Carbon Tax & Cap and Trade

As we all know, carbon dioxide is a potent greenhouse gas that is linked to climate change. In order to fight climate change and lower global temperatures, governments around the world have adopted policies such as environmental taxation and cap and trade programs to disincentivize firms to produce using unsustainable energy such as oil and gas.

Carbon Tax

Carbon tax is perhaps the most direct way to reduce carbon emissions through providing financial incentives through utilizing loss aversion. The mechanism of action is very simple—these taxes incentivise firms to invest in sustainable technology to maintain a larger profit margin over the long term. 

A price is usually set on a certain amount of tonnes of carbon dioxide emitted and firms have to pay according to the quantity that they emit. Many countries such as Argentina, Canada, the UK, EU, and more have adopted this policy, and it has been proven to be successful in reducing carbon emissions. 

However, there are many limitations to carbon tax. Namely, it is hard to agree universally upon a certain set price on a number of carbon emissions. Large firms and monopolists of markets are likely to be able to absorb such costs and continue to produce at high levels of carbon emissions, meaning a flat tax structure may be likely to benefit larger companies than smaller companies. If companies are able to absorb the prices of the carbon tax, then the environmental consequences would not be fully internalized.

Cap and Trade

Another type of environmental policy is cap and trade. Cap and trade programs adopt a unique quota-based allowance which allows companies to emit carbon emissions under a certain quota. Companies will be fined or punished through legislation if they exceed that quota. These emission allowances are often distributed to larger companies either for free or through an auction. The ‘trade’ aspect of the program is the aspect of tradable permits. If firms are able to adopt greener production practices and invest in green technology such as renewable energy, firms can sell their unused quota to firms that need it, hereby creating a financial incentive for firms to invest in green energy in the long run. 

As cap-and-trade programs are often operated over a long period of time, the government eventually decreases the amount of quotas that are distributed across companies, thus raising the prices of quotas even further and further incentivizing firms to invest in green technologies.

To a certain extent, it can be argued that cap and trade programs provide a larger incentive for firms to invest in green technologies than carbon tax because of its quota-based mechanism. It is also able to quantify the maximum amount of carbon emissions emitted by a country, thus allowing the government to measure environmental activities easier and set up policies accordingly. 

Works Cited

Cheung, J. (2022). Explainer: Cap and Trade vs Carbon Tax. [online] Earth.org. Available at: https://earth.org/cap-and-trade-vs-carbon-tax/ [Accessed 1 May 2025].

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Lewis, J. (2021). Carbon Tax: Pros and Cons | Earth.org. [online] Earth.org. Available at: https://earth.org/carbon-tax-pros-and-cons/ [Accessed 1 May 2025].

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