Carbon pricing can take a variety of forms. A carbon tax places a direct price on carbon. In contrast, under a cap-and-trade program, the government sets a long-term goal and interim yearly caps, and then distributes emission allowances equal to the cap. If the government distributes the allowances by means of an auction, then the auction price establishes the carbon price. If the government gives away allowances, then allowance trading among regulated entities establishes the carbon price. Each type of program, tax and cap-and-trade, can take a variety of forms and operate pursuant to a wide range of parameters. Because this essay focuses on carbon pricing writ large, I do not parse through the details here.
Notwithstanding its limitations, carbon pricing has a vital role to play. A carbon price would help internalize the societal costs of emitting carbon dioxide, incentivize reductions, and generate revenue to invest in an equitable transition and prepare for climate impacts.
Notwithstanding the limitations I articulate below, I want to make clear that carbon pricing has a vital role to play. As pricing advocates have explained in detail,[i] a carbon price would help internalize the societal costs of emitting carbon dioxide and would create at least some ongoing incentive for producers and consumers to reduce carbon consumption.
A carbon price, particularly a carbon fee or auctioned allowances in a cap-and-trade program, would also generate revenue that would help finance a clean energy transition, finance climate adaptation, and, for disadvantaged communities, help buffer higher costs and enable participation in a green transition. Carbon pricing could also spur regulatory innovation, as government entities consider how they can help their constituents – across all sectors – better avoid the cost of carbon.
I pointedly exclude one frequently articulated advantage of market mechanisms: their relative cost-effectiveness.[ii] In the short term, market mechanisms save costs by allowing entities facing high emission-reduction costs to either pay the tax or, in a cap-and-trade program, buy allowances from lower-cost reducers. Collectively, then, reductions are done by those who can do them most cheaply, lowering the cost of achieving a collective goal. However, the downside to this dynamic is that it gives high-cost reducers an out[iii] – and could reduce the incentive to invest now in a long-term, economy-wide green transition. That brings us to the limitations of market mechanisms.