Cap and Trade Rules
Carbon Tax vs. Cap and Trade

By Denis Du Bois
Energy Priorities
December 31, 2008

The best way to start addressing climate change is to yank subsidies from fossil
fuels and put a price on carbon dioxide emissions from them. Of the two methods
widely discussed for pricing carbon -- cap and trade, and a carbon tax, which is

Economist Gilbert Metcalf argues his case for a tax.

The January-February 2008 issue of Technology Review has two interesting
articles about renewable energy and smart grids. Sandwiched between them is a
Q&A with Tufts University economist Gilbert Metcalf about how best to price
carbon emissions.

Metcalf argues in favor of a carbon tax over a cap-and-trade system. A tax would
be levied on the production of fossil fuels -- coal at the mine, and petroleum
at the refinery. An initial tax of $15 per ton of carbon should be used to
create a tax credit for individuals, he says, to offset the higher prices
they'll pay for goods and services as a result of the tax.

Metcalf admits that a direct carbon tax would not be very effective at reducing
transportation emissions. Motor fuel use contributes only about 20 percent of
this country's carbon emissions. A tax would add 25 to 40 cents to the cost of a
gallon of gas, he says. The impact would be neglibible.

The cheapest place to get initial emission reductions will be from the electric
utility sector and from industry, Metcalf says. At $20 per ton, a tax would
double the price of coal and add 40 percent to the cost of coal-generated
electricity -- bringing renewable energy closer to cost parity.

Metcalf may be right about a tax, but his argument is weak on many points. The
basis of his case is that a tax is simpler to administer than a cap-and-trade
system. As long as he thinks of the United States as an isolated economy, he's
right. But when energy imports (including energy embedded in products) come into
the picture, it gets more complicated.

He also argues that a tax is better for utilities because "they need to know
what price they are going to face to make [new] plants competitive." But
utilities have never known the future prices of commodity fuels. Enron based its
business on that fact. The cost of a percentage tax is no more predictable than
the price of coal, natural gas, or uranium. Tradable carbon allowances, though,
are a commodity -- an uncertainty that utilities know how to deal with -- and a
globaly compatible, tradable instrument.

Finally, he says that a cap-and-trade system creates unfamiliar, complicated
financial instruments. "I think some of the bloom is off the rose in creating
these kinds of instruments," he says, referring to the recent financial and
mortgage crisis. "It could make the tax that much more politically attractive."
Tradable carbon allowances can't any get less politically attractive than a new
tax. Dr. Metcalf should instead examine ways to repeal tax subsidies that have
been granted in perpetuity to fossil fuel industries.


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