Both cap-and-trade and carbon taxes can be deployed to reduce GHG emissions, but the mechanics of how they incentivize reductions varies. The fundamental difference between a carbon tax and a cap-and-trade program is that the former sets the price and lets the market determine the quantity of emissions, while the latter sets a firm cap on emissions and the market determines the price.
As summarized by the Center for Climate and Energy Solutions, “Each approach has its vocal supporters. Those in favor of cap-and-trade argue that it is the only approach that can guarantee that an environmental objective will be achieved, has been shown to effectively work to protect the environment at lower than expected costs, and is politically more attractive. Those supporting a carbon tax argue that it is a better approach because it is transparent, minimizes the involvement of government, and avoids the creation of new markets subject to manipulation (C2ES 2009).”
A cap-and-trade approach (also called cap-and-invest) sets a firm cap on emissions from one or more sectors that declines over time. Compliance entities, such as a power plant, must secure carbon allowances equal to their emissions. State regulators can sell these allowances through an auction platform, generating auction proceeds. The proceeds can then be reinvested to support state climate action priorities. The key feature of this type of system is a mechanism that decreases the total allowable emissions total over time, which means less allowances available per auction.
Both options leverage market drivers in order to reconcile the negative impacts of GHG emissions. Both can also be designed to avoid disproportionate impacts on vulnerable communities, and proceeds can be directed at investments that directly support disadvantaged and marginalized populations.
Thus far, no U.S. states have adopted the tax option, although the State of Washington tried twice to implement a carbon tax through ballot measures. British Columbia, Canada, instituted a revenue-neutral carbon tax of $10 CAD per tonne of CO2e in 2008 that gradually rose to $40 CAD per tonne CAD in 2019.
Beginning in the early to mid-2000s, a number of U.S. states and Canadian provinces began pursuing cap-and-trade programs. The Regional Greenhouse Gas Initiative (RGGI) formed in the Northeast and Mid-Atlantic, while the Western Climate Initiative (WCI) formed in the West.
RGGI has been successfully implementing a linked, interstate carbon market for the electric power sector since 2008 and is the first established market-based mechanism to control GHGs in the United States. This initiative established a cap-and-trade program for the power sector across 10 Eastern states in the Northeast and Mid-Atlantic: Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, and Vermont. (Virginia will become the 11th state to join in January 2021 and Pennsylvania is currently developing their regulations with a plan to join in 2022). Power plants larger than 25 MW are required to hold allowances equivalent to their GHG emissions and to surrender those allowances at the end of each three-year compliance period. According to the RGGI website: “A CO2 allowance represents a limited authorization to emit one short ton of CO2 from a regulated source, as issued by a participating state. Regulated power plants can use a CO2 allowance issued by any participating state to demonstrate compliance in any state. They may acquire allowances by purchasing them at regional auctions, or through secondary markets.”
Proceeds generated are re-invested in participating states to support state-specific climate action goals. These include re-investing in projects that support energy efficiency, clean energy and transportation, enhancement of natural and working lands, community adaptation and resilience, and the creation of state green banks. In 2018, RGGI realized $248 million in proceeds.
Beyond the revenue generated to support state climate priorities, RGGI has achieved a 50% reduction in power-sector GHG emissions while GDP across the participating states continues to grow (RGGI, 2020). The market has also significantly improved the health of children across the region, avoiding more than 500 pediatric asthma cases and 100 preterm births, with associated avoided costs in the range of $191–$350 million (NIH, 2020).
Building on the success of RGGI, a number of RGGI states—with the addition of Virginia, Pennsylvania, and the District of Columbia—are working to “design a regional low-carbon transportation policy proposal that would cap and reduce carbon emissions from the combustion of transportation fuels.” The Transportation & Climate Initiative (TCI) is currently undergoing its policy design process, with a final memorandum of understanding planned for release in 2020 and a model rule for winter 2020–2021.
Initiated in 2013, California’s cap-and-trade program, administered by the WCI, covers 85% of the state’s total GHG emissions and is the only multi-sector cap-and-trade program in the U.S. As with RGGI, statewide limits are placed on GHG emissions with the cap declining over time, as well as similar allowance and auction processes. However, one difference is that the California cap-and-trade program incorporates a floor price for allowances that increases over time. This “creates a steady and sustained carbon price signal to prompt action to reduce GHG emissions.”
Auction proceeds from California’s cap-and-trade program contribute to the state’s Greenhouse Gas Reduction Fund, which are in turn allocated to the California Climate Investments programs. Projects funded by these programs include energy efficiency installations, land restoration, urban tree planting, rebate programs, and many other initiatives designed to further reduce California’s GHG emissions. In 2019, $5.3 billion in projects were supported across the state, including in excess of $1 billion for new projects in California’s disadvantaged communities (CCI 2020).
In 2014, the California cap-and-trade program linked with the program in Quebec. For a brief period in early 2018, Ontario also joined the network. However, in July 2018, Ontario’s government revoked their cap-and-trade regulation. Nevertheless, the California-Quebec Cap-and-Trade Program continues.
Although an important tool, carbon pricing alone is insufficient to reach net-zero targets by mid-century. To be fully effective, market-based solutions should be used with additional, complementary mitigation-focused policies (WRI, 2019; CGEP, 2020). This suite of supporting policies must be unique to the carbon-pricing market in place. For these reasons, it is critical to establish a framework (e.g., CGEP, 2019) that will identify the policies that dovetail with and bolster an appropriate carbon price solution.