Tax or Trade

If you walked past a newstand on Saturday in London it was hard not to notice that climate change was back on the front page of the Independent — Oil giant comes in from the cold. The article, with its very bold headline, covered a recent speech by Rex Tillerson, CEO of ExxonMobil, in which he called for a carbon tax in preference to an emissions trading system. In his speech, strengthening global energy security at the Woodrow Wilson International Center for Scholars, Mr Tillerson also said that an emissions trading system was complex and added uncertaintly due to price swings.

I am not going to use this blog to argue with ExxonMobil, but I do think it is important to revisit the reasons why cap-and-trade (or emissions trading as we call it in the EU) is the policy instrument of choice in the EU and now Australia and is already operating in parts of the United States.

  • An emissions trading system is designed to deliver an environmental outcome, in that the cap must be met. This is certainty that is critcal for the environment. Whilst a carbon tax delivers some level of fiscal certainty, it does not necessarily deliver any particular environmental outcome. Emissions could fall, but equally they may continue to rise. It may take some years for policy makers to establish the level of tax necessary to deliver a given emissions reduction pathway.


  • Importantly and particularly in the current financial situation, an emissions trading system will deliver its environmental objective at lowest cost to the economy. By combining trading with a price for emitting CO2, the approach seeks out the most attractive reduction projects within the market which then drives the overall system to a lowest cost outcome. Emissions trading was applied to the problem of sulphur emissions from power stations in the United States. The overall cost of the meeting the environmental goal has been much lower than expected.


  • Despite claims of complexity by some, an emissions trading system is in fact remarkably simple. It does require monitoring and verification of emissions, but so too would a tax based system. Once the environmental objective is established and the equivalent number of allowances distributed – ideally by auction, the market then does the rest. In a tax based system, much of the infrastructure of a trading system would have to be replicated. For example, if for the sake of simplicity the point of tax collection was at the top of the value chain with the fuel supply (e.g. at the coal mine or oil well or point of import), a crediting system would have to be devised for downstream projects which dealt specifically with emission reduction (e.g. a carbon capture and storage project). Crediting would then require specific project oversight, measurement and verification. Alternatively, the point of tax collection could be set at the point of emissions, but that would entail a much broader bureaucracy due to the very large number of emitters.


  • A national trading system can be linked with other such systems, delivering over time a global market based approach. The bigger and broader the market, the wider the range of projects it can encompass, which leads to even lower costs overall.


  • A trading system offers policy flexibility which is important for business. For example, in Phase III of the EU Emissions Trading System some allowances will be distributed for free to deal with competitiveness concerns. Despite this, the incentive to reduce emissions remains in that the allowances have a value. This construction would be difficult to replicate in a tax based system, in that competitiveness issues would best be dealt with by not taxing – so the incentive to reduce emissions would vanish. Other tax constructions which attempted to mimic the “free allowance” position are feasible, but would add to the complexity of the approach.

So there is a choice – an approach designed specifically to tackle the environmental challenge in front of us, but which offers flexibility and lowest cost for business whist still ensuring the environmental objective is delivered, or more taxation.

I will opt for cap-and-trade any day.