Carbon Emission: Regulatory Controls vs. Market Based Solutions

Many of you have been asking what the difference is between regulatory approaches and market based solutions to carbon emissions.  The answer is fairly simply but depends on what you want the outcome to be.  The whole question can be boiled down to: Tax or Trade?

A carbon tax is a pure price instrument that establishes a certain price on pollution.  While the price is guaranteed, the final emissions reduction is not.  For example, a $5 tax/ ton on CO2 emissions for a firm that pollutes 100 tons of CO2/ year would cost the firm $500.  This policy creates certainty for businesses and governments, but leaves uncertain the amount of emissions reduction. 

On the other hand, a cap-and-trade system (or quantity instrument) determines the final output of allowed emissions, but leaves the price uncertain.  In a certain year where polluters find it hard or costly to reduce emissions, the price of each credit would rise as companies bid up the price of the allowance.  In a different year, the price of the credits might fall as many industries would have a surplus of their pollution credits available on the market.  As companies find it harder to meet the required pollution allowances, the price of each credit would increase with demand.  Every so often credits would be removed from the market in order to achieve the desired level of emissions.

So which one is better?  Depends.  It all depends on what the predicted damage costs are.  If the marginal damage costs are high, then it is better to use a quantity mechanism because you know the level of pollution output.  The market will set the rate.  If the marginal damage costs are low, and policy makers are worried about the high costs of transition to a low-carbon economy, then a price mechanism would be the better option because it would provide more clarity to the business community when making future investment decision.  Hit me back and let me know your thoughts.