Summary

Global climate change is one of the nation’s most significant long-term policy challenges. Human activities are producing increasingly large quantities of greenhouse gases, particularly carbon dioxide (CO₂), which accumulate in the atmosphere and create costly changes in regional climates throughout the world. The magnitude of such damage remains highly uncertain, but there is growing recognition that some degree of risk exists for the damage to be large and perhaps even catastrophic. Reducing greenhouse-gas emissions would be beneficial in limiting the degree of damage associated with climate change. However, decreasing those emissions would also impose costs on the economy—in the case of CO₂, because much economic activity is based on fossil fuels, which release carbon in the form of carbon dioxide when they are burned. Most analyses suggest that a carefully designed program to begin lowering CO₂ emissions would produce greater benefits than costs.

The most efficient approaches to reducing emissions involve giving businesses and individuals an incentive to curb activities that produce CO₂ emissions, rather than adopting a "command and control" approach in which the government would mandate how much individual entities could emit or what technologies they should use. Incentive-based policies include a tax on emissions, a cap on the total annual level ofemissions combined with a system of tradable emission allowances, and a modified cap-and-trade program that includes features to constrain the cost of emission reductions that would be undertaken in an effort to meet the cap. In this study, the Congressional Budget Office (CBO) compares these incentive-based approaches, focusing on three key criteria:

Other criteria could be of interest to policymakers in determining how best to address concerns about climate change. For example, the efficiency criterion addresses how well policies might function to minimize the cost of reducing emissions over a period of several decades; however, policymakers may choose to place more emphasis on providing certainty about the amount of emissions at specific points in time. Similarly, policymakers may also wish to focus on how different policy designs affect different segments of society.

Incentive-based approaches can reduce emissions at a lower cost than more restrictive command-and-control approaches because they provide more flexibility about where and how emission reductions are achieved.

Under a tax, policymakers would levy a fee for each ton of CO₂ emitted or for each ton of carbon contained in fossil fuels. The tax would motivate entities to cut back on their emissions if the cost of doing so was less than the cost of paying the tax. As a result, the tax would place an upper limit on the cost of reducing emissions, but the total amount of CO₂ that would be emitted in any given year would be uncertain.

In contrast, under a cap-and-trade program, policymakers would set a limit on total emissions during some period and would require regulated entities to hold rights, or allowances, to the emissions permitted under that cap. (Each allowance would entitle companies to emit one ton of CO₂ or to have one ton of carbon in the fuel that they sold.) After the allowances for a given period were distributed, entities would be free to buy and sell the allowances among themselves. Unlike a tax, a cap-and-trade program would place an upper limit on the amount of emissions, but the cost of reducing emissions would vary on the basis of fluctuations in energy markets, the weather (for example, an exceptionally cold winter would increase the demand for energy and make meeting a cap more expensive), and the technologies available for reducing emissions.

Given the gradual nature of climate change, the uncertainty that exists about the cost of reducing emissions, and the potential variability of the cost of meeting a particular cap on emissions at different points in time, a tax could offer significant advantages. If policymakers chose to specify a long-term target for cutting emissions, a tax could be set at a rate that could meet that target at a lower cost than a comparable cap. In addition, if policymakers set the tax rate at a level that reflected the expected benefits of reducing a ton of emissions (which would rise over time), a tax would keep the costs of emission reductions in balance with the anticipated benefits, whereas a cap would not.

There is significant interest, however, in a cap-and-trade approach (which has been used in the United States to reduce emissions that cause acid rain and is currently being used in the European Union to limit CO₂ emissions).¹ This study therefore explores ways in which policymakers could preserve the structure of a cap-and-trade program but achieve some of the efficiency advantages of a tax. Specifically, policymakers could take one or more of these steps:

The policy options described above differ in their potential to reduce emissions efficiently, to be implemented with relatively low administrative costs, and to create incentives for emission reductions that are consistent with incentives in other countries. CBO draws the following conclusions:


Policy	Efficiency		Implementation Considerations	International Consistency Considerations
	Ranking	Considerations
Carbon Dioxide Tax	1	A tax would avoid significant year-to-year fluctuations in costs. Setting the tax equal to the estimate of the marginal benefit of emission reductions would motivate reductions that cost less than their anticipated benefits but would not require reductions that cost more than those benefits. Research indicates that the net benefits of a tax could be roughly five times as high as the net benefits of an inflexible cap. Alternatively, a tax could achieve a long-term target at a fraction of the cost of an inflexible cap.	An upstream tax would not require monitoring emissions and could be relatively easy to implement. It could build on the administrative infrastructure for existing taxes, such as excise taxes on coal and petroleum.	A U.S. tax could be set at a rate consistent with carbon dioxide taxes in other countries. Consistency would require comparable verification and enforcement. If countries imposed taxes at different points in the carbon supply chain, special provisions could be needed to avoid double-taxing or exempting certain goods. Setting a U.S. tax that would be consistent with allowance prices under other countries' cap-and-trade systems would be somewhat more difficult because it would require predicting allowance prices in different countries.



Cap With Safety Valve and Either Banking or a Price Floor	2	A cap-and-trade program that included a safety valve and either banking or a price floor could have many of the efficiency advantages of a tax. The safety valve would prevent price spikes and could keep the costs of emission reductions from exceeding their expected benefits. Banking would help prevent the price of allowances from falling too low, provided that prices were expected to be higher in the future. A price floor, however, would be more effective at keeping the cost of emission reductions from falling below a target level.	An upstream cap would not require monitoring emissions. It would require a new administrative infrastructure to track allowance holdings and transfers. Implementing a safety valve would be straightforward: The government would offer an unlimited number of allowances at the safety-valve price. Banking has been successfully implemented in the U.S. Acid Rain Program. A price floor would be straightforward to implement only if the government chose to sell a significant fraction of emission allowances in an auction.	Either a safety valve or banking would become available to all sources of CO2 emissions in a linked international cap-and-trade program. Some countries could object to linking with a U.S. program that included those features, because linked countries could not ensure that their emissions would be below a required level in a given year. Linking would also create concerns about inconsistent monitoring and enforcement among countries and international capital flows (as described below in the inflexible cap policy). Countries with different cap-and-trade programs could capture many of the efficiency gains that would be achieved by linking—while avoiding some of the complications—if they each included banking (or set a similar price floor) and agreed on a safety-valve price.

Cap With Banking and Either a Circuit Breaker or Managed Borrowing	3	Allowing firms to bank allowances would help prevent the price of allowances from falling too low, provided that prices were expected to be higher in the future. Including a circuit breaker—or increasing the ability of firms to borrow allowances—would help keep the price of allowances from climbing higher than desired, but would be significantly less effective at doing so than a price ceiling.	An upstream cap would not require monitoring emissions. It would require a new administrative infrastructure to track allowance holdings and transfers. Banking has been successfully implemented in the U.S. Acid Rain Program. Determining when to trigger a circuit breaker, or modify borrowing restrictions, would require judgment about current and future allowance prices. Such interventions could aggravate price fluctuations if those judgments were incorrect.	Including banking and either a circuit breaker or borrowing in the U.S. program could reduce the likelihood of linking because it would cause uncertainty about the stringency of the U.S. cap relative to other countries’ caps and about the total supply of allowances in the global trading market.



Inflexible Cap	4	Allowance prices could be volatile. An inflexible cap could require too many emission reductions (relative to their benefits) if the cost of achieving them was higher than anticipated and could require too few reductions if the cost of meeting the cap was lower than policymakers had anticipated.	An upstream cap would not require monitoring emissions. It would require a new administrative infrastructure to track allowance holdings and transfers.	Linking an inflexible U.S. cap with other countries’ cap-and-trade systems would create a consistent global incentive for reducing emissions. However, inconsistent monitoring and enforcement in any one country could undermine the entire linked trading system. Further, linking would alter allowance prices in participating countries, create capital flows between countries, and possibly encourage countries to set their caps so as to influence those flows.

Note: An "upstream" tax or cap would be imposed on suppliers of fossil fuel on the basis of the carbon dioxide (CO₂) emitted when the fuel was burned. A "safety valve" would set a ceiling on the price of allowances. "Banking" would allow firms to exceed their required emission reductions in one year and use their extra allowances in a later year. Under a "circuit breaker," the government would stop a declining cap from becoming more stringent if the price of allownces exceeded a specified level.

The most efficient policy tool for decreasing CO₂ emissions is the one that can best balance the costs and benefits of the reductions, even when both are uncertain. The features that make a policy tool most efficient would also enable it to minimize the cost of achieving a given target, even if that target was not explicitly chosen to balance costs and benefits.

A Tax Versus an Inflexible Cap. Analysts generally conclude that a tax would be a more efficient method of reducing CO₂ emissions than an inflexible cap. The efficiency advantage of a tax stems from the contrast between the long-term cumulative nature of climate change and the short-term sensitivity of the cost of emission reductions. Climate change results from the buildup of CO₂ in the atmosphere over several decades; emissions in any given year are only a small portion of that total. As a result, limiting climate change would require making substantial reductions in those emissions over many years, but ensuring that any particular limit was met in any particular year would result in little, if any, additional benefit (avoided damage). In contrast, the cost of cutting emissions by a particular amount in a given year could vary significantly depending on a host of factors, including the weather, disruptions in energy markets, the level of economic activity, and the availability of new low-carbon technologies (such as improvements in wind-power technology).

Relative to a cap-and-trade program with prespecified emission limits each year, a steadily rising tax could better accommodate cost fluctuations while simultaneously achieving a long-term target for emissions. Such a tax would provide firms with an incentive to undertake more emission reductions when the cost of doing so was relatively low and allow them to reduce emissions less when the cost of doing so was particularly high. In contrast, an inflexible cap-and-trade program would require that annual caps were met regardless of the cost, thereby failing to take advantage of low-cost opportunities to cut more emissions than were required by the cap and failing to provide firms with leeway in years when costs were higher.

The efficiency advantage of a tax over an inflexible cap depends on how likely it is that actual costs will differ from what policymakers anticipated when they set the level of the cap. Given the uncertainties involved, such differences are likely to be large—and, therefore, analysts generally conclude that the efficiency advantage of a tax is likely to be quite large. Specifically, available research suggests that in the near term, the net benefits (benefits minus costs) of a tax could be roughly five times greater than the net benefits of an inflexible cap.² Put another way, a given long-term emission-reduction target could be met by a tax at a fraction of the cost of an inflexible cap-and-trade program.

Flexible Cap Approaches. A cap-and-trade program could incorporate various design features that would keep allowance prices from rising or falling farther than policymakers wanted. Combined, some of those features could allow a cap-and-trade program to achieve many of the efficiency advantages of a tax on emissions.

Keeping Costs From Climbing Too High. Including a safety valve could make a cap-and-trade program more efficient than an inflexible cap. Such a policy would set a ceiling on the price of allowances, preventing the cost of reducing emissions from exceeding either the best available estimate of the benefit (avoided damage) that would result from those reductions or the cost that policymakers consider acceptable.

Alternatively, policymakers could attempt to cap the price of allowances by adjusting the stringency of the cap. For example, policymakers could specify a circuit breaker, which would prevent a declining cap from becoming more stringent (fixing the cap at one level) if the price of allowances reached a certain level. Unlike a safety valve, a circuit breaker would not necessarily stop the price of allowances from continuing to rise, but it would result in smaller price increases than would otherwise occur. (The price would probably still increase because meeting a fixed cap would become more and more costly over time as the economy grew.)

Finally, allowing companies to borrow allowances—and thus defer emission reductions to the future—could help keep the price of allowances from rising too high. Policymakers could alter the constraints placed on firms’ use of borrowed allowances on the basis of the price of allowances. Like a circuit breaker, such an approach could help constrain the price of allowances under some circumstances, but it is unlikely to be as effective at doing so as a safety valve. Policymakers would need to forecast future allowance prices in order to know when to loosen or tighten constraints on borrowing. To the extent that those forecasts were inaccurate, borrowing could exacerbate price fluctuations. Further, firms would find it profitable to borrow future allowances only if they expected the price of allowances to be lower in the future. That is, borrowing could help deal with temporary spikes in allowance prices but not circumstances in which allowance prices were expected to remain high in the long term.

Keeping Costs From Falling Too Low. Policymakers could prevent the price of allowances from falling too low by setting a price floor. If the government chose to sell a significant portion of the allowances by auction, it could specify a reserve price and withhold allowances from the auction as needed to maintain that price. Attempting to prevent the price of allowances from dropping too low by adjusting the supply of allowances would entail the same complications associated with a circuit breaker.

Alternatively, policymakers could help keep the price of allowances from falling below some desired level by allowing companies to exceed their required emission reductions in low-cost years in order to bank allowances for use in future high-cost years. The additional emission reductions motivated by banking in low-cost years would put upward pressure on the price of allowances in those years. Similarly to borrowing, banking would be most effective in addressing short-term lows in allowance prices rather than circumstances in which allowance prices were expected to remain low in the long term.

Policies that are efficient in theory will be efficient in practice only if they can be implemented effectively without excessive administrative costs. Either a tax or an inflexible cap could meet that criterion.

Administering an "upstream" tax or cap-and-trade program for CO₂ emissions would involve taxing or regulating the suppliers of fossil fuels—such as coal producers, petroleum refiners, and natural gas processors. Compared with a "downstream" design, which would tax or regulate users of fossil fuels, an upstream approach would have two administrative advantages. It would involve regulating a limited number of entities, and it would not require firms to monitor actual emissions. Rather, each firm’s tax payment or allowance requirement could be based on the carbon content of its fuel and the amount it sold.³

An upstream tax may be somewhat easier to implement than an upstream cap-and-trade program because many of the entities that would be covered by either policy are already subject to excise taxes.⁴ A CO₂ tax could build on that existing structure. Implementing a cap-and-trade program, by contrast, would probably require a new administrative infrastructure. However, the Environmental Protection Agency’s experience with the Acid Rain Program (a cap-and-trade program designed to reduce emissions of sulfur dioxide by electricity generators) suggests that the cost of administering such a program could be modest.

Some design features that might improve the efficiency of a cap-and-trade program—such as a price ceiling, banking, and borrowing—could be implemented without unduly increasing administrative costs. A price floor could be relatively easy to implement, but only if the government chose to auction off a significant fraction of the allowances. Other design features could prove more challenging to implement. For example, determining the basis for triggering a circuit breaker (or, more generally, for loosening or tightening the stringency of a cap) would require the government to make judgments about current and future allowance prices.

Carbon dioxide is a global pollutant. A ton of emissions from any point on the globe at any given time would have the same effect on the atmospheric concentration of CO₂ and thus would cause the same amount of damage. Consequently, the most cost-effective way to reach a specific atmospheric concentration would be to undertake the lowest-cost emission reductions regardless of where they were located. Achieving that goal would require creating a uniform incentive to reduce emissions in countries that are major emitters of CO₂.

One option is to have each of the major emitting countries agree to adopt a similar tax on CO₂ emissions. However, a system of harmonized taxes would produce a consistent global incentive for cutting emissions only if participating countries also adopted similar monitoring, verification, and enforcement provisions.

Alternatively, major emitting nations could agree to link their cap-and-trade programs. In that case, competitive forces would equalize the price of allowances between countries and create consistent incentives to reduce emissions. Uniformity of monitoring and enforcement would be even more important in such an international program. With harmonized taxes, lax monitoring or enforcement by any one country could reduce the incentives for emission reductions in that country. But with linked cap-and-trade programs, laxity in one area could undermine the integrity of allowances throughout the entire system. In addition, linking existing cap-and-trade programs could result in significant flows of capital between countries (from the sale of allowances) and could encourage a nation to set the level of its cap so as to influence those flows.

If the United States included a safety valve or banking or borrowing provisions in its cap-and-trade program, those design features would become available to all sources of CO₂ emissions within a linked cap-and-trade system, regardless of their location. The increased flexibility provided by those design features could undermine the ability of all participating countries to meet a fixed emissions limit in a given year or compliance period; thus, they could be seen as an obstacle to linking with a U.S. cap-and-trade program. For example, if the United States had a cap-and-trade program with a safety valve and linked that program to the European Union’s Emission Trading Scheme, which has a fixed cap and no safety valve, countries in the European system would no longer be able to ensure that they could meet the fixed caps they agreed to under the Kyoto Protocol.

Alternatively, any set of policies that resulted in a similar allowance price in different countries would produce efficiency gains similar to those of linking, without requiring nations to give up sovereignty over the price of their allowances or the integrity of their programs. For example, countries with nonlinked cap-and-trade programs could agree to include a safety valve set at a similar level, or the United States could set its safety valve at the same level as a CO₂ tax in another country.

One challenge in crafting an efficient global approach to cutting CO₂ emissions is the inclusion of developing countries that are becoming (or are expected to become) major emitters. China, for example, contributed roughly 8 percent of the world’s CO₂ emissions from fossil fuels in 1980, but its share reached 19 percent in 2005. (During the same period, the U.S. share of global emissions fell from 26 percent to 21 percent.⁵) Some researchers suggest that a system of linked cap-and-trade programs could equalize the marginal cost of emission reductions among participating countries while allowing for different levels of reduction among the countries on the basis of fairness or other criteria.⁶ Alternatively, some analysts suggest that the revenue generated by taxing CO₂ emissions or selling emission allowances in developed countries could be used to fund emission reductions in developing nations.⁷

Other opportunities also exist for including developing countries. For example, in the European Union’s trading program for CO₂ emissions, companies are allowed to comply with some of their allowance requirements by funding emission reductions in developing countries, such as financing a low-emission power plant in China.

For more information about U.S. cap-and-trade programs for sulfur dioxide and nitrous oxide and about the European Union’s program for carbon dioxide, see the appendix.

See, for example, William A. Pizer, "Combining Price and Quantity Controls to Mitigate Global Climate Change," Journal of Public Economics, vol. 85 (2002), pp. 409–434; Michael Hoel and Larry Karp, "Taxes and Quotas for a Stock Pollutant with Multiplicative Uncertainty," Journal of Public Economics, vol. 82 (2001), pp. 91–114; and Richard G. Newell and William A. Pizer, "Regulating Stock Externalities Under Uncertainty," Journal of Environmental Economics and Management, vol. 45 (2002), pp. 416–432.

For example, coal producers pay an excise tax that is used to fund the Black Lung Trust Fund, and petroleum producers and importers pay an excise tax that finances the Oil Spill Trust Fund.

Department of Energy, Energy Information Administration, International Energy Annual 2005 (updated September 18, 2007), Table H.1co2, available at www.eia.doe.gov/iea/carbon.html.

This point was made by Robert N. Stavins in "Linking Tradable Permit Systems: Opportunities, Challenges, and Implications" (paper presented at the 7th International Emissions Trading Association’s Forum on the State of the Greenhouse Gas Market, Washington, D.C., September 27, 2007).

See Joseph E. Aldy, Peter R. Orszag, and Joseph E. Stiglitz, "Climate Change: An Agenda for Global Collective Action" (paper prepared for the Pew Center on Global Climate Change’s workshop "The Timing of Climate Change Policies," Washington, D.C., October 11–12, 2001); and Joseph E. Aldy, Scott Barrett, and Robert N. Stavins, 13+1: A Comparison of Global Climate Change Policy Architectures, Discussion Paper 03-26 (Washington, D.C.: Resources for the Future, August 2003).