Carbon Cap-and-Trade de-mystified

Myth 1: A Carbon tax provides much greater price stability than emission trading under a cap and trade system.

To ensure stability, an emission trading system needs be designed with banking and borrowing options to allow firms to smooth emissions over time. This in turn contributes to leveling of the price of allowances and creates certainty in the market and thus spurs investment.

Tax regimes can easily be changed by legislative bodies and follow the general dynamics of politics: two factors which can introduce great instability.

Myth 2: A carbon tax is a preferable option because the revenues from taxation can be used to invest in low carbon technology and/or used to offset potential regressive effects of carbon taxes on poorer households.

Governmental funding tends to “pick a winning” technology, whereas technological innovation is needed in many areas (renewable energy, energy efficiency, energy storage, etc). A cap and trade system provides a greater incentive for the development of these technologies by providing a price signal that enables firms to capture the value of new technologies. Because cap and trade is not technology specific, it can encourage and accommodate any emerging GHG control technologies or practices.

Myth 3: The introduction of a carbon tax is simpler than an emission trading scheme under cap and trade.

True, the introduction of a new tax does not require setting up a new system with additional administrative costs attached to it. To be effective, though, it would need be backed by an international agreement on a global carbon tax: an event highly unlikely if not impossible.

Myth 4: A Cap and trade system creates market and environmental uncertainty.

A cap and trade system sets an assessment system which can be used to monitor, measure, and achieve a specific environmental objective. This can also be dynamic, moving forward following progress in technologies and environmental quality. A tax does not have such dynamic qualities.

Myth 5: Cap and trade doesn’t work because the European Union Emissions Trading (EU ETS) Scheme did not prove that significant emissions reductions were achieved.

Phase I of the EU ETS achieved only small reductions in emissions: this was not due to the embedded flaw in the cap and trade but because the emission cap was set too high. In addition, the EU over allocated allowances. This was mainly due to many countries lacking reliable data monitoring and information standards of GHG emissions when the scheme was first introduced. Since then the EU has solved the problem of monitoring and reporting and tightened the cap for Phase II.

Myth 6: A Cap and trade system allows for ‘windfall profits’ for regulated firms.

The implementation of the trading scheme in the EU led to the increase in retail electricity prices: a flaw that can occur under any type of regulation and cannot be blamed on a cap and trade system only. The determining factor is not the type of regulation but the ability of a company to pass through the costs to consumers. Based on the EU ETS example, electricity generators were able to make profits because they were able to reflect the value of allowances in prices of electricity, even though they received the allowances for free (‘grandfathering’). This problem can be addressed through the mechanism of allocating allowances and more specifically through auctioning. Regulators would require companies to purchase allowances, and this could ensure that the companies incur direct costs, thus reducing their profit margin. However, this does not solve the problem of passing costs onto consumers. One can solve this by passing the revenues from the auctioning of allowances back to the consumers.


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