Carbon Tax Regime And Cap And Trade Accounting Essay

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Scientists have discovered that in the past 100 years the temperature on land and at sea have increased significantly by an average of about 0.6°C. [1] This increase has been largely attributed to anthropogenic emission of Green House Gases (GHG) which is mainly as a result of fossil fuel combustion for energy provision and alterations in land use. These increased GHG concentrations in the atmosphere give rise to global warming and subsequently climate change. Although changes to the climate system can be as a result of other natural phenomena like fluctuations in solar radiation, ocean twirl, volcanic eruptions etc, there is sufficient proof based on models used in detecting the drivers of increased GHG concentrations in the atmosphere, that there is an indubitable human imprint on the climate system. The adverse aftermath of climate change can be in the form of increased risk of flooding due to increased sea level by 0.18 to 0.59 metres, increased global temperature between 1.8°C and 4°C both between 1990 and 2100, contraction of ice cover, increased heat events and changes in precipitation. [2] 

International, regional and national measures can be employed in addressing issues of climate change. The 1992 United Nations Framework Convention on Climate Change (UNFCCC) and the 1997 Kyoto Protocol symbolize the initial actions undertaken by an international consensus to safeguard the global climate from hazardous human-induced intervention. Under the Kyoto Protocol, industrialized nations are committed to GHG reductions by at least 5% below 1990 emission levels for the commitment period 2008-2012. [3] In addition to these international agreements, national policy options in the form of economic instruments, regulatory instruments and voluntary agreements can be employed by countries as additional measures in tackling climate change.

Given that increased utilization of fossil fuel based energy is the principal source of global warming, there is need to incentivise transition to low carbon technologies for meeting energy demand. To achieve this, governments need to establish a price for carbon. A price tag on carbon, in addition to making energy conservation more appealing, will tend to capture the external environmental costs associated with fossil fuel based energy which will allow for efficient pricing of energy from these sources, thereby causing alternative energy to be more cost competitive. This competitive status will allow for a level playing field for other alternative energy sources and encourage investments in clean technology and alternative energy.

This paper will provide a comparative analysis of two key economic instruments; carbon tax and cap and trade; either of which can be applied towards mitigation of pollution and environmental protection by attaching a price to carbon. Chapter two will cover an overview of economic instruments and some certain selection criteria for the adoption of an appropriate instrument. While chapter three will look thoroughly at cap and trade, its history, past and present successes and challenges, with emphasis on the present largest trading scheme; the European Union Emission Trading Scheme EU ETS, chapter four will focus on carbon tax under similar headings. The pros and cons of each instrument will be highlighted. In conclusion, the main findings based on the salient points of chapters three and four will be brought together and suggestions proffered as to under what conditions either of the instruments can be applied.


2.1 The Role and Purview of Economic Instruments

The use of economic instruments for environmental protection is aimed at correcting the institutional, policy and market failures in the form of lack of property rights, environmental externalities and distorted subsidies which result in under pricing of scarce natural resources and environmental assets. [4] This inefficient pricing has two key effects; excess production and consumption of commodities that are exhaustible and contaminate the environment, and minimal production and consumption of commodities that conserve resources and are environmentally benign.

There exists a link between the promotion of sustainable development and internalization of external environmental costs. The 1992 UNCED in Rio de Janeiro recognized the crucial role of economic instruments as a tool for environmental protection. [5] Economic instruments provide changes in economic incentives which consequently influence a polluter's behaviour. It moves the onus of recognizing and employing contemporary and supplementary cheap sources of pollution repress from administrators to the market.

2.2 Selection Considerations in Adoption of Economic Instruments [6] 

In choosing a specific instrument or a combination of instruments towards environmental protection and management, countries need to take into consideration their specific peculiarities and circumstances. Some essential considerations include:

a) Flexibility: The adaptability of the instrument to changes in technology, market

conditions and resource dearth needs to be taken into account. The instrument should

uncover the degree of dearth and the value should increase at increased dearth levels. For

example, given that an instrument is inclined towards a specific technology, its efficacy

will be reduced with novel technologies and alterations in monitoring, enforcement and

compliance costs and procedures as well as other factors will be required.

Ease of Introduction: The possibility of a country's existing legislative framework to accommodate the introduction of any economic pollution control instrument has to be critically considered. Normally, instruments not requiring new legislation or administrative structures are usually preferred.

Environmental Effectiveness: This considers the degree of certainty of achievement of the environmental aim that the use of a particular instrument offers. This is dependent on the type of environmental damage. The allowable limit of error is higher for revertible ruin of replaceable and renewable resources than for resource losses that are irreversible and irreplaceable.

Ease of monitoring and enforcement: The essence of any environmental management system is effective monitoring and enforcement. Even the best combination of alternatives will not achieve the desired results with poor monitoring and enforcement capacities. This factor will greatly influence a country's choice of mitigation instrument.

Cost Effectiveness: The level of costs incurred by the use of a particular instrument in attaining the environmental objective is a main determinant in the choice of an instrument. All possible costs need to be considered; monitoring and enforcement costs as well as compliance costs on the part of the industry. Also, minimized costs that enhance environmental damage should also be avoided (e.g. subsidies on potentially polluting substances)

Predictability: A mix match of flexibility and predictability is a vital ingredient of any economic instrument. As much as the instrument should be adaptable to changing circumstances, it stability is also critical, as this will incite the industry to remodel its long-term investment objectives towards declining environmental costs.


3.1 What is Cap and Trade?

Cap and trade also known as emission trading is a pollution control scheme where governments or interstate governing bodies in a bid to achieve environmental sanitization, place an overall allowable limit (cap) on emissions and distribute carbon permits within that limit to existing major polluting industries. These permits are distributed either free (based on grandfathering or benchmarking) or through auctions. The companies are permitted to pollute up to their level of carbon allowances. Depending on the cost of pollution control faced by each participant, there is the choice of trading excess permits where abatement costs are lower or buying permits in the event that emission reductions are costlier or an outright payment of prescribed penalties as a result of non-adherence to allowable limits. The presumption is that the accessibility of carbon allowances will steadily be cut down providing scarcity, driving the market to maintain its monetary worth as well as necessitating pollution declines on the whole.

Different countries and regions have undertaken trading schemes involving varying pollutants. Some well established emission trading schemes include the United States Acid Rain Programme, the EU ETS, the New Zealand ETS with the Australian Carbon Trading Scheme slated to commence by 2011. In the United States, the House of Representatives have passed an energy bill that looks towards the creation of a cap-and-trade scheme for combating global warming. The bill is still being debated in the upper house. While some of the trading schemes have been successful in achieving emission reductions, some others are still in the process of overcoming the challenges towards actual emission reductions.

3.2 Major Emission Trading Systems

3.2.1 The United States Acid Rain Programme [7] 

The Acid Rain Programme (ARP) marks the foremost trial of the use of the tradable permit system in limiting environmental damage resulting from harmful pollutants. The command and control approach was previously the main mitigation option for pollution from stationary sources (usually power plants). The ARP was formed under Title IV of the 1990 Clean Air Act (CAA) Amendments to minimize the unfavourable impact of acid deposition by cutbacks in annual emissions of SO2 and NOx principally from combustion of fossil-fuel for electricity generation. [8] Under the Act, SO2 reductions from all sources of 10 million tons from 1980 emission levels is required, this is largely to be actualized through a emissions trading system which sets an emission cap on SO2 emissions from electricity generating units (EGUs) at power plants. [9] The objective of the NOX program which is restricted to a subset of coal-fired EGUs is to reduce NOX emission levels from the selected coal-fired boilers such that their emissions are at least 2 million tons less than the projected level for the year 2000 without implementation of Title IV. [10] 

According to the United States EPA 2007 Acid Rain Progress Report, in terms of emission reductions, compliance, environmental results, and economic efficiency the following key findings were highlighted:

Reduction in annual SO2 emissions by about 6.8 million tons since 1990 (43 percent). The overall SO2 emissions in 2007 were 8.9 million tons from 3,536 affected electric generating units well below the annual emission cap of 9.5 million tons, making it the first time, SO2 emissions were lower than the ARP's long term annual emission cap of 8.95 million tons, three years before the 2010 statutory deadline.

Full compliance in 2007 with the SO2 allowance holding requirements and NOX emission limits.

NOX emissions from a subset of 978 coal-fired electric generating units also continued a steady decline in 2007, decreasing by about 121,000 tons (3.5 percent) from 2006 levels to about 3.0 million tons. Total NOX emissions from all 3,536 ARP electric generating units were 3.3 million tons in 2007.

A considerable reduction in acid deposition has been recorded from levels calculated before the 1995 implementation of the ARP. Improvements in quality of shallow water of lakes and streams and similar measurement parameters from long-term monitoring display signs of ecosystem reinstatement. However, air quality improvements may be also due to other natural occurrences like soil type and atmospheric chemistry in addition to emission reductions as has been proven with long term monitoring and assessment data analysis.

Cost-Benefit analysis of ARP estimates greater public health benefits to program costs by a ratio of more than 40:1.

The ARP is perceived to have achieved actual emission reduction of SO2 and NOx for the stipulated period of the programme. However, this cannot be said of other emission trading schemes like the EU ETS. The challenges faced by the latter cannot be unconnected with its complexity by virtue of its wider coverage.

3.2.2 The European Union ETS

The European Union Emission Trading System (EU ETS) is the largest multi-national, multi-sector Greenhouse Gas Emission Trading System globally. [11] The scheme commenced on the 1st of January 2005 and is based on Directive 2003/87/EC of the European Parliament and of the Council of 13th October 2003 which entered into force on 25 October 2003. [12] The EU ETS has the objective of assisting EU member states in meeting their commitments under the Kyoto Protocol at the least cost. The scheme presently covers over 10,000 installations in the energy and industrial sectors and only covers carbon dioxide (C02) emissions, with only the Netherlands, opting for reduction of emissions from nitrous oxide (NOX). [13] 

The EU ETS puts an allowable limit on emissions and allows installations trade allowances amongst themselves with the least cost alternative prevailing. The cap is expected to be lower than the level of emissions projected under business-as-usual conditions. This cap restriction induces scarcity in the market and allows the expected environmental quality to be achieved as longs as the cap is maintained. The scheme has three trading periods; 2005-2007, 2008-2012 and 2013-2020. [14] The EU ETS: The Journey So Far

The first period of the scheme highlighted some fundamental issues that need to be addressed in subsequent phases in order for the scheme to achieve its long term environmental objective. Some of the identified loopholes were in the areas of cap-setting, allocation methodology of allowances resulting in the inability of the carbon price to incentivise actual emission reductions. Despite these shortfalls, the first phase was able to jumpstart the actual trading of emission permits and the creation of a carbon market within the EU, however inefficient in achieving actual reductions.

Based on experience, in addition to verified emissions data, in order for the EU ETS to achieve its environmental aim of emissions reductions in a cost effective manner and also for the purpose of equity amongst all participants, it is essential that greater harmonisation in the form of an overall EU cap is adopted. [15] Also the issue of excess profits as a result of allocation of allowances free of charge will be addressed.

A Directive [16] amending the initial directive that brought the EU ETS into existence highlights the major changes that will mostly take effect from the third phase (2013-2020) of the scheme.

Some of the crucial design changes include: [17] 

An 8 year trading period from 2013 to 2020 as against 5 years in the second phase with a linearly declining emission cap for the same period.

Allocation of allowances will be more by auctioning especially for sectors that are capable of passing down carbon costs to consumers and will be based on EU wide rules. About 50% of the revenue generated from auctioning of allowances will be used to tackle and adapt to climate change primarily in the EU but also in developing countries.

A harmonised EU emissions cap in place of the individual member states caps in phases 1 and 2.

The expansion of coverage to include the aviation sector as from 2012 as well as N2O and perfluorocarbons from some specific sectors. Carbon Capture and Storage (CCS) of all GHG emissions will also be included.

Linking of the EU ETS with other trading schemes around the globe.

3.3 Criticisms of Cap and Trade

While some governments, international financial institutions and organisations on climate change matters and the Kyoto Protocol, directly or implicitly advocate for a quantity restricting instrument as the preferred instrument in stabilizing GHG emissions, this choice of instrument is fraught with very substantial loopholes that tend to water down the possibility of its effectiveness in addressing the climate problem.

First is the impact of non-compliance. Given that emissions trading allows for buying of emission permits in place of actual emissions reductions (offsetting), there is the tendency to encourage inaction on the part of the buyers of permits. There is the likelihood of attenuation of the environmental objective of the cap-and-trade regime by the excess sale of permits by one country or a limited number of countries. [18] 

A second issue is in the area of enforcement. This is the heart of any emissions trading system. Absence of efficient monitoring, reporting, verification (MRV) and enforcement undermines the very essence of the scheme. The costs associated with these measures are usually high, especially when considering an international trading system with a large number of participants.

Thirdly, is the issue of distribution of permits. In the 1st and 2nd phases of the EU ETS, allowances were allocated freely resulting in excess permits, collapse of permit prices and windfall profits. Inefficient distribution mechanism can greatly undermine the expected outcome of the programme.

3.4 Arguments In Favour of Cap-and- Trade

Despite being faced with valid criticisms, proponents of cap-and trade still hold on strongly to some of its exclusive characteristics which make it favourable in addressing climate change. The underlying leverage of a cap-and-trade which is its provision of a set environmental quality is the first of such characteristics. In tackling a global issue like climate change, it is easier under a cap-and-trade to have definitive emissions reductions agreements.

Secondly is that an efficient trading system will encourage emission reductions in areas with least costs of pollution control regardless of inter-country boundaries. Given that the impacts of climate change are global with little regard to the source of emissions, the choice of this action is justified on this premise.

The third advantage is that a cap-and-trade is more suitable in dealing with all six GHGs covered in the KP in one extensive setup. Each gas has a CO2 equivalent thus companies with multiple GHG discharges can achieve emission reductions concurrently.

Fourthly, permits adapt accordingly to external occurrences such as external price shocks and inflation.


4.1 The Design Of A Carbon Tax

A carbon tax, a direct tax on pollution is an environmental tax used to internalise negative externalities. A carbon tax, based on the carbon content of fossil fuels, is aimed at capturing the external costs due to the expulsion of CO2 associated with the combustion of such fuels. In order for a carbon tax to reflect efficient pricing, it should be equal to the marginal environmental damage (also known as Pigouvian tax). CO2 emissions reduction can be achieved with a carbon tax by influencing both energy consumption and fuel choice. Like is characteristic with other forms of taxes, a carbon tax is a means of revenue generation, however, due to the underlying purpose of such a tax, unlike the norm where such revenues are transferred to the government, the bulk of such revenues is channelled into other measures or initiatives in combating climate change. A design of a policy on carbon tax should be such that the tax increases overtime to give the picture that continuous consumption of these polluting fuels is also becoming increasingly expensive and as such creates an incentive for technological innovations away from the status quo.

With the issue of climate change, were costs and benefits are highly uncertain, a tax based instrument both as regards impacts on emissions and implementation costs has very diverse implications when compared to a quantity instrument. [19] A carbon tax gives a stable incentive in monetary terms per ton of emissions irrespective of the degree of emissions which consequently results in less varying implementation costs.

4.2 Carbon Tax Around The Globe

Different countries at different times have deployed carbon taxes in climate policies towards environmental preservation. Finland was the first country to enact a carbon tax in 1990. [20] Sweden was the next in line with the exemption of fuels used for electricity generation and a 50% rebate for industries. [21] This tax led to the huge growth in the use of biomass for district heating and industrial processes. The Swedish government announced in September 2007 to 'up' carbon taxes in response to climate change and included is a plan to counteract such action with a raise in tax-deductions for work related trips. [22] The US pioneer carbon tax in the electricity sector was implemented in Boulder (Colorado) in 2007 at about $7 per ton of carbon with revenue generated from this tax expected to fund the town's climate change initiatives. [23] Canada has not been left out in the wave of carbon taxes. The provinces of Quebec and British Columbia (BC) have been collectors of carbon tax since 2007 and 2008 respectively. While that of BC is much higher than Quebec at a level of $10 (Canadian) per metric tonne of CO2, it is revenue-neutral and considered noteworthy in the Western Hemisphere. [24] 

Also France, formerly disinclined towards a carbon tax, has recently been involved in deliberations on its introduction as an instrument facilitating emissions reductions. The EU is currently playing with the idea of an EU regional carbon tax. The flaws of the EU ETS have created concerns about its ability to achieve actual emission reductions; thus talks on carbon tax as a more effective tool in combating carbon emissions are ongoing. As an added reason to adopt a carbon tax, two significant pollution contributing sectors; transport and agriculture, not covered in the EU ETS can be dealt with by a carbon tax.

According to The Guardian news paper, there is a call by the environmental audit committee of the European Parliament on the government to initiate actions in the form of a new carbon tax to raise the price of carbon from its level of €15 (£13) a tonne under the EU ETS to a plausible price of €100 (£87). [25] This call became necessary due to the unsuccessful attempt so far of the EU ETS in achieving the much needed efficient price level on carbon, to battle global warming. Other countries like Norway, The Netherlands, Denmark, and Italy, have put in place taxes based on the carbon content of energy products. [26] Â 

4.3 Why Support A Carbon Tax?

The use of carbon tax as the preferred instrument to achieve emissions reductions is based on the following essential reasons:

Carbon taxes will provide certainty to energy prices, which will consequently encourage investments in renewable energy, clean technologies and energy efficiency improvements.

Given that time is of essence in addressing the climate dilemma, carbon taxes are favourable being that they are less complex and can be adopted as soon as possible.

The workings of a carbon tax are pretty straightforward and unambiguous. Grasping public support based on this is quite likely.

The application process of carbon taxes is less susceptible to undue influence by vested interest groups in which selfish financial interests override societal gains.

A tax on carbon will raise revenue which can be ploughed back towards the same cause of environmental management in different forms like research and development in alternative energy, energy efficiency programmes etc.

4.4 The Knotty Side of A Carbon Tax

Although a carbon tax has recently been gaining grounds as the way forward in climate change mitigation due to the complexity of the much proposed cap-and-trade and the urgency of the matter, the practicability of such a tax especially on an international level raises some questions for some reasons.

Determining such a tax entails absolute measurement of pollution, which for small sources of pollution, can be complicated.

In setting a carbon tax at a suitable level, monetary estimates on the damages as a result of the pollution as well as knowledge about the damage itself needs to be ascertained. This is most times quite complex.

A carbon tax faces administration challenges. The effectiveness of a carbon tax could be undermined when for example countries engage in changes in other tax or subsidy policies like raising coal subsidies or decreasing fuel taxes.

Considering the significant disparity in the abatement costs of CO2 emissions across countries and time span implications, imposition of an international carbon tax would be difficult to achieve.

There is also the concern of the regressive impact of a carbon tax on income. Studies have shown that the poorest are usually get hit the hardest as they tend to spend a larger percentage of their income on energy.


The change in the climate system is the utmost collective dilemma in recent times. In meeting their commitments under the KP, Annex B parties to the convention would require to put in place national policies providing economic incentives to GHG emissions. This could be in the form of emissions trading or carbon tax. Table 1 shows a highlight of their peculiar characteristics.






Difficult to attain, due to disparity in economic levels and emission contributions across the globe.

More feasible as trade considers low and high cost abatement possibilities.


Equally important but not as heavily dependent as in a cap-and-trade.

Requires a greater burden from institution set-up to monitoring, enforcement


Provides more certainty in prices as changes in costs have no effect on the price as they are fixed

Prices are volatile as changes in costs move the allowance prices up or down consequently.


Non compliance by a party cannot undermine the effectiveness of the scheme

Non-compliance by country/countries can undermine the entire environmental objective.


All the cards are on the table; economic costs are very visible; less prone to manipulation.

The costs are not quite clear. Prone to manipulation.


No guarantee on emissions levels.

Guarantees a particular acceptable level of emissions.

The choice of an effective instrument boils down to efficient enforcement. Theoretically, both instruments tend to bring about similar outcomes i.e making carbon emissions a costly venture and accelerate the drive towards non-emitting, cost-effective and renewable alternative sources of energy.

By the scope covered by this research the author is of the opinion that in truly tackling the climate challenge, the focus should not be on advocates or adversaries of a particular instrument. However, given that time is of the essence, while addressing the hurdles in the way of common consensus, a bottom up approach is advised in that each country should look at their peculiar situations and adopt the best options not entailing excessive costs which could be in the form of one instrument or a combination of instruments, be it regulatory or economic.