Econ 101: What you need to know about carbon taxes and cap-and-trade

Ottawa’s climate change kabuki theater


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I didn’t think it was possible for the climate change policy debate to drift even further from reality than it already had. But a series of  posts by Maclean’s Aaron Wherry—most recently here and summarised here—has proven me wrong. The politics of climate change has always required a certain suspension of disbelief. But the Conservatives’ attempt to portray the NDP’s climate change policy as the equivalent of a carbon tax and the NDP’s indignant rebuttal to the effect that their policy is in fact a cap-and-trade model have advanced the transformation of the file into a form of kabuki.

To a first approximation, cap-and trade is the equivalent of a carbon tax. Here is the Econ 101 version of how the two work:

Before the policy, the intersection of the supply and demand curves for greenhouse gas-emitting products—point A on the graphs—will generate emissions equal to Q0, and the price will be P0. Suppose that the government wants to reduce the quantity to Q1.

  • Carbon tax: Suppose that a carbon tax T is added into the price. For a given quantity, the supplier’s price will be the old price plus the amount of the tax, and the supply curve will shift up to S*. The new equilibrium is at point B, the quantity is the target Q1, and the price will increase to P1. Note that the price increase will be less than the tax, although if the demand curve is fairly steep (i.e., inelastic, or relatively insensitive to changes in price), the increase in the price will be pretty close to T.
  • Cap-and-trade: Suppose that the government restricts emissions to a level consistent with Q1. The new supply curve—denoted by S*—is now vertical at the target: no matter how high the price goes, supply will remain fixed at Q1. The new equilibrium is again B: the quantity is determined by the cap at Q1, and the price will rise to P1.

So as far as prices and quantities go, the two policies are equivalent: as we go from A to B, quantities fall to the target Q1, and prices rise to P1. From the consumer’s point of view, that’s all that matters.

What distinguishes the two is what happens to T—the difference between the price the consumers pay at B and what it costs suppliers to produce at Q1. In the case of the carbon tax, the money goes to the government. But if output is capped at Q1, that difference is pure profit: a permit to produce one unit of output allows its owner to collect a rent equal to to the difference between the selling price and the cost of production. If permits are traded, their price will be bid up so that their price will be equal to T. So where that money goes depends on how the permits are allocated in the first place. If the permits are simply given to existing emitters, then those profits are pocketed by the firms. If the permits are auctioned off, the price will be bid up to T, and the government gets the money.

So if permits are auctioned off by the government, then cap-and-trade and a carbon tax are equivalent: same quantities, same prices, and the government gets revenues equal to the area in the green rectangle in the graphs.

When you leave the world of Econ 101, there are some important differences that can be the basis of a meaningful debate:

  1. Uncertainty. Since we don’t know with absolute certainty just how sensitive demand is to changes in prices, a case can be made for preferring one policy over the other. If you’re less concerned about the effects on prices, then a cap-and-trade system will provide an assurance that the target for quantities will be met. If you’re more concerned about the economic disruption associated with uncertainties about prices, then a carbon tax would provide more certainty on that front.
  2. Distributional effects. Low-income households will be hit (relatively) harder by the increase in the prices of such basic goods as gasoline, natural gas, heating oil and electricity. The more concerned you are with income inequality, the harder you will argue the case for using the revenues generated either from the carbon tax or the sale of emission permits to offset the hardships that climate change policy will impose on low-income households. The best way of compensating low-income households will depend on how prices change, which, in an uncertain world, will also depend on whether or not a carbon tax or cap-and-trade is put in place.

The distinction between carbon taxes and cap-and-trade, though, is a second-order debate. Why? Here’s an excerpt from an open letter signed by 250 or so economics professors—myself included—during the 2008 election:

Pricing carbon is the best approach from an economic perspective. Approaches to reaching any particular climate change goal that involve pricing carbon, such as carbon taxes and cap and trade systems, involve less economic damage to businesses and families than the alternatives. Carbon pricing is good for several reasons:

  1. Pricing allows each business and family to choose the response that is best and most efficient for them. Firms and families will differ greatly in the options they have for reducing their use of carbon, as well as in the value they place on carbon-generating activities. Price mechanisms give everyone the incentive to reduce their carbon use, but to do so to the degree and in the way that is best for them. This is the main reason that pricing policies are the lowest-cost way to meet our climate change goals.
  2. Pricing induces innovation. As the price of carbon increases, users of carbon intensive goods will demand alternatives. This will induce innovations in the goods and services that are produced, how those goods and services are produced, and the way people live. By moving relatively early in terms of climate policy, Canada has an opportunity to innovate and sell new technologies to the rest of the world.
  3. Carbon is almost certainly under-priced right now. In a fully efficient price system, the price we pay for a product would reflect the full costs of producing and using it, including the costs to the environment. Prices do not currently reflect those environmental costs. When carbon is under-priced, consumers and businesses tend to use too much of it. Policies that increase the price of carbon provide the proper incentives for consumers and businesses when they are making their investment and consumption decisions.

The best way to reduce the use of of fossil fuels is to increase their price. So yes, to the extent that the NDP is proposing a cap-and-trade model in which carbon is priced, their policy is essentially the same as a carbon tax. But then again, so was the cap-and-trade model the Conservatives offered as an alternative (sic) to the Liberals’ carbon tax. In 2008, all three major parties proposed climate change policies that would have increased the prices consumers would pay for fossil fuels, but only one admitted the point. It is possibly not a coincidence that the party that provided an accurate description of how its climate change policy would work is currently languishing in third place.

The Conservatives have since stepped back from their cap-and-trade stance, and moved onto an approach based on regulation. Here’s another extract from that open letter:

Regulation tends to be the most expensive way to meet a given climate change goal. Under regulation, businesses and consumers are mandated to take particular actions related to carbon use (e.g., use a particular technology or stay under mandated levels with no option to trade carbon emission rights). As a result, they are not given the choice of adjusting in the way that is best for them. Regulation therefore increases the costs of achieving carbon reduction compared to when pricing mechanisms such as a carbon tax or a cap and trade system are used. Furthermore, while regulations imposed on firms may appear to be so far removed from the typical consumer that they might think they will not bear these costs, this is not true. Those increased costs will be passed on to consumers due to normal market forces. There may be circumstances when regulation is the appropriate policy tool, but in most cases it is the most economically damaging.

So the Conservatives—defenders of markets and the foes of big government—are relying on the heavy hand of regulation, while the NDP is supporting the market-oriented approach preferred by economists. But the spectacle of the two largest parties playing against type—amusing in its own way—isn’t the part that’s divorced from reality. It’s the refusal to acknowledge that any effective climate change policy will affect consumers. Again from the open letter:

Policies that impose costs on producers (big or small) affect consumers. Some voters seem to think that policies like cap and trade, which apply directly to producers, have less impact on the prices they face than carbon taxes, where the impact can be seen immediately. In fact, voters would do better to assume that all such policies would, ultimately, affect the prices they pay. Indeed, since the goal of these policies is to change what we buy, policies applied to producers must affect the prices faced by consumers if they are to meet environmental goals. The argument that a policy capable of reducing carbon emissions will only affect producers is without economic merit.

Bismarck once noted that “politics is the art of the possible.” By this standard, promising to significantly reduce greenhouse gases without significantly increasing the prices faced by consumers isn’t politics. It’s theater, and it’s getting more bizarre as time goes on.


Econ 101: What you need to know about carbon taxes and cap-and-trade

  1. The best way to reduce the use of of fossil fuels is to increase their price.


    The best way to reduce the use of fossil fuel is most likely to simply ban the most wasteful instances of fossil fuel use. Extra fees are likely second best.

    • Except of course that it’s been shown above that regulation is the most expensive and least efficient method compared to all the others right?

  2. Stephen,

    What is your source that the Conservatives propose regulation?

    Here is the Conservative election platform for the 2011 election. Here is the part that deals with proposals for climate change (bottom of page 41). I see no evidence of proposed regulations:

    “Stephen Harper’s Government will also continue taking action on climate change. Unlike the previous Liberal government – which signed grand international accords but took no action – our Government has a climate change plan, and it is working. As part of our ongoing efforts we will make new investments to improve air quality and reduce greenhouse gas emissions – including an extension of the ECOEnergy Retrofit Homes program. We will also provide additional support for research and development in clean energy and energy efficiency.”

    Which for all intents and purposes says they will do nothing.

    • In early September 2012, the Conservatives introduced weak emissions regulations for the coal-fired electricity sector. They also promised oil and gas industry emissions regulations before the 2009 Copenhagen conference but have done very little since then. It is not a secret that Harper’s approach is sector-by-sector regulations that they introduce only after the US have committed to targets. Many experts, including some in the energy industry, claim that this approach is detrimental to the industry; they want medium to long term certainty and are calling for a carbon pricing strategy.

      • Perfect…thank you. And agree that it may not amount to much if anything. Would not surprise me if the regulations were based on, for example, unrealistic growth expectations, and thus achievable with little to no changes required.

        • Canada recently announced new CAFE standards for automobiles, in lockstep with US announcement:

          I can’t see how this would be particularly expensive for gov’t. Wouldn’t the car companies simply be required to submit annual sales reports and report on how they perform relative to the standard? ie aren’t most of the costs borne by the car companies (and hence consumers)?

          • Another example where regulation works.

            Oil and gas production (primary extraction from wells) – new AB regs. in 90s limited amount of flaring (when testing deliverability of new gas wells) and seriously restricted venting/ flaring of associated gas at oil batteries.

            Result of local environmental concerns (not global). Low hanging fruit. Doubtful whether a carbon tax or cap and trade would work as effectively here. Same reporting req’nts by industry. Plus easy to inspect by ERCB officials.

          • Agreed there are probably some cases where regulation works and works effectively.

            However, I don’t actually believe that the Harper government particularly cares whether it meets its own emissions targets or not. I mean come on…you’ve got Peter Kent as Environment Minister. Pretty much shows the priority level right there.

            I believe part of their goal of getting the big emitters signed up to Copenhagen was to level the playing field and get the game off the environmentalists’ terms and into an overall accord that is doomed to failure from the start; in that he has succeeded.

            Harper knows full well that the Chinas and Indias of the world don’t care either and will take no action on emissions, and that Copenhagen is not achievable because if the big emitters don’t step up, the accord is not achievable, whether or not Canada meets its targets or not; then when Canada is inevitably criticized by the enviro-loons for failing to achieve its targets, it is much easier to point to the fact that the entire accord failed because of China/India/Brazil/USA.

          • Agree with what you wrote. They are counting on apathy of a critical mass of voters.

            So, widely pointing out the hypocrisy of their arguments makes sense. But, at the same time, acknowledging some effort that does work.

            (btw getting a new accounting allowance for trees/forests in Kent claiming we are over 50% to Copenhagen targets is lame. The forests were already there, so no NET reduction)

          • Whaddya mean the forests were already there…no one told me that. I’ll have to consult with the boys and girls in Environment Canada – if there are any left.
            Minister Kent.

          • If a tree falls in the forest, and no one is there to hear it, the forest doesn’t exist.

          • Ah but then you wouldn’t be able to write it down as a carbon sink when your boss needs to duck tighter regulation, so you must be a communist.

          • Oh i know it was supposed to be part of the Liberal Kyoto package all right. It’s just odd to see the Cons reaching into that bag of tricks for their latest bit of made on the fly CC policy. Perhaps they should ask Mr Dion for his old notes?

          • Actually, it goes back to David Anderson when he was Environment Minister under Chretien/Martin.

          • I wondered if it did. Now i know it did.

          • There’s gotta be a limit to how far that can go.

            On the flip side, the new CAFE standards implemented in the USA are completely divorced from reality as well. So you have government instituting fantasy regulations followed by industry claiming fantasy achievements matching those regulations.

  3. The best way to reduce the use of gasoline for transport is to ensure our zoning codes and geometric street designs make walking and cycling a joy, transit feasible (connecting complete mixed-use ‘villages’ not single use cul-de-sacs) and driving the preserve of the elderly and infirm. A carbon tax won’t help suburbia if zoning policy restricts complete, walkable communities.

    The best way to reduce heating fuel use is regulation of building codes. A carbon tax can’t induce renters to fix up their landlord’s place.

    The best way to reduce electricity generation emissions is a carbon price.

    In the hydro-provinces, the first two are most important. 

  4. Good post.

    Nice separation and balance between economic theory, politics, and practical impacts of a given approach.

  5. Once again the politically naive Stephen Gordon leaps into a fight without knowing what the fight is about. Reality check, professor. This isn`t about the policies, it`s about the Conservatives telling bald faced lies.

    • The Fog of War – best dissipated with a bit of sunshine.

    • Oh come on… he’s also pointing out that the NDP likes to pretend that if you just go after the evil producers, then the innocent and the weak, the women and the children will feel nothing whatsoever but gratitude to the NDP…for ever and ever. His post is a lot more interesting than simply stating what we all aready know – that this Conservative party would lie to Jesus if they thought it would keep them and SH in power one more hour.

      • The Carbon tax should be directed at the producers who can most afford additional taxes .Governments conveniently forget that
        Private sector workers have not received wage increases in hje past 20 years…
        Meanwhile Public sector workers have been continuously eceiving annual wage increases .
        Without mandatory cost of living increases for private secor workers -THERE IS NO MORE MONEY TO PAY FOR TAXES.
        ONE TAXPAYER …
        Private sector wage earners cannot afford the goverments we have !
        Time to DOWNSIZE governments at all levels …
        Without wage growth in the private sector -There can be no further Tax, Toll or Fee increases from the privaye sector wage earner who also cannot afford yearly tax increases coming from municipalities .
        There is no more $ !!!
        Time for government to live within its means …if private sector wage earners are NOT receiving salary increases then governments CANNOT imcrease taxation,Tolls or Fees.
        We have too much government to support relative to population …time to ensure that the private sector can increase wages to their workers so that we can afford to pay tax increases .
        Otherwise – Its cutback time on the “Cost” of government .
        !!! You cannot grow government without a growth in private sector wages for taxpayers.

  6. The Conservative party does not believe in climate change so why would they do anything sensible about it?

  7. There is an elasticity of supply too, and the statement that carbon taxes would obviously drive up prices is suspect – particularly as the price elasticity of supply, for energy, has likely been greater than the price elasticity of demand for some time.
    The cost of regulation is very much dependent on the regulation: CAFE standards are cost controlled through application in multiple jurisdictions – and the improvements in emissions from transportation has been quite impressive recently. There are also relatively few coal plant … building codes exist anyway, etc.
    The main problem of both cap-and-trade, and/or carbon taxes are the political problem coming from the economic reality that both, if applied only locally, are intended to present a universal benefit at a local cost.
    That is a problem.

  8. “So if permits are auctioned off by the government, then cap-and-trade
    and a carbon tax are equivalent: same quantities, same prices, and the
    government gets revenues equal to the area in the green rectangle in the

    Not quite. In an auction, government revenues come from the specific suppliers who decide to participate in the auction. With a carbon tax, government revenues comes from the suppliers when producing.

    The primary difference is that in an auction the suppliers must make a decision ahead of time how much carbon they intend to produce. With a carbon tax, no such decision is required, they can adjust production as they see fit with no requirement to either go back to the government for more credits, and no requirement to sell unused credits. The credits increase uncertainty and overhead.

    Anyway, for all I know you agree and you thought your post was already long enough.

    Anyway, both the credits and the tax are unnecessary. I don’t think there is necessarily any inconsistency in the Conservative position, they have repeated on numerous occasions that they only intend to match what is done in the US. As long as the US does not institute a carbon tax or carbon credits or increased regulation, there will be none in Canada.

  9. “But the spectacle of the two largest parties playing against
    type—amusing in its own way—isn’t the part that’s divorced from reality.
    It’s the refusal to acknowledge that any effective climate change
    policy will affect consumers. Again from the open letter:”

    I don’t know if there is an effective rebuttal to this, but it strikes me as a very good post, short, succinct and very much to the point; shining a very bright light on just how dumb and parochial politcs can become. Both parties pretending that their proposed policy wont effect the consumer – will effectively hide the political costs – may look like good politics until you consider, as SG points out, that IS the whole f***ing point of the exercise in the first place – to change consumer and producer habits.
    What this really tells us is that many of our politicians think we are simply too thick to get that good policy will inevitably have sometimes painful trade offs.They treat us like children and behave like children themselves.

  10. “I didn’t think it was possible for the climate change policy debate to drift even further from reality than it already had.”

    The whole global warming/climate change debate is entirely divorced from reality because the world hasn’t been warming for at least two decades and the changing climate is proof nature is working as its meant to. If society was serious about global warming, we would not be relying on bureaucrats, windmills and a few cents gasoline tax, we would be urgently encouraging development of proper technological solutions in free market.

    BBC Interview with Phil Jones:

    Q) Do you agree that from 1995 to the present there has been no statistically-significant global warming
    A) Yes, but only just.

    wiki ~ The Medieval Warm Period (MWP), Medieval Climate Optimum, or Medieval Climatic Anomaly was a time of warm climate in the North Atlantic region, that may also have been related to other climate events around the world during that time, including in China, and other countries lasting from about AD 950 to 1250. It was followed by a cooler period in the North Atlantic termed the Little Ice Age.

  11. If we had a carbon tax or a cap in 2008, the intellectual capital of Canadians would be higher regarding our carbon sinks. If we had higher corporate tax rates on petro, we’d have peat moss carbon-sequestering companies.
    Those pages serve an important purpose. In Gr 10, they were the only things keeping the smoker doors kids interested in Parliament. Of course, smooth talking MPs couldn’t pick them up without money and events. Arent’t some of them at the P.Martin age of consent?!
    I’ve figured out that nesting and the John Wayne chauvanist culture of N.A. makes women a little eviller than in Northern Europe (I assume). Women are less likely to care about utlitarianism and be genuises than men. They are also more likely to get a higher basic level of ethics voting for education and health and daycare. But the lack of nesting teaching/instinct makes men in general, better humans. Simply because of the internet. Even if you are stuck in a cuckoo clock country where you don’t get rewarded with a GAI that would enable housing, food, dating, you can aid intelligent nations like the Saudis and China and the USA (probably). Even if I can’t boink a page someday China’s grandkids will be able to as long as they don’t buy cdn tar.

    • What I liked about that Ottawa newspaper column was that it showed how down to Earth most politicians are. I don’t understand why MPs are so hard on drugs when they know alcohol is a nice high/escape/party. I never had a hard drug problem probably because I witnessed friends tweak out on my carpet and I don’t like pooping myself. I did a pt and it had the surprising effect of being like an alcoholic doing acid once: they often stop drinking. I don’t have much of an urge to smoke pot now. It wasn’t physiologically addictive much but I needed it like coffee. I figure a gram will last me for a week or two now for quite some time.
      It is disappointing our R+D is so low and we don’t have much of a materials science multinational, like Siemens, 3M, China-Japan…the lower corporate taxes worsen things. I’d like to setup some peat moss carbon sequester experiments, but I’m not going to be able to get European scientists to come do the research (logs and woodchips under various imaging technologies. This get a job get a family CPC attitude is to distract from cdn evil. MPs that nail pages are in the majority, evil.