To trade or tax – Six of one, half a dozen of the other – Or is it?  

With climate change policy seemingly becoming one of the topics of the upcoming elections, it is important that we understand exactly what we are talking about and that we understand the benefits of pricing carbon when discussing the characteristics of policy instruments designed to tackle climate change.

You may have already seen the Coalition’s video response to the announcement of Labor’s Climate Change Action Plan. Déjà vu? You would be right to think so… the same noise about what pricing carbon in this country is: a carbon tax, an emissions trading scheme, or whatever you can think of. Unfortunately, we are already experiencing the same twist on words as we did during the last elections.

Support for carbon pricing in Australia appears to depend on how it is framed in popular debate and lobbying by fossil-fuel and energy-intense industries. At the best of times, taxes and additional compliance costs are not politically popular, so we should not allow the discussion to be muddied by imprecise language and high-jacked by political gamesmanship.

To this end, I would like to provide a brief definition, as well as key advantages (+) and disadvantages (-) of a carbon tax and emissions trading.

To be clear, both approaches are designed to reduce emissions at the lowest cost, and both can generate government revenue. The difference is mainly in how the incentive structure works, what aspect is controlled and what is left to the market to work out.

Carbon tax

A carbon tax requires individual liable entities to pay a charge (or tax) for every tonne of greenhouse gas (GHG) emissions released into the atmosphere, e.g. $23/t CO2-e, regardless of how much emission reduction is being undertaken or has been achieved. Liable entities weigh the cost of emission reductions against the cost of emitting and paying the tax to the applicable government agency.

A carbon tax

  • Offers more stable prices/ continuing price signal because there is more certainty around regulatory costs
  • Can rely on existing tax infrastructure and is administratively easier to implement
  • Can be used in conjunction with other policy instruments and have an additional environmental effect to policies such as subsidies to renewables or performance and energy efficiency standards
  • Does not set a limit on GHG emissions
  • Needs to be adjusted for, e.g. inflation, economic downturn, changes in technology, new emission sources, or new GHG targets through (inter-)national commitments
  • Difficult to ascertain optimal tax design, e.g. high taxes that grow slowly versus low taxes that rise very fast. Consideration must be given on how the revenue is used, e.g. for general tax revenue, tax offsets, or specific abatement projects.

Emissions trading

At the heart of emissions trading are tradable allowances. An allowance is a permit that allows the holder to emit a specified amount of GHG emissions. There are two types of emissions trading systems, (1) cap-and-trade and (2) baseline-and-credit.

In a cap-and-trade system, a maximum limit or ‘cap’ is set on GHG emissions and the applicable government agency issues an equivalent number of allowances (one allowance equals one tonne CO2-e). Permits are subsequently allocated among polluters and trade leads to a market price. The allocation of emission allowances is done through free distribution according to specific criteria (e.g. grandfathering, emissions-intensive, trade-exposed entities) or through auctioning.

At the end of a compliance period, liable entities must have enough allowances to cover their reported emissions. If a liable entity emits less than the amount of allowances it holds, it may sell its surplus allowances to other liable. Conversely, if a liable entity does not hold enough allowances to cover its emissions for the period, it must buy allowances from the market (i.e. ‘trade’).

Once again, liable entities weigh the cost of emission reductions against the cost of emitting. A cap-and-trade system lowers overall compliance costs by enabling liable entities to pursue the most cost-effective emission reduction options in form of, e.g. investing directly into abatement project to reduce the number of allowances required, selling surplus allowances to fund internal abatement projects, or choosing to pay for allowances if emissions reductions are too difficult to achieve or too expensive.

In Australia, the Carbon Pollution Reduction Scheme and the Carbon Price Mechanism are examples of a cap-and-trade emissions trading system.

Under a baseline-and-credit system, there is no fixed limit on emissions. Liability is established by setting a baseline of GHG emissions for liable entities. A liable entity then must keep its future GHG emissions at or below facility baseline emissions levels, or pay a penalty per t CO2-e above the baseline. However, liable entities that reduce their GHG emissions below the baseline can in some instances earn ‘credits’ (usually project-based) that they sell to other liable entities which have exceeded their baseline. Alternatively, an entity that is not subject to the baseline-and-credit scheme could also generate project-based credits which it can then sell to liable entities.

The NSW Greenhouse Gas Reduction Scheme, the Carbon Farming Initiative, and now the Emission Reduction Fund with its Safeguard Mechanism are examples of a baseline-and-credit schemes. And from what we know of Labor’s proposed emission trading schemes, these would also fall under the baseline-and-credit category.

Emissions trading

  • Can ensure that a certain quantity of emissions will be reduced, if the cap or baseline is sufficiently stringent to affect emission-related decisions
  • Promotes a highly cost-effective emissions abatement
  • Can be linked to other emissions trading schemes internationally (e.g. the suggested link of the Carbon Price Mechanism to the European Union’s Emissions Trading Scheme)
  • Other environmental policies cannot be easily added to a cap-and-trade system. Either cap-and-trade renders the other policies irrelevant or is itself rendered irrelevant by them. It is redundant if meeting the other policy would involve marginal abatement costs lower than the price for allowance, or vice versa
  • Little incentive to reduce emissions beyond the cap or baseline
  • Free allocation of allowances may lead to windfall profits and/or strategic behaviour

As you can see, there is not really the one best approach. It is more a matter of designing a carbon pricing system than arguing whether a carbon tax or emissions trading is better. What should be discussed are issues around sector coverage, allocation of allowances, borrowing and banking of allowances, offsets, potential risk of carbon leakage, price volatility and linking of schemes, and the impact such regulation has on businesses and individuals.

A discussion on climate policy should be informed, a contest of ideas around the design, even robust in nature… but it cannot be a debate that centres around whoever yells ‘TAX’ the loudest or most often. In fact, several jurisdictions have implemented both, emissions trading and a carbon tax, such as the U.K., Sweden, or British Columbia. And as far as I know, those societies have not descended into chaos or are on the brink of collapse.


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