Preserving the environment has become an issue of increasing concern during the last few decades. The level of consumption maintained in developed countries requires a massive amount of petrochemicals, energy products, raw materials, and transportation to sustain. All of these industries contribute to negative externalities. Negative externality is defined as when a coal plant burns coal, they create energy for consumers, however, they also subsequently emit pollution into the air, a common resource that can harm the environment. Negative externalities are created when firms pollute but they do not have to pay the full burden of doing so.
As much as we would like to believe people want to conserve resources, in reality this is not the case. Economists argue that, if the market is left to operate freely, greenhouse gas emissions will be excessive, since there is insufficient incentive for firms and households to reduce emissions ( Macdiarmid, 2013). One way economists’ reduce negative externalities is through pigouvian taxes or cap and trade program. While both a carbon tax and carbon cap-and-trade will achieve the same level of increased efficiency and have the same outcome, the difference between them is the distributional implications. Cap-and trade program is more feasible due to it generates more revenue and it is more efficient in comparison to pigouvian tax. Furthermore, a carbon tax is an explicit tax, and Americans are notoriously tax phobic. In contrast, cap and trade levies an implicit tax on carbon.
One of the assumptions is that people respond to incentives, therefore, if we tax firms so that they pay the full cost, they will reduce their consumption—thereby reducing the size of the negative externality. The Pigouvian tax imposes a tax on each unit of greenhouse gas emissions and gives firms (and households, depending on the scope) an incentive to reduce pollution whenever doing so would cost less than paying the tax. As such, the quantity of pollution reduced depends on the chosen level of the tax.
By contrast, a cap-and-trade system sets a maximum level of pollution, a cap, and distributes emissions permits among firms that produce emissions, which they can then use or trade (sell). The government sets the cap across a given industry, or ideally the whole economy. It also decides the penalties for violations (Keohane, 2017). Firms don’t pollute because they take pleasure in fouling the air and water but because clean production processes cost more than dirty ones. Requiring firms to buy pollution permits gives them an incentive to adopt cleaner processes. To avoid buying expensive permits, firms that have access to relatively cheap, clean alternative production methods will be quick to adopt them. A firm will buy pollution permits and continue polluting only if it lacks such alternatives (Schmalensee and Stavins, 2017).
There are many debates regarding which policy to implement. Cap-and-trade has one key environmental advantage over a carbon tax, it provides more certainty about the amount of emissions reductions that will result and little certainty about the price of emissions (which is set by the emissions trading market). A carbon tax provides certainty about the price but little certainty about the amount of emissions reductions. In the real world, cap and trade has a political advantage of getting large parts of the regulated industry in favor of the regulation and thus eliminating a lot of potential opposition.
There are also political disadvantages to cap and trade. Carbon tax is easier and quicker for governments to implement. Carbon tax can be very simple. It can rely on existing administrative structures for taxing fuels and can therefore be implemented in just a few months. From a global perspective, allocating permits for cap and trade would be contentious and unlikely to work. It is much more feasible to get non-OPEC (Organization of the Petroleum Exporting Countries) nations to agree on a global gasoline tax. Reduced demand for gas would lower the price of oil, allowing us to collect some revenue from OPEC countries (Keohane, 2017). Carbon tax allows the government to collect more money. However, in the balance sheet that money would show up in the budget, get labelled taxation, which will make it harder for the administration to deny that it is raising taxes to pay for its programs.