Reducing Greenhouse

Gas Emissions
Carbon Cap and Trade and the Carbon Tax
By Glen Andersen and David Sullivan July 2009

As states deal with climate change, many seek

economically efficient ways to reduce greenhouse gas
emissions. The most popular market-based approach,
cap and trade—which limits greenhouse gas emissions
and allows emitters to trade allowances—now is being
implemented in more than 10 states. Despite the
popularity of cap and trade, many economists think
a carbon tax is the least costly and simplest approach.
Although few states have considered a carbon tax, San
Francisco, Calif., and Boulder, Colo. have created small
carbon taxes.

Congress is seriously considering the cap and trade

approach, creating concern about how much freedom
states have under federal requirements and whether they
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would be allowed to surpass federal standards. Since

states are at the forefront of designing and implementing
cap and trade systems and many regional monitoring and
trading systems will be operating by the time national wish to reach their targets. California, which is furthest
legislation is passed, states are urging federal policymakers along in implementing its greenhouse gas reduction strategy,
to expand on existing state efforts instead of creating a has created a multi-faceted program that relies on many
completely new system. policies in addition to cap and trade. The state estimates
that its cap and trade policy will meet about 24 percent of
States usually see market-based emissions reductions its targeted greenhouse gas emissions reductions by 2020.
policies as a component of a larger climate change Other policies—including renewable electricity standards
strategy, which also includes policies that reduce (requirement for renewable energy production), low-carbon
emissions through energy efficiency, renewable energy and fuel standards (requirements that fuels for automobiles
community design. These other policies are important, release less carbon dioxide), vehicle emissions standards
since raising the cost of emitting greenhouse gases alone (requirements that new vehicles emit less carbon dioxide)
may not access some of the most cost-effective means and energy efficiency requirements—will provide the
of reducing greenhouse gas emissions, such as energy remaining emissions reductions.1
efficiency.
Cap and Trade Policy
Cap and trade and carbon tax policies increase the cost Policymakers and economists have shown considerable
of emitting carbon dioxide gradually over time, allowing interest in the cap and trade approach since a federal cap
industries to adapt and change as new technologies and and trade program created in the 1990s successfully in
resources are developed. States with emissions goals are reduced sulfur dioxide emissions at relatively low cost. The
ISBN 978-1-58024-562-3

finding that various greenhouse gas reduction sources policy is best suited to larger multi-state regions that include
must be addressed immediately and simultaneously. They multiple emissions sources with varying reduction costs.
can not wait until cap and trade policies take effect if they
 A cap and trade system functions by placing a ceiling or The amount of allowances allocated influences their price
“cap” on the annual amount of greenhouse gas that can be and plays a critical role in the success of a cap and trade
released in a state or region. Emission allowances then are program. Thus, it is crucial that greenhouse gas emissions
distributed to emitting industries, which can sell or buy registries accurately assess how many allowances are needed.
them as needed. Each year, the amount of allowances given If the registry number is higher than actual emissions,
or auctioned to emitters is reduced to meet state or regional emitters will receive more allowances than they need and
reduction goals, requiring industries or power plants to can sell them for profit with no emissions reductions.
either reduce emissions or purchase allowances from other Inaccurate registries in the European Union’s European
emitters that have surpassed their requirements. Industries Trading System, along with free distribution of carbon
that can reduce emissions at low cost will reduce first, then allowances, resulted in such a scenario. Electric utilities
sell excess allowances; those for whom reductions are too were given more allowances than they needed, sold them
expensive will buy them. Trading allows emitters to reduce for windfall profits, and passed on higher energy prices to
emissions based on their cost of reductions, as opposed consumers. The mistake resulted in substantial analysis and
to requiring all industries to meet the same emissions revision of the European program.5
requirements, regardless of cost. The price of emitting
greenhouse gases then is passed to consumers, ensuring that As soon as a cap and trade system is established, emissions
energy costs reflect the added environmental damage that allowances have substantial value and can result in
may be associated with greenhouse gas emissions. significant transfer of wealth. Accordingly, equitable
and efficient distribution of allowances is paramount.
Each allowance is equal to 1 ton of carbon dioxide (CO2) In Europe, utilities passed on the cost of the value of
emissions. Other greenhouse gases, such as methane or allowances even though they received them for free. Many
nitrous oxide, are included in the cap. Allowances for economists argue that allowances are so valuable that the
these gases are calculated in CO2 equivalents. For example, most efficient method of distribution is auctioning, which
methane has 25 times the heat trapping potential of CO2, offers greater transparency and is more immune to lobbying
so 1/25 of a ton of methane emissions is equivalent to 1 than free allocation.6 Since energy prices increase regardless
ton of CO2. Accurate measurement and verification of of whether allowances are given away or auctioned,
emissions are essential to accurately setting the cap and auctioning provides for reinvestment of money in programs
assessing compliance. such as energy efficiency or clean energy development,
where both consumer and energy costs are reduced.
The First Cap and Trade Experience
The 1990 Clean Air Act Amendments required the U.S. Although economists tend to agree that auctioning is the
Environmental Protection Agency to establish a cap and most efficient distribution approach, there is pressure to
trade approach to reduce sulfur dioxide (SO2) emissions allow free allocation of allowances. Many policies propose
from coal-burning power plants. At the time, acid rain, a mix of auctioned and freely allocated credits to assuage
which is caused by the release of SO2, was damaging emitters’ cost concerns.
lake and forest ecosystems. By 2006, the program had
reduced power sector SO2 emissions to 40 percent below Price Volatility and Flexible Caps
1990 emission levels, at just one-fourth of projected Price stabilization is a key concern in implementation of
costs.2,3 In 2010, the annual health benefits from the
a cap and trade system because total CO2 emissions are
program are predicted to total more than $119 billion,
held constant while credit prices are allowed to fluctuate,
not including the value of reduced acid content in lakes
and streams.4 resulting in price volatility.7 The cost of emissions
allowances depends upon many factors, such as new
technology, weather, changes in demand and new buyers.
Distributing Emissions Allowances Price volatility can be problematic because it can inhibit
Assigning a cost to carbon emissions ensures that the cost long-term investment in measures to reduce emissions.
of activities that release greenhouse gases are reflected in Extreme price volatility has occurred in both the U.S. sulfur
the cost of energy production. A carbon pricing scheme dioxide program and the European Trading System.8
attempts to incorporate the potential environmental costs
related to burning fossil fuel—rising sea levels, agricultural Many economists suggest implementing different measures
and natural resource damage, increases in severe weather, to help stabilize prices and improve efficiency.9 These
drought and other damage. mechanisms create a more flexible cap that corresponds

2 NCSL | Tel: 303.364.7700 | 7700 East First Place | Denver, CO 80230

to the price of allowances—if the price becomes too high, be eligible for sale there. Price caps could hamper U.S.
the cap adjusts to reduce prices. The three most common competitiveness in the emerging clean energy sector by
policies are described below. limiting the market’s ability to function freely. Carbon
prices could then become too low to drive development and
• Circuit Breaker – This option allows the government adoption of efficiency and clean energy technologies. Table
administrator to modify the cap if the price of 1 illustrates pros and cons of the cap and trade system.
allowances passes a predetermined amount.
State and Regional Efforts
• Borrowing and Banking – Borrowing allows emitters
to exceed their required emission reductions for the The Regional Greenhouse Gas Initiative
year with the promise that they will repay allowances
with reductions in the following year. Banking allows Ten northeastern states—Connecticut, Delaware, Maine,
firms to exceed emissions reduction requirements and Maryland, Massachusetts, New Hampshire, New Jersey,
save allowances for future use or sale. It provides an New York, Rhode Island and Vermont—developed the first
option for quicker reductions and allows firms to hold U.S. multi-state greenhouse gas cap and trade, called the
allowances if prices are low. Regional Greenhouse Gas Initiative (RGGI). The cap began
in 2009, covering CO2 emissions from power plants in the
• Safety Valve – A safety valve sets a ceiling on the price 10 states. The cap will remain at the same level through
of allowances in a cap and trade system, which allows 2014, then will be lowered each year thereafter, dropping to
emitters to buy additional credits from the government 10 percent below the 2009 level by 2018.15
when the credit price reaches a certain level. This keeps
a cap on prices when the demand for allowances is The first of the quarterly auctions occurred in September
high. 2008. Regulated facilities purchased 80 percent of
the allowances, and the remainder were purchased by
Some argue that price caps or safety valves on the price individuals or companies that had no emissions restrictions
of emissions credits should not be allowed because they under RGGI. The initiative requires states to auction at
could delay the emissions reductions needed to prevent least 25 percent of allowances and use proceeds to benefit
catastrophic global warming scenarios. Since the European consumers and efforts such as energy efficiency, renewable
program rejected price caps, there is also the chance energy and technology development. RGGI states, after
that allowances from markets with price caps would not seeing the benefit of auctions, have agreed to auction almost

Table 1. Pros and Cons of Cap and Trade

Pros Cons
Banking, auctioning and safety valves help stabilize prices.10 Large fluctuations and unpredictability in allowance prices to make
investment decisions difficult.
Complexity of a trading regime could foster delay and be difficult
to enforce.
Free allocation of allowances can help energy intensive industries Firms operating under cap and trade are at a competitive
remain competitive with companies in regions that have no disadvantage.
emissions caps.
Allowance auctioning eliminates windfall profits, provides money Free allocation of allowances provides windfall profits for
for clean energy development, and helps low-income ratepayers. polluters.11
Allowances can be distributed only to major greenhouse gas A comprehensive program must encompass many sectors, creating
emitters and suppliers of fossil fuel, simplifying the system. complications for trading and enforcement.12
The initial start-up time will be long.
Carbon taxation is more efficient than cap and trade.13
The cap, which will shrink over time, guarantees that specific
emissions reduction targets will be met.
Auctioned cap and trade brings in revenues that can be used to Increased energy prices will burden low-income families.
ease the burden on those with lower incomes.

Sources: NCSL and Sightline Institute,14 2008.

NCSL | Tel: 303.364.7700 | 7700 East First Place | Denver, CO 80230 3

 all their allowances. The first four RGGI auctions—the as such as low-carbon fuel standards and regional incentives
most recent in June 2009—netted the 10 participating and funding mechanisms.
states $365 million, with credits selling for between $3.01
and $3.51 per ton. In the future, RGGI may be extended Carbon Tax
to include other sources of CO2 emissions and greenhouse A carbon tax is a direct fee on CO2 emissions that is
gases.16 raised over time until emissions goals are reached. Most
economists feel that taxing greenhouse gases is the most
Western Climate Initiative efficient way to reduce carbon dioxide emissions because
the tax is easily understood, transparent and relatively
Partners of the Western Climate Initiative (WCI)— simple to implement.18 To reduce the number of taxable
Arizona, British Columbia, California, Manitoba, entities, only emitters high in the supply chain would
Montana, New Mexico, Ontario, Oregon, Quebec, Utah be taxed for each ton of carbon they emit. Emitters will
and Washington—are designing a system to achieve reduce emissions when they find the tax payment is higher
greenhouse gas emissions reductions of 15 percent below than the cost of emissions reductions. A slowly increasing
2005 levels by 2020. The WCI, which was initiated by carbon tax would first encourage the lowest cost abatement
governors of the member states an provinces, plans to measures and would allow time for industry to invest in
implement a regional cap and trade program to help reach emissions reduction technology and develop low carbon
its goal. Many participants still need the support of their energy sources. Because a carbon tax uses existing tax
state legislatures before cap and trade can become a reality structures for collection, administering it is likely to be
for the entire region. WCI members will begin reporting much simpler than managing a cap and trade regime.
their emissions in 2011, and the cap and trade program is
slated to begin in January 2012.17 Since a carbon tax makes the cost of emissions predictable,
it is easier for taxed entities to make long-term investments
Midwest Greenhouse Gas Accord and budgetary decisions regarding abatement measures.
Unlike cap and trade, it is difficult to know what effect the
Members of the Midwestern Greenhouse Gas Accord tax will have on actual CO2 emissions reductions. The tax
include Kansas, Illinois, Iowa, Michigan, Minnesota, must be set to increase over time in order to reach a level
Wisconsin and Manitoba. The accord aims to reduce that matches reduction goals. The cap and trade approach
greenhouse gas emissions through a multi-sector cap and sets the emissions amount and allows the cost of emissions
trade mechanism. Still in the planning phase, the goal of to adjust through auctioning and trading allowances, until
the accord is to help members establish reductions targets they reach a price that induces the targeted reductions.
and time frames. It also will develop and implement Eight government entities have instituted some form of
additional steps to support the cap and trade system, such carbon tax—British Columbia, Finland, Great Britain, New
Zealand, Quebec, Sweden, and the cities of Boulder, Colo.,
and San Francisco, Calif.

Revenue Generation and Uses

Carbon taxation is considered politically unpopular, as

most taxes are, because it places an additional tax burden
on the economy. The goal of the cap and trade system—to
raise the cost of greenhouse gas emissions in order to create
reductions—is the same as the carbon tax. As with the
carbon tax, governments receive funds to offset potential
increases in energy costs and to invest in clean energy.
Carbon tax income also could be used to offset or reduce
other taxes, such as income tax or sales tax, resulting in no
net tax increase. This approach, called tax shifting, can be
used to discourage damaging activities, such as polluting,
while removing the earning disincentives that may be
caused by taxing income. Table 2 discusses the pros and
cons of the carbon tax.

4 NCSL | Tel: 303.364.7700 | 7700 East First Place | Denver, CO 80230

 Table 2. Pros and Cons of Carbon Taxation
Pros Cons
A revenue neutral carbon tax shift, one that reduces Taxes are politically unfavorable.
heavily regressive taxes (such as sales tax), can be politically
favorable.
A slowly increasing carbon tax will allow low-cost Carbon taxation does not guarantee decreased CO2
improvements to happen first while the tax is adjusted to emissions.
reach the desired emissions reductions.
Generated revenue can be invested in research and Carbon taxation puts too much money in the hands of the
development and clean energy and efficiency incentives, government.
and can be used to help low-income families pay higher
energy costs.
A revenue neutral carbon tax shift (using revenue to reduce A carbon tax is regressive and will distort the economy.
sales or other taxes) could reduce regressive taxes.
Slowly increasing the tax will allow transitional investment,
adjustment and technological development.

Sources: NCSL and Sightline Institute,14 2008.

jobs created in the clean energy and energy efficiency

Case Study: Sweden’s Carbon Tax
sectors will promote growth and provide economic
Sweden introduced a carbon tax in 1991. Today, the stimulus. As more states create market-based programs,
tax is $150 per ton of carbon dioxide, but various they are considering the potential societal costs of adding
industries receive exemptions or do not pay the greenhouse gases to the atmosphere and attempting
entire tax. No tax is placed on fuels used to generate to ensure that cost is reflected in the energy prices.
electricity, fuels from renewable sources, or fuels used These policies increase the value of new clean energy
for ships, planes and trains. However, individual technologies, allowing them to compete with established
consumers pay a tax on electricity and motor fuel use.19 fossil fuel power generation.
The Swedish Ministry of Environment found the tax
has helped change energy consumption patterns.20 Although concerns about the costs of such programs
Boats at the Port of Goteborg use the local power grid
are common, some consider the cost of not reducing
instead of burning diesel oil or sulfurous bunker fuel
greenhouse gas emissions to be far higher. Assessments
to power their ships. Sweden’s carbon emissions have
decreased by an estimated 9 percent since 1990.21 by two states found economic benefits from their
climate policies. The California Air Resources Board’s
economy-wide analysis of the state’s plan to reduce CO2
emissions to 1990 levels by 2020 found the plan would
Conclusion increase state productivity by $27 billion. Some of the
As states advance their efforts to reduce greenhouse gas benefits from energy inefficiency improvements will save
emissions, they are considering policies that help reach households $400 per year.22 New Jersey’s analysis of its
their goals while protecting the economy. The appeal climate reduction plan also found a net benefit to the
of cap and trade—and, more recently carbon taxes—is state.
growing as states look for cost-effective reduction
approaches that also support their mandates for clean Since a national cap and trade policy for greenhouse gas
energy and energy efficiency. Many policymakers are emissions is looking more likely, those states with climate
beginning to consider reduction efforts to be compatible policies are likely to be a step ahead when such a program
with economic growth. Some feel the technologies and is implemented.

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 12. Kenneth Green, “Climate Change: Caps vs.
Notes Taxes,” American Enterprise Institute for Public Policy
Research (2007); www.aei.org/docLib/20070601_EPOg.
1. California Air Resources Board Climate Change pdf.
Draft Scoping Plan (Calif.: CARB, June 2008), 17; www. 13. Ian Parry, “Fiscal Interactions and the Case for
arb.ca.gov/cc/scopingplan/document/draftscopingplan.pdf. Carbon Taxes Over Grandfathered Carbon Permits,” Oxford
2. U.S. Environmental Protection Agency, Acid Rain Review of Economic Policy (2003): 385-399.
Program 2006 Progress Report (Washington D.C.: U.S. 14. Clark Williams-Derry, “Three Major Contenders
EPA, 2007); www.epa.gov/airmarkets/progress/docs/2006- for Carbon Pricing” (Washington: Sightline Institute,
ARP-Report.pdf 2008); www.sightline.org/research/energy/res_pubs/carbon-
3. U.S. Environmental Protection Agency, Cap and pricing-101-1-08.pdf.
Trade: Acid Rain Program Results (Washington D.C.: 15. Regional Greenhouse Gas Initiative Model Rule
U.S. EPA, 2007); www.epa.gov/airmarkt/cap-trade/docs/ (2008); www.rggi.org/about/history/model_rule.
ctresults.pdf. 16. Information from the RGGI website (www.rggi.
4. Lauraine G. Chestnut and David M. Mills, “A org) and its current press release - Design Elements for
Fresh Look at the Benefits and Cost of the US Acid Rain Regional Allowance Auctions under the Regional Greenhouse
Program,” Journal of Environmental Management 77, no. 3 Gas Initiative (March 17, 2008); http://www.rggi.org/
(November 2005): 252-266; www.epa.gov/airmarkt/cap- docs/20080317auction_design.pdf.
trade/docs/benefits.pdf. 17. Western Climate Initiative press release, “U.S.
5. A. Denny Ellerman and Barbara K. Buchner, “The States, Canadian Provinces Announce Regional Cap-and-
European Union Emissions Trading Scheme: Origins, Trade Program to Reduce Greenhouse Gases” (Sep. 23,
Allocation, and Early Results,” Review of Environmental 2008); www.westernclimateinitiative.org/ewebeditpro/
Economics and Policy 1 (2007): 66-87. items/O104F19871.pdf.
6. Clark Williams-Derry and Eric De Place, 18. A Poll of 47 economists found that a majority
“Why Free Allocation of Carbon Allowances Means agreed that a tax on greenhouse gases would be the most
Windfall Profits for Energy Companies at the Expense of efficient way to reduce emissions. Phil Izzo, “Is it time for a
Consumers” (Washington: Sightline Institute, 2008); www. new tax on energy?” The Wall Street Journal (2007).
sightline.org/research/energy/res_pubs. 19. Bengt Johansson, “Economic Instruments in
7. Robert Shapiro, “Addressing the Risks of Climate Practice 1: Carbon Tax in Sweden” (Stockholm, Sweden:
Change: The Environmental Effectiveness and Economic Swedish Environmental Protection Agency, 2000); www.oecd.
Efficiency of Emissions Caps and Tradable Permits, org/dataoecd/25/0/2108273.pdf.
Compared to Carbon Taxes,” The American Consumer 20. Swedish Ministry of the Environment and Natural
Institute (2007); www.theamericanconsumer.org. Resources, Taxes and Charges in Environmental Policy: The
8. William Nordhaus, “To Tax or Not to Tax: Swedish Experience (Stockholm, Sweden: Swedish Ministry
Alternative Approaches to Slowing Global Warming,” of the Environment and Natural Resources, 1995); www.
Review of Environmental Economics and Policy (2007): 26- ksdn.or.kr/consumption/eloffson.txt.
44. 21. Edward Gomez, “Sweden’s innovative green
9. William Pizer, “Combining price and quantity tech: It’s a [bio]gas, gas, gas!” San Francisco Chronicle
controls to mitigate global climate change,” Journal of (May 1, 2008); www.sfgate.com/cgi-bin/blogs/sfgate/
Public Economics (2002): 409-434. detail?blogid=15&entry_id=26154.
10. Ibid. 22. California Air Resources Board, Climate Change
11. lark Williams-Derry and Eric De Place, Draft Scoping Plan, Economic Analysis Supplement, Pursuant
“Why Free Allocation of Carbon Allowances Means to AB 32 (Sacramento, CA: CARB, 2008); www.arb.ca.gov/
Windfall Profits for Energy Companies at the Expense of cc/scopingplan/document/economic_analysis_supplement.
Consumers.” pdf.

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