleavey.

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