Carbon tax versus cap-and-trade: what’s the difference? (Hint: it’s smaller than you think)
By Paul Lanoie
When we talk about pricing carbon, there are two main possibilities. One option is creating a carbon tax, as B.C., Denmark and Sweden have done. The other option is to create a cap-and-trade system. This is the route Quebec has taken, along with California, Korea and parts of Europe.
(It’s also possible to create a hybrid, like the one in Alberta, but other jurisdictions don’t seem to be following this example.)
What’s the difference between a carbon tax and cap-and-trade?
In a nutshell, with a tax, you fix the price, and with a cap-and-trade regime, you fix the quantity.
Everyone understands the idea of a tax. The only questions are how big you make it, exactly what you tax, whether you make any exceptions, and what you do with the revenue you collect.
Cap-and-trade is a little more complex. With this system, essentially you determine the maximum amount of carbon that companies are allowed to emit. That’s the “cap.” (A cap-and-trade system usually applies only to larger emitters, such as oil and gas, cement, or pulp and paper companies.) You then sell the appropriate number of emissions permits to companies based on that cap.
If Company A doesn’t need all its permits, it can sell the surplus to Company B. That’s the “trade,” and the trade puts a price on carbon. For this system to work well, you need many players so that you have many opportunities to trade.
Both carbon pricing approaches have pros and cons
A carbon tax is much easier to implement. For instance, B.C.’s carbon tax was put in place in just a few months. It is simple, transparent and easy to administer. And with a tax, companies know exactly how much they’re going to pay for their emissions.
However, you never know how sensitive consumers and companies will be to price changes. So when you put in place a carbon tax, you don’t know how much carbon emissions will drop.
A cap-and-trade system is more time-consuming to develop. It creates more paperwork for businesses to track their permits and trades. And under this kind of system, the price of carbon can vary a lot, creating uncertainty for companies. For instance, investing in new technology to reduce carbon might be profitable if the price of a permit is 20 euros per tonne, but it might not be profitable if the price drops to 5 euros per tonne.
The main advantage of cap-and-trade is that you know exactly how much carbon will be emitted each year. You also have the option of linking to other cap-and-trade systems, like Quebec has done with California.
More similar than different
Fundamentally, though, the two approaches are more similar than different. Both put a price on carbon — a price that can gradually be increased by either raising the tax or lowering the cap. Both create economic incentives for companies to reduce their emissions and develop greener technology. Done right, both reduce carbon emissions. Finally, both do it more cost-effectively than regulations.
To learn more about Canada’s carbon pricing systems, including B.C.’s carbon tax and Quebec’s cap-and-trade system, check out the interactive summary of our report “The Way Forward: A Practical Approach to Reducing Canada’s Greenhouse Gas Emissions”.