THE

carbon
alternative tax
An alternative
to carbon
trading

ROBERT J. SHAPIRO is the chairman of Sonecon, LLC, a private firm that

7 advises US and foreign businesses, governments and non-profit

organisations. Dr. Shapiro has advised, among others, US President Bill

Clinton and British Prime Minister Tony Blair; private firms including Amgen,

AT&T, Gilead Sciences, Amgen, SLM Corporation, Nordstjernan of Sweden,

and Fujitsu of Japan; and non-profit organisations including the American

Public Transportation Association, the Education Finance Council, and the

US Chamber of Commerce. He is Senior Policy Fellow of the Center for

Business and Public Policy of Georgetown University, a Senior Fellow of the

Progressive Policy Institute (PPI), a director of the Ax:son-Johnson

Foundation in Sweden, and co-chair of American Task Force Argentina.

From 1997 to 2001, he was Under Secretary of Commerce for Economic

Affairs. Prior to that, he was co-founder and Vice President of PPI.

Dr. Shapiro also served as the principal economic advisor to William

Clinton’s 1991-1992 presidential campaign, senior economic advisor to

Albert Gore, Jr. and John Kerry in their presidential campaigns, Legislative

Director for Senator Daniel P. Moynihan, and Associate Editor of US News

& World Report. He has been a Fellow of Harvard University, the Brookings

Institution and the National Bureau of Economic Research. He holds a Ph.D.

from Harvard University, as well as degrees from the University of Chicago
and the London School of Economics and Political Science.

66 CEDA GROWTH 59
 PHOTO: iSTOCK

Summary their emissions targets year by year, but will introduce sig-
A solid consensus has emerged among scientists and nificant additional volatility in energy prices. These
most public officials around the world that emissions of systems also entail substantial administrative complexities
greenhouse gases from burning fossil fuels, especially and costs, and their emissions goals can be undermined by
carbon dioxide (CO2), contribute significantly to climate evasion and manipulation. Carbon taxes are less certain to
changes which could have very serious, adverse effects. achieve their emissions targets year by year, but their levels
Wherever greenhouse gases originate they affect everyone can be adjusted to minimise this deficiency. They are also
because they disperse widely in the upper atmosphere easier and less expensive to administer, less vulnerable to
and accumulate there for a century. Since every industri- manipulation and evasion, and provide more reliable
alised nation produces these emissions they all need to be incentives to develop and use alternative fuels and more
part of the global effort to control them. energy-efficient technologies. Based on economic analyses
and evidence, we conclude that carbon taxes are the more
This paper examines the two most prominent strategies
environmentally effective and economically efficient
for reducing greenhouse gases: a global system of national
strategy for addressing climate change.
caps on the emissions and tradable permits, modelled on
the Kyoto Protocol, and global, harmonised, net carbon-
based taxes. It finds that cap-and-trade systems can achieve

CLIMATE CHANGE GETTING IT RIGHT 67

 Introduction cap, but the cap for the system is set below its current or
Scientists and most public officials around the world forecast emissions. Companies and countries whose
have come to a solid consensus that the greenhouse gases emissions exceed their caps therefore either have to
emitted when fossil fuels are burned, especially carbon reduce them either by cutting their energy use or substi-
dioxide (CO2), contribute to climate changes that will tuting cleaner forms of energy, or by purchasing permits
have very serious effects on the planet. These greenhouse to cover the gap from those whose emissions are less than
gases disperse widely through the upper atmosphere and their own caps. The costs of the permits or the steps
remain there for about a century, so wherever they origi- taken to cut energy use or use cleaner fuels are passed on
nate they affect everyone on Earth. Since every nation in higher prices, so once again countries and firms with
with an industrialised economy produces these emis- higher emissions pay higher prices for energy. However,
sions, a successful effort is needed to control them which those price increases are less predictable and will vary
must include all industrialised countries. With strong month to month depending on the size of the gap.
leadership, the world community may be able to come
together to address this problem before the limited Kyoto
agreement expires in 2012. To prepare, policymakers
The critical economic distinction
must very carefully analyse their alternatives, to ensure
that the approach finally chosen is the most effective and
is that cap-and-trade directly
efficient one available.
controls the quantity of emissions,
In this paper we examine the two leading strategies for
reducing greenhouse gases: a global system of national while carbon taxes directly control
caps on greenhouse gas emissions and tradable permits,
based on the emissions targets and timetables created by their price.
the Kyoto Protocol (cap-and-trade); and global, har-
monised, net carbon-based taxes (carbon taxes). Recent
The two approaches differ in several other important
economic analyses and evidence strongly suggest that
ways. The critical economic distinction is that cap-and-
carbon taxes would be a more environmentally effective
trade directly controls the quantity of emissions, while
and economically efficient way to address climate change
carbon taxes directly control their price. The result is that
than a cap-and-trade system, and provide stronger incen-
cap-and-trade can produce a designated quantity of
tives to develop alternative fuels and more energy-efficient
emissions, but with much greater potential volatility in
technologies (Nordhaus 2005; Cooper 1998, 2005).
energy and energy-related prices, while carbon taxes will
Other policies also affect climate change, especially produce more certain prices for energy and energy-inten-
steps to protect and re-plant tropical forests and to sive goods, but greater uncertainty about the quantity of
support new technologies that can reduce emissions or total emissions. These two trade-offs are not equivalent.
their adverse effects on the climate. Reforestation and By regulating the quantity of emissions, a strict cap-and-
such scientific advances will have to play important roles trade program will drive the price of permits to whatever
in any climate change effort. Forestry measures are the level is required to bring emissions under its cap. The
most cost-effective responses available for many Latin price of permits and their underlying energy source will
American and African countries (Enkvist et al 2007). rise sharply when emissions increase, because, for
Moreover, both a strict cap-and-trade program and example, an industry or country’s growth accelerates or
carbon taxes impose substantial costs on emissions and the winter weather is colder than expected. This price
the energy that produces them, creating incentives to effect will introduce much greater up-and-down move-
reduce those costs by developing cleaner fuels and more ments in national energy prices, on top of the normal
energy-efficient technologies. As a political matter, the increases and declines in global energy prices. Under a
higher energy prices required to make progress will be cap-and-trade program strict enough to affect climate
difficult to sustain for longer periods without the change this increased volatility in energy prices will affect
prospect of technological advances that eventually can business investment and consumption. As the public
stabilise or even bring down those prices. learns to associate these unexpected price movements
with the cap-and-trade system, their support for the
Both of the two principal policy approaches necessarily
effort could erode. As we will see, this price volatility is
result in higher prices for fossil fuels, but in different
both evident and substantial in both the emission
ways. Carbon taxes raise the price of carbon-based energy
permits traded under the US acid rain program, the
directly, predictably and in a constant manner, imposing
major US example of cap-and-trade, and in the first 22
the greatest costs on those firms and economies that
months of CO2 permit trading under the European
produce the most emissions. In so doing, carbon taxes
Emissions Trading Scheme (ETS).
create direct incentives to reduce carbon-based energy
use or substitute cleaner forms of energy, until the cost of A carbon tax does not increase or accentuate the
doing so is greater than the tax. A serious cap-and-trade volatility of energy prices because it raises the unit-cost of
program applies no direct charge to emissions up to its energy by a constant amount (depending on its carbon

68 CEDA GROWTH 59
content), regardless of how fast a company, industry or industries and their thousands of companies and plants
nation’s emissions are growing. The predictable cost of a in the form of permits; then it must set up a monitoring
carbon tax facilitates government and business decisions system to track energy production at every site before
about investments and other steps to reduce emissions and after permits are traded.
and thereby reduce the burden of the tax. While the tax
Cheating also poses a more serious problem for cap-
will reduce emissions by raising the relative price of more
and-trade than carbon taxes. While some companies will
carbon-intensive fuels (and lowering the relative price of
try to evade their taxes, the government on the other side
less carbon-intensive alternatives), no one can predict the
of the transaction has a strong interest in discovering and
precise extent of those effects for any particular level of
stopping it. Under cap-and-trade, if a company fraudu-
carbon tax, and consequently the tax may be set too low
lently understates its energy production and emissions so
to achieve a particular emissions goal in a given year.
it can sell permits for some of them, the buyer on the
However, this shortcoming is more easily offset than the
other side of the transaction has no incentive to uncover
price volatility of cap-and-trade. The environmental
or reveal the fraud. As a result, Yale economist William
costs of greenhouse gases occur over a long term, and in
Nordhaus (2005) has concluded that “cheating will
principal a government can raise or lower the carbon tax
probably be pandemic” under cap-and-trade.
rate year by year to achieve the long-term emissions
reductions it seeks. While some proposals for cap-and- By creating tradable financial assets worth tens of
trade systems include provisions to reduce price volatility billions of dollars for governments to distribute and
by auctioning or distributing additional permits when monitor among their industries and plants, cap-and-
permit prices increase sharply, these provisions address trade programs also introduce incentives to cheat by
the price volatility after it has already occurred and taken corrupt and radical governments. Corrupt governments
a toll on investment. Moreover, the distribution of addi- will almost certainly distribute their permits in ways that
tional permits in the face of rising prices may also favour their supporters and understate their actual energy
sacrifice much of the environmental benefits of the cap- use and emissions. By doing so they can “earn” billions of
and-trade system. dollars in hard foreign currencies trading “excess”
permits, and in the process undermine the program’s
A second important difference is that global carbon
environmental goals. A global cap-and-trade program
taxes have generally comparable effects from country to
also has no way to prevent radical governments from
country, while a global cap-and-trade program usually
using such transfers to finance whatever purposes they
does not. When slow growth or mild weather reduces the
choose, whether it is education or domestic oppression,
energy use and emissions of a country or an industry it will
foreign assistance or foreign terrorism. Corrupt and
pay less carbon taxes, but in good times or bad times a
radical states can use carbon-tax revenues for such
uniform net carbon tax will impose comparable costs and
purposes too, but at least the resources come from their
provide comparable incentives from country to country to
own economies.
develop and adopt climate-friendly technologies and
strategies. By contrast, a global cap-and-trade system Given these drawbacks, cap-and-trade’s principal attrac-
creates a range of effects and incentives across countries, tion appears to be political feasibility. Many
depending on the base from which it calculates the emis- environmental activists assume that a global cap-and-trade
sions targets for each country. Once a cap-and-trade program is more achievable than global carbon taxes,
agreement determines that a country’s emissions should be because much of the world agreed to Kyoto and most
reduced by a certain percentage relative to its current emis- people resist higher taxes. On close analysis, the Kyoto
sions or to its emissions in a previous base year, the country agreement is too weak to signify a meaningful consensus
may be able to meet its target without taking any steps if for the kind of strict caps needed to address climate
its economy slows – or it could take serious measures to change. This disappointing result reflects three major
reduce emissions and still fail to meet its target because its political compromises that eroded most of Kyoto’s envi-
economy is growing faster than normal. ronmental potential: 1) its exemption for all developing
countries, including major greenhouse-gas producers such
The third important difference is that cap-and-trade
as China, India and Brazil; 2) its effective exemption for
programs are more difficult to administer and more vul-
Russia and the Eastern European countries, and substan-
nerable to evasion, corruption and manipulation than
tial leeway for many Western European countries, based
carbon taxes. The administration of a net carbon tax is
on the selection of the base year from which reductions are
straightforward: Each country would apply a tax rate to
calculated; and 3) a system of transfers that would have
every energy source, which, after counting the country’s
imposed such disproportionate costs on the world’s largest
current energy taxes and subsidies, would produce the
economy, the United States (along with Australia and a
global net carbon tax rate. Each country could also
few others), that it declined to ratify the agreement.
collect the receipts using the same mechanisms it relies
on for existing energy or business taxes. Under cap-and- People and companies in every country resist higher
trade, each country first has to create a new system to taxes. Yet Sweden and Denmark have applied carbon
distribute its national cap among its energy-related taxes, or their equivalent, and are now among the most

CLIMATE CHANGE GETTING IT RIGHT 69

 FIGURE 1
US ACID RAIN PROGRAM: ANNUAL PERCENTAGE CHANGE IN CLEARING PRICES FOR SO2 PERMITS, 1993–2006

ANNUAL CHANGE (%)

200

150

100

50

-50

-100
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

FIGURE 2
EUROPEAN EMISSIONS TRADING SCHEME: DAILY PRICE MOVEMENTS OF CO2 PERMITS, MARCH 2005–JANUARY 2007

SETTLEMENT PRICE (EUR/EUA)

35

30

25

20

15

10

0
05

06
05

06
05

06
5

06
05

06

06

07
05

06
05

06
05

06
05

06
06
05

06
0

L–

L–
T–

T–
R–

R–
R–

R–
N–

N–

N–

N–
V–

V–
G–

G–
C–

C–
Y–

Y–
B–
P–

P–
JU

JU
OC

OC
AP

AP
MA

MA
JU

JA

JU

JA
NO

NO
MA

MA
AU

AU
DE

DE
SE

SE
FE

emission-efficient economies in the world. A global Price volatility

carbon tax sufficiently high to affect climate change may When the world’s nations negotiated the cap-and-trade
also be seen more broadly as politically achievable when arrangements of the Kyoto agreement in the 1990s,
governments recognise that they can use its revenues to many economists and environmental activists supported
reduce their existing payroll or corporate taxes or finance the process and its result as a politically acceptable,
popular pension or health-care programs. On balance, if market-based way of improving the global environment.
the world community intends to take serious steps to By the late 1990s, however, researchers identified a
slow and ultimately reverse climate change, the evidence number of serious problems with cap-and-trade, and
strongly suggests that a global carbon tax would be many began to favour carbon taxes as a better alternative.
preferable to a global cap-and-trade system on economic, William Nordhaus (2005) recently published a literature
environmental and even political grounds. review covering recent economic research in this area,
and much of the following discussion draws on that
review and the research on which it is based.

70 CEDA GROWTH 59
 One serious problem is the well-documented tendency emissions are electricity-generating utilities, especially
of regulations that directly limit the quantity of some- those powered by high-polluting coal. Under a strict cap-
thing that people need to produce large volatility or and-trade program, when a particularly cold winter or
swings in the price of what is regulated. A powerful hot summer occurs or an economy grows faster than
demonstration occurred from 1979 to 1982, when the trend, CO2 emissions will rise sharply with electricity
US Federal Reserve Board shifted from targeting the consumption. Since the quantity of emission permits
price of credit (interest rates) to its quantity (monetary would be capped, their price would also rise sharply and
aggregates). As demand for credit increased or waned, be passed on to the consumer as higher electricity prices.
while the quantity of credit remained strictly regulated, The same dynamic would occur in oil and gasoline prices
interest rates moved much more sharply than at any time when demand for those fuels rise.
before or after this brief experiment in “monetarism”.
These national-based price movements will not only
The same price volatility is evident in the leading US tend to dampen business investment, especially in
instance of a cap-and-trade based environmental regula- energy-incentive areas such as manufacturing, where the
tion, the acid rain program. The program applies additional costs could make the difference between
cap-and-trade arrangements to major emitters of SO2 financially acceptable and unacceptable rates of return.
(sulfur dioxide) and NOx (nitrogen oxide). Recent More important, unexpected and accentuated energy-
analysis has found that the trading prices for the SO2 and price increases publicly linked to a cap-and-trade system
NOx emission permits have ranged from $66 per ton to could undermine public support for the effort and force
as high as $1,700 per ton, moving up and down by an governments to roll back or suspend their caps, poten-
average of 10 per cent per month and 43 per cent per tially unravelling the entire program.
year, or several times the volatility seen in oil prices or
stock-market prices (EPA). Moreover, this volatility has
increased in the last three years as permit prices have Kyoto shortcomings
risen by an average of more 80 per cent a year despite the The Kyoto agreement was signed and ratified by 165
use a “safety valve” provision under which the US nations, still awaits ratification by two other nations
Environmental Protection Agency has auctioned addi- (Croatia and Kazakhstan), and was signed by two more
tional permits to temper the volatility. countries that subsequently declined to ratify it (the US
and Australia). Despite its broad global support, Kyoto
The European Union’s Emissions Trading Scheme
commits only 38 industrialised countries – 36 with the
(ETS) for CO2 emission permits issued under the Kyoto
withdrawal of the US and Australia – to take action
guidelines has also experienced great price volatility. Its
before it expires in 2012. The agreement covers six emis-
permit prices have moved up or down by an average of
sions – CO2 (carbon dioxide), CH4 (methane), N2O
10 per cent per month in its first 12 months and 23 per
(nitrous oxide), HFC (hexafluorocarbon), PFC (perfluo-
cent per month from March 2006 to January 2007
carbon) and SF6 (sulfur hexafluoride).) These 36
(European Energy Exchange 2007). From March 2005
countries agreed to achieve specific reductions in their
to February 2006, permit prices predominantly moved
CO2 and other greenhouse emissions, ranging from 8 per
up, increasing by 17 per cent per month in the first four
cent below 1990 levels for the EU and 6 per cent below
months and an average of 6 per cent per month in the
1990 for Japan, to 10 per cent above 1990 emissions for
first 12 months. From March 2006 to January 2007,
Iceland. The Kyoto agreement also allows countries and
ETS permit prices generally moved down, with average
companies to buy and sell rights to produce emissions.
price declines of 23 per cent per month. In contrast to
Since the cost of reducing emissions differs from plant to
the constant impact of a carbon tax, those sharp declines
plant, industry to industry and country to country, this
in permit prices greatly reduce incentives for firms to
trading provision creates a market for emission rights
limit their emissions (IHT 2006).
that can help to ensure that emission reductions consis-
For this and other reasons, the ETS is failing to reduce tent with the overall targets occur where they can be
overall emissions. In 2005 total CO2 emissions increased achieved relatively inexpensively.
by 0.4 per cent in the EU-25 and by 0.6 per cent among
In addition to price volatility, the Kyoto-based arrange-
the EU-15, despite the “caps” (European Energy Exchange
ments embody two problems that seriously impair its
2006). Looking ahead, the European Environmental
effectiveness and efficiency, namely, the base year from
Agency (EEA) projects that the EU is likely to achieve no
which its targeted reductions are calculated, and the
more than one-quarter of its Kyoto-targeted reductions by
exclusion of developing nations from the targets. Both
2012, and much of that will reflect credits purchased from
aspects were necessary to achieve a political agreement,
Russia or other transitional countries, with no net envi-
but together they profoundly weaken the project.
ronmental benefits (Egenhofer, et al. 2006; European
Energy Exchange 2006). In 1997 the parties to Kyoto designated 1990 as the
base year from which it would calculate its 2008–2012
Comparable price fluctuations for CO2 permits under
national targets for lower emissions. The choice of 1990
a serious, global cap-and-trade program would have sig-
created serious distortions which were well recognised at
nificant economic costs. The largest producers of CO2

CLIMATE CHANGE GETTING IT RIGHT 71

 the time. First, 1990 was the peak year of economic centrate all of the reductions in 38 countries that
activity in the Soviet Union and Eastern Europe before produce just over half of all worldwide emissions; with
their state-directed economic systems unravelled. The the US and Australian withdrawal, the agreement covers
World Bank (2006) reports that Russia’s economic pro- just 30 per cent of global emissions (Nordhaus 2005).
duction slumped from $385 billion in 1990 (2000 The exemptions for developing countries also seriously
dollars) to $286 billion in 2002, and its corresponding impair the program’s economic efficiency, since about
CO2 emissions fell from 2.26 million tons to 1.43 half of the most cost-effective opportunities for reducing
million tons. Since Russia’s Kyoto target is an 8 per cent emissions would occur as developing economies replace
reduction from its 1990 levels of 2.26 million tons, the old industrial plant, build new energy infrastructure, and
1990 base year allows Russia to increase its emissions find alternatives to deforestation.
from 1.43 million tons to 2.08 million tons (2.26 x 0.92)
Unsurprisingly, an econometric simulation of the costs
or 45 per cent, and earn an enormous financial windfall
and benefits for the world’s regions estimates that the
by selling its excess tradable permits until its emissions
benefits will exceed costs only for those countries that are
reach that level. According to one estimate, if the 38
exempt from the costs (Nordhaus 2005). If the US par-
nations assigned targets under Kyoto all participated on
ticipated, however, it could face net long-term costs of
a strict basis Russia and Eastern Europe could take in
more than $5 trillion, while Western Europe, Japan,
about $40 billion a year (1990 dollars) by selling their
Canada and Australia together would face $2 trillion in
excess permits, principally to companies in the US,
net costs (Aldy et al. 2003).
Australia, Canada and Japan (Nordhaus 2005; Nordaus
and Boyer 2000). The designation of those countries subject to Kyoto
targets and those which are exempt has no economic or
Kyoto’s 1990 base year also allows Germany and the
environmental justification. It is not based on a nation’s
United Kingdom, which together account for 80 per cent
ability to bear the costs, since Kyoto exempts wealthy
of the EU-15’s targeted reductions, to avoid taking serious
Middle Eastern states such as Qatar with a per capita
steps to reduce their emissions. Following Germany’s
GDP of $43,110, and the United Arab Emigrates,
reunification in October 1990, much of East Germany’s
Kuwait and Brunei with per capita GDP of more than
out-dated and high-polluting, state-owned industrial
$20,000 (World Bank 2006). The exempt countries also
plants were dismantled or closed down. As a result,
include many major producers of greenhouse gases,
Germany’s target of 8 per cent reductions from a 1990
including several with substantial per capita GDPs such
base also became a license to increase emissions. Similarly,
as Singapore, Taiwan, Korea and Hong Kong.
the privatisation of British coal mining in 1995 cut coal
use in Britain just as its North Sea natural gas operations One justification commonly cited is a sense of histor-
expanded, allowing Britain to actually increase its emis- ical equity – since the developed countries are responsible
sions and still meet an 8 per cent reduction target for most of the current atmospheric stock of greenhouse
calculated from a 1990 base (Aldy et al. 2003). gases, they should bear the cost. Wealthy countries were
largely responsible for the greenhouses gases produced in
The 1990 baseline also penalises countries that had
the 1970s and 1980s. However, by 2002 when Kyoto
already made substantial progress in reducing emissions.
was approved, six major exempt countries – China,
The Netherlands, Sweden, Denmark and Japan, which
India, Korea, Brazil, Mexico and South Africa –
had controlled much of their emissions by 1990, will
accounted for more than 25 per cent of global CO2 emis-
find it more difficult and expensive to further reduce
sions (World Bank 2006). By 2012, China and those five
them and will have to purchase additional permits from
other large, exempt nations will produce more than one-
Russia and Eastern Europe (Cooper 2001). The Kyoto
third of global CO2 emissions.
baseline also penalises the US, Australia, Ireland and few
other countries for experiencing strong growth and con- The result of the combination of these exemptions and
sequent increases in energy use since 1990 (Canes 2003). the 1990 base year is that Kyoto will produce little
For them, the 1990 base year produces 2012 caps which progress on global warming. Even if the US shifted course
they cannot meet regardless of how much they invest in and participated, and Kyoto’s provisions were all strictly
new technologies and alternative fuels. Instead, they implemented and enforced, the program would abate the
would have to pay Russia and Eastern Europe tens of expected increase in global temperatures between now
billions of dollars for their excess permits (Cooper 1998). and 2050 by just 0.02˚ to 0.28˚C (Nordhaus 2005).
Kyoto’s prospects for affecting climate change are The complex trading arrangements of a cap-and-trade
further undermined by the exemption granted to devel- program also present problems that tend to degrade its
oping countries, including major sources of CO 2 environmental results and increase its costs. Once negotia-
emissions such as China, India and Brazil. Those and tors determine a global cap and distribute it across the
other developing nations agreed to ratify Kyoto only if it involved nations, each government is free to distribute its
imposed no constraints on their economic development, nation’s permits among its industries and companies as it
and as recently as 2006 China reiterated its position of chooses. Even in a transparent and democratic society, dis-
never accepting emission caps. These exemptions con- tributing a scarce and valuable benefit through the normal

72 CEDA GROWTH 59
political process invites pressures that often produce Tax relief
special preferences for influential interests and companies. The first burden for any tax-based regulatory approach is
For example, the German government announced in June to minimise its effects on “relative prices”, which can make
2006 that it would exempt its coal industry, the country’s an economy less efficient. The gist of this issue is that
largest greenhouse-gas producer, from its CO2 caps under whatever is taxed becomes more expensive relative to what
the European ETS. In countries without a transparent remains untaxed, so what consumers and corporations buy
democratic process – Russia, the Ukraine, and many and use is no longer determined simply by prices reflecting
others – these pressures may go unchecked, and political the costs to produce them. Since taxes of some kind are
favouritism and corruption will almost certainly substan- unavoidable the challenge is to design them so they distort
tially determine how the permits are distributed. these relative prices as little as possible. Part of the answer
is to make the base of the tax broad, so its rate can be low
and most people and activities are affected equally. Carbon
… cap-and-trade programs create taxes generally meet this criterion, although not as well as
broad income or consumption taxes. Moreover, the
new temptations for countries to economic drawback of raising the price of carbon-inten-
sive products and operations, relative to those which are
cheat, because … “limiting emissions not, is the environmental purpose of a carbon tax.

[through caps] creates a scarcity Further, a close analysis shows that these traditional
concerns about efficiency effects are largely moot for
where none previously existed – in carbon taxes. Efficient markets and correct relative prices
depend on a close correspondence between the prices of
essence printing money for those in goods and services and the total costs to produce them.
However, economists have long recognised that the pol-
control of the permits”. lution created by the production and use of fossil fuels is
a cost not captured in the prices of these fuels. These
“externality” costs fall on those who happen to live or
The subsequent trading of the permits introduces more
work close to where the fuel is produced or used, usually
problems. To have much effect, a global cap-and-trade
in the form of higher health care costs. In the case of
program will have to cover hundreds of thousands of
greenhouse gases and climate change these costs are
installations in scores of countries, and the trades among
borne by almost everyone, but again based not on how
them will require accurate measurements of the energy
much fuel a person uses but on where he or she lives.
production or emissions on both sides of each transac-
tion, before and after the trade. That may be plausible in A carbon-based tax could capture the externality costs of
advanced countries with elaborate, professionalised regu- those pollution emissions and embed them in the market
latory systems, but it’s considerably less likely in price of fuel, creating what economists call a market-per-
transitional economies such as the Czech Republic and fecting Pigouvian tax (after Arthur Pigou, the English
Romania, and frankly implausible in places such as Russia economist who first wrote about these issues). Using a
and China. Cap-and-trade systems also have built-in Pigouvian tax that raises the price of a fuel to reflect its
incentives for cheating and corruption, because both externality costs should improve economic efficiency by
buyer and seller can gain by understating their emissions. better aligning the relative prices of things with all of their
Even if only the seller cheats by understating its emissions costs, especially if the revenues were used to offset the costs
(creating or increasing the permits it can offer for sale), borne by those subject to its pollution. While we do not
the buyer has no incentive to discover or reveal the fraud. know what precise level of carbon tax would capture all of
these costs, a tax which embeds a significant part of those
Finally, cap-and-trade programs create new tempta-
costs should improve the efficiency of prices.
tions for countries to cheat, because, as Nordhaus (2005)
notes, “limiting emissions [through caps] creates a Another economic issue is the degree to which a carbon
scarcity where none previously existed – in essence tax would focus environmental improvements where they
printing money for those in control of the permits”. A can be achieved most cheaply or efficiently. Cap-and-trade
global cap-and-trade system will include countries ruled programs achieve this by using tradable permits, at least in
by corrupt or radical regimes – as does Kyoto – presum- principle. Carbon taxes also can achieve this form of
ably eager to raise billions of dollars or euros by economic efficiency and without a cumbersome trading
understating emissions and then trading artificially mechanism susceptible to base-year distortions, exemptions
inflated numbers of excess permits. Under a global-cap- and cheating. The tax would raise the price of carbon-based
and-trade program, countries such as Iran, Syria and the energy in proportion to its carbon content, so that coun-
Sudan might be able to raise international capital by tries and companies which can reduce their carbon
selling permits; and even under Kyoto they can receive emissions for less than the incremental cost of the tax can
credits for clean-energy investments which can be traded be expected to do so, while those which find that reducing
like permits to raise funds (Torvik 2002). emissions would cost more than the tax will pay it. The

CLIMATE CHANGE GETTING IT RIGHT 73

 consequent reductions in emissions should be greatest cent compared to their 1990 levels, while Kyoto could
where the costs of achieving them are lowest, within each reduce those emissions by 12 per cent with US participa-
country and worldwide. Carbon taxes should also create tion and by 3 per cent without the US. By 2045, the
more reliable incentives for companies to develop environ- carbon tax would bring down emissions by 30 per cent
mentally-friendly technologies or abatement strategies. The from their 1990 levels, while Kyoto would produce
tax would provide “a continual incentive to reduce the costs reductions of 15 per cent with US participation and still
of carbon abatement”, as one expert has put it (Chupka 3 per cent without the US. By 2075, the hypothetical
2001), because the permanent increase in the cost of carbon tax would reduce emissions by fully 40 per cent
carbon-intensive energy would raise the rate of return on compared to their 1990 levels, while Kyoto could achieve
the development and use of technologies that reduce the only a 16 per cent reduction with US participation and
consumption of those forms of energy. less than 4 per cent without it.

Administrative ease Overseas results

A global carbon tax regime would still present serious In 2005 New Zealand proposed a carbon tax, scheduled
challenges. Significant CO2-producing countries have to to take effect in April 2007, but reversed course in
agree on what is to be taxed, the rate, and how to treat December 2005 after elections increased the influence of
other taxes and government spending that may reduce or minor parties supporting the government but opposed to
increase the effective burden of a carbon tax for partic- the tax. Sweden and Denmark have had substantial
ular industries. However, it would be unrealistic to carbon taxes in place since the early 1990s. While all
expect governments to strip their budgets and tax codes Western European countries impose significant taxes on
of all preferential treatment for energy companies or gasoline and other transportation fuels, only Denmark
energy-intensive manufacturers. Instead, the agreement and Sweden also apply them to carbon-based energy used
could set a uniform net carbon tax for countries and by industry. In 2000 their taxes, respectively, were $67
create an arbitration body to determine each country’s and $64 (PPP $) per ton of CO2 for coal in industrial uses
current net carbon tax burden based on its existing fuel- and $72 and $52 per ton of CO2 for diesel, oil and other
related subsidies, taxes, credit programs and other fuels used for industrial purposes (Baranzini, Goldenberg
preferences, plus the additional tax required to achieve a and Speck 2000). By contrast, Germany, the UK,
roughly uniform carbon tax level (Victor 2001). These Australia, the US and most other advanced economies
issues are complicated, but technically manageable. The imposed no taxes on coal used for industrial purposes and
International Monetary Fund (IMF) could review these modest taxes on other fuels used by industry.
net carbon tax burdens as part of its annual consultations
These tax differences play a significant role in differ-
with countries about their macroeconomic and fiscal
ences in their relative emissions. For each dollar (PPP) of
policies (Cooper 1998). Panels of experts could resolve
GDP, the Swedish economy in 2003 generated 0.221 kg
technical disagreements on the model of the panels that
of CO2 and the Danish economy 0.301 kg of CO2,
resolve technical issues in trade disputes before the World
compared to an average of 0.460 kg of CO2 for all high-
Trade Organization.
income OECD economies, 0.380 kg of CO2 per dollar
Once the terms of the tax are established, most countries of GDP in Germany, 0.353 kg in Britain, 0.604 kg in the
would apply it at the points where energy is generated or US and 0.717 kg in Australia (World Bank 2006). These
distributed, based on the fuel’s carbon content, much as results confirm the vast body of analysis and evidence
caps and permits are usually distributed at such points. In that carbon-based taxes are a highly effective way to
other respects a carbon tax should be relatively simple and reduce and control greenhouse gas emissions.
inexpensive to administer and enforce. While cap-and-
The evidence from cap-and-trade systems is less encour-
trade requires additional administrative systems and
aging. The chief example, the ETS, is expected to show
structures to allocate the permits and monitor their subse-
little genuine progress on European emissions. As noted
quent trades every government has a tax system in place
earlier, among the EU-15, total CO2 emissions actually
already, and most of them already tax energy.
increased by 0.6 per cent in 2005. Nor are the signs heart-
For all of these reasons a carbon tax regime should be ening for the 2008–2012 Phase 2 of the ETS. As of
more environmentally effective and less economically dis- December 2006, 11 of the EU-25 had failed to submit
ruptive than a cap-and-trade program. This expectation is completed plans for Phase 2 (EU 2006), and analysts
supported by recent econometric modelling that found that among those that did comply, most projected
compared the impact on CO2 emissions of the Kyoto higher base emissions than most independent analyses in
version of cap-and-trade with and without US participa- order to reduce their future burdens (Rathmann, Reece,
tion, and a hypothetical global carbon tax which limited Phylipsen and Voogt 2006). Further, Climate Action
CO2 concentrations to twice their pre-industrial levels by Network Europe, the region’s leading umbrella group for
2075 (Nordhaus 2005). By 2025 the hypothetical carbon environmental organisations, has found that many ETS
tax would reduce worldwide CO2 emissions by 17 per members have little capacity to monitor or verify the energy

74 CEDA GROWTH 59
 Economics, vol. 32, No. 3.
use or emissions of those who hold permits (Rathmann et
al. 2006). Finally, as also noted earlier, the EEA has pro- Canes, M. E. 2003, “Economic modeling of climate policy impacts,” The Climate Policy
Center, November.
jected that the entire ETS effort is likely to achieve no more
than one-quarter of the EU’s Kyoto-targeted reductions by Carlson, C., Burtraw, D., Cropper, M., and K. Palmer 2000, “Sulfur dioxide control by electric
2012 (EEA 2006), with much of those “reductions” utilities: What are the gains from trade?” Resources for the Future, Discussion Paper 98-
44-REV, April.
reflecting credits purchased from Russia or other countries
outside the EU with no net environmental benefits. Chestnut, Lauraine G., Mills and M. David 2005, “A fresh look at the benefits and costs of
the US acid rain program,” Journal of Environmental Management, 19 September.

Chupka, M. 2001, “Carbon taxes and climate change,” Encyclopedia of Energy, vol. 1.

Conclusion Climate Action Network – Europe 2006, “National Allocation Plans 2005–07: Do they
As the risks of climate change continue to grow, few coun- deliver? Key lessons for Phase II of the EU-ETS,” April.
tries seem prepared to pay a significant price to reduce “Climate Change Monitoring: International Greenhouse Gas Emissions Trading”. Available at
their greenhouse gas emissions. The Kyoto agreement was www.emissierechten.nl/climate_change_moniotring_inter.html.
achieved only after ensuring that most nations would pay Cooper, R. 1998, “Toward a real treaty on global warming,” Foreign Affairs, vol. 77, No. 2.
little or no price for many years, ultimately producing little
Cooper, R. 2001, “The Kyoto Protocol: A Flawed Concept,” Fondazione Eni Enrico Mattei
progress on climate change. The EU’s Emissions Trading Series, Working Paper 52-2001, July .
Scheme, based on the Kyoto targets, will likely achieve
Cooper, R. 2005, “Alternatives to Kyoto: The case for a carbon tax,”. Available at
even less. Moreover, there are powerful reasons to doubt http://www.economics.harvard.edu/faculty/cooper/papers.html.
that a better-designed cap-and-trade system could effec-
Egenhofer, C., Fujiwara, N., Ahman, M. and L. Zetterberg 2006, “The EU Emissions Trading
tively control global greenhouse gas emissions. The world’s Scheme: Taking stock and looking ahead,” European Climate Platform, July.
major CO2-producing, developing countries, including
Enkvist, P-A, Naucler, T. and J. Rosander 2007, “A cost curve for greenhouse gas reduc-
China and India, have vowed never to join a cap-and-trade
tion,” The McKinsey Quarterly, No. 1.
regime. Its complex administrative mechanisms and
United States Environmental Protection Agency, 2006, “Clean Air Markets – Data and
internal incentives are likely to produce substantial
Publications,”. Available at www.epa.gov/airmarkets/auctions/index.html.
cheating by both companies and some governments.
Perhaps most important, the energy-price volatility likely European Energy Exchange, EU Emission Allowances, 2005, available at
www.eex.de/get.php?f=emission_spot_historie_2005.
to arise in countries that strictly enforce genuine caps on
their emissions could rapidly undermine public support European Energy Exchange, EU Emission Allowances 2006, available at
www.eex.de/get.php?f=emission_spot_historie_2006.
and unravel the system. On balance, an alternative
approach based on global, harmonised net carbon taxes, European Energy Exchange, EU Emission Allowances 2007, available at
www.eex.de/get.php?f=emission_spot_historie_2007.
can better contain the risks of climate change, and do so in
an economically efficient and politically feasible way. European Energy Exchange, EU Emission Allowances 2006 “Annual European Community
2006 greenhouse gas inventory 1990–2004 and inventory report 2006.” Submission to
The task is to persuade the world’s major energy pro- the UNFCC Secretariat, European Environment Agency, December.
ducing and consuming countries to adopt harmonised European Environment Agency 2006, “Greenhouse gas emission trends and projections in
carbon taxes. The first step of simply expanding the public Europe 2006,” EEA Report No. 9/2006.
debate to include rigorous environmental and economic European Union 2006, “Climate change: Commission takes legal action over missing
analyses of the advantages and disadvantages of carbon national allocation plans, incomplete emissions reports,” December 12, available at
taxes and a cap-and-trade regime will be challenging. The http://europa.eu/rapid/pressReleasesAction.do?reference=IP/06/1763&format=HTML&ag
ed=0&language=EN&guiLanguage=en.
current US Congress and President oppose higher energy
taxes. On the other side of the world, the Australian International Herald Tribune 2006, “EU trading of pollution credits fails on goals,” 24 July.
Government recently issued a task force report, concluding Nordhaus, W. D. 2005, “Life after Kyoto: Alternative approaches to global warming policies,”
that emissions trading would be preferable to carbon taxes, National Bureau of Economic Research, Working Paper 11889, December.
but it failed to address the current results from the Nordhaus, W. D. 2006, “After Kyoto: Alternative mechanisms to control global warming,
European Trading Scheme, the environmental effectiveness foreign policy in Focus Discussion Paper, 27 March.
of Scandinavian carbon taxes or the growing economics lit- Pew Center on Global Climate Change, “The European Union Emissions Trading Scheme
erature on the subject (Australian Government 2007). The (EU-ETS) Insights and Opportunities”.
importance of these matters for every country deserves Rathmann, M., Reece, G., Phylipsen, D., and M.Voogt 2006, “Initial assessment of national
serious and dispassionate analysis. allocation plans for Phase II of the EU Emission Trading Scheme,” Ecofys, November.

Stavins, R. 2002, “Experience with market-based environmental policy instruments,”

Kennedy School of Government Working Paper No. 00-004, Harvard University.
REFERENCES
Trovik, R. 2002, “Natural resources, rent seeking and welfare”, Journal of Development
Aldy, J., Barret, S. and R. Stavins 2003, “Thirteen plus one: A comparison of global climate
Economics, Vol. 67.
policy architectures”, Kennedy School of Government Working Paper No. RWP03-012,
Harvard University. Victor, D. 2001, The Collapse of the Kyoto Protocol and the Struggle to Slow Global
Warming, Princeton University Press.
Australian Government 2007, “Report of the Task Force on Emissions Trading” Department
of the Prime Minister and Cabinet . World Bank 2006, World Development Indicators.

Babiker, M., Jacoby, H., Reilly, J. and D. Renier 2002, “The evolution of a climate regime:
Kyoto to Marrakech and beyond,” Environmental Science & Policy, Vol. 5.

Baranzini, A., Goldenberg, J. and S. Speck 2000, “A Future for Carbon Taxes”, Ecological

CLIMATE CHANGE GETTING IT RIGHT 75