Academics serious about addressing the climate crisis agree: we need to put a price on carbon. But it’s tough to sell an idea without a shared vocabulary and many people are unclear about what this phrase – “put a price on carbon” – even means. Still more are puzzled by terms like “cap-and-trade,” “fee-and-dividend,” and “revenue neutral carbon tax swap.”
We need to fix this problem. Winning broad support for an idea requires that it be intelligible to the general public, not just a bunch of policy wonks. Therefore, this post and the next one will be dedicated to decoding the jargon around “putting a price on carbon.” I will return to explaining why adopting Pure Cap-and-Dividend is the best of the many policy options available to us later. For now, I just want to make sure we are speaking the same language.
Putting a Price on Carbon
Let’s start with the basics. “Putting a price on carbon” means “making utilities and other significant emitters of carbon dioxide and other greenhouse gases pay money for the greenhouse gases they emit.” The concept is straightforward: Requiring payment for greenhouse gas emissions creates a financial incentive to reduce or avoid the emissions. After all, businesses don’t want to pay more than necessary for the inputs used to create their products and services and consumers prefer lower prices, other factors being equal.
You might have noticed that “carbon” is a slippery term. Sometimes it is short for “carbon dioxide,” sometimes for “greenhouse gases” more generally. At times it means “greenhouse gas emissions” – as it does in the phrase “put a price on carbon.” In the context of “carbon trading” (discussed below) it means “greenhouse gas emissions permits.” Sometimes it even means, well, “carbon.”
“Carbon” is often used as shorthand for greenhouse gases because carbon dioxide is the most prevalent greenhouse gas (causing around 80% of the trouble). In addition, some other greenhouse gases include carbon; methane, for example, consists of carbon and hydrogen.
Different gases have different “strengths” when it comes to causing climate change – but carbon dioxide serves as a benchmark. For example, when looked at over a one hundred year period, one metric ton of methane results in about the same amount of warming as 21 metric tons of carbon dioxide. Thus, emissions of all greenhouse gases are frequently discussed in terms of their equivalence to carbon dioxide, and, more specifically, measurements are converted to “metric tons carbon dioxide equivalent” (mtCO2e). In keeping with common practice, I refer to metric tons of carbon dioxide equivalent as “tons of carbon dioxide” as shorthand. Thus, in the discussion below, what I really mean by “ton of carbon dioxide” is “a metric ton of carbon dioxide or an equivalent amount of any other greenhouse gas.”
Taxes and Caps
Plans to tax carbon emissions generally require that utilities and other major emitters of greenhouse gases pay a tax on each ton of carbon dioxide they release, usually with the tax increasing over time. To make the system easier to administer, fuel suppliers rather than actual emitters would pay the tax in many cases. Having the supplier pay eases the administrative burden when fuel is widely distributed as with gasoline and fuel oil, for example. Since we know how much carbon dioxide will be emitted when the fuel is burned, it’s easier to collect the tax from the supplier.
Sometimes the carbon tax is referred to as a “fee.” Call it what you will. As Richard Darman, Bush 41’s budget director, famously observed, “If it looks like a duck, walks like a duck, and quacks like a duck, it’s a duck.”
Capping carbon emissions is a more direct approach to fighting climate change. Instead of placing a set price on carbon emissions and hoping that the price increase will result in the desired decrease in emissions (as the tax approach does), carbon cap proposals start by limiting aggregate emissions. Those aggregate limits then drop each year.
To enforce the limits, each year the government creates a quantity of emissions permits equal to the number of tons of carbon dioxide allowed by that year’s emissions cap. Each permit, then, grants the permit holder the right to emit one ton of carbon dioxide. The permits are then auctioned off to the highest bidder. Auctions take place periodically, much like treasury notes are auctioned off. For example, one twelfth of the annual quantity could be auctioned off each month.
Emitters must periodically surrender permits for each ton of carbon dioxide they have emitted. (Similar to the carbon tax, in certain cases the obligation to obtain permits would fall to the fuel supplier instead of the actual emitter in order to ease administrative burden.) A rigorous carbon cap program imposes steep penalties on emitters that fail to surrender permits. (The penalty must be higher than the market price for permits, otherwise emitters would simply pay the penalty.)
As with a carbon tax, with a carbon cap in place, emitters must pay for their emissions. But while a carbon tax has a fixed price per ton of carbon dioxide emitted, the price under a carbon cap program is determined by market demand for the limited number of permits available. (For purposes of this discussion, I am ignoring “offset projects” which can increase the supply of emissions permits. Many people dislike offset projects because some projects have been bogus. I will defend offset projects in a later post; for now, please keep an open mind.) And, yes, since emitters now have to pay a price for emissions permits, well, it’s another duck. Opponents of carbon caps sometimes attack carbon cap programs as “cap-and-tax” in an effort to emphasize that point.
As if policymakers wanted to keep things confusing, some proposals combine the tax approach and the cap approach. One way to do this is to cap emissions and create emissions permits, but then place a floor (minimum) and ceiling (maximum) on the price of the permits. Similarly, some emissions cap proposals include an “alternative compliance payment” (ACP) mechanism. These are payments that emitters can make instead of surrendering permits; these fixed charges effectively serve as a ceiling on the price of emissions permits since no rational actor would ever buy a permit for more than the ACP. They also essentially eviscerate the cap since emitters could pay the ACP payments for unlimited emissions, just like they could pay a tax for unlimited emissions.
Carbon Trading
Carbon cap programs allow utilities and other emitters to buy and sell (or “trade”) the emissions permits that they purchase (or, which are given to them) just as they trade other commodities, such as oil and gas. Thus, carbon cap programs are also called “cap-and-trade” programs.
Carbon cap-and-trade programs are modeled, in large part, on the cap-and-trade program used to limit emissions of sulfur dioxide and nitrogen oxides, pollutants largely responsible for acid rain. The Clean Air Act Amendments of 1990 established a cap-and-trade program that is widely credited with achieving significant reductions in these pollutants (and a corresponding reduction in acid rain) at a fraction of the predicted cost. Still, references to “cap-and-trade” today are most often references to carbon cap-and-trade policies.
Developing a robust, efficient, and transparent market for trading carbon emissions permits is important to a carbon cap program’s success. The market helps utilities and other emitters plan. For example, they can lock in permit prices by purchasing futures and options, much the way they can lock in fuel prices and other costs in advance.
Although some people assert that trading carbon emissions permits (a.k.a. “trading carbon” or “carbon trading”) is too complicated, in truth existing infrastructure and regulations can be adapted to include emissions permits which are essentially just another commodity. Trading of emissions permits and futures and options on those permits would fall to the Commodities Futures Trading Commission. Emissions permits (including permits for other types of pollution) have been traded at the state, regional, national, and international level for many years so we have plenty of experience to draw upon.
Coming Up Next
We have now reviewed the basics of carbon taxes and carbon caps – two policies that “put a price on carbon” – and hopefully I have successfully decoded some of the accompanying jargon. My next post will build on the above and explain related terms. So stay tuned and be prepared to become an expert on “revenue neutral carbon tax swaps” and “cap-and-dividend” proposals.