Harvard Environmental Economics Program and Enel Foundation on theory and practice on Carbon Pricing Mechanisms

The Harvard Project on Climate Agreements—in collaboration with the Enel Foundation—released the ninth annual discussion paper “Carbon Taxes vs Cap and Trade:  Theory and Practice.”

The paper was also discussed at an official side event during COP25 in Madrid. 

The research, carried out by Robert N. Stavins, A.J. Meyer Professor of Energy & Economic Development from John F. Kennedy School of Government at Harvard University and Director of the Harvard Environmental Economics Program, focuses on a comparison among the two main carbon pricing instruments currently available to governments - namely carbon taxes and cap-and-trade mechanisms - in the context of climate policy.

After coupling theory with relevant empirical data many similarities emerge along with certain differences between the two instruments. They are equivalent in terms of incentives to emission reduction, effect on competitiveness, and aggregate abatement costs. They are nearly equivalent in terms of possibilities for raising revenue, and similar in terms of distributional impacts and costs to regulated firms.

Distinctions appear since cap-and-trade systems involve the trading of allowances among firms and therefore have higher transaction costs.

Carbon taxes are slightly disadvantaged as they underperform in the presence of uncertainty and in terms of easiness of linkage with other jurisdictions.

Carbon taxes bring instead some advantages if we look at the effects on carbon price volatility, at the interaction with complementary policies, at the potential for market manipulation or at the level of complexity and administrative requirements.

Nevertheless, it should be highlighted that many of the instruments’ differences fade with specific implementation choices. In other words, what appears at first to be a dichotomous choice between two distinct policy instruments often turns out to be a choice of design elements along a policy continuum. Furthermore, the merits of the two policy instruments – theoretically and empirically – are not entirely separate from issues pertaining to adoption and implementation.

The paper also includes an appendix by Marcos Barrozo and Robert Stowe with a case study on carbon pricing in South America, focusing on the political economy of adoption and implementation. More specifically, it addresses carbon pricing in Argentina, Chile, and Colombia. The findings mirror the ones obtained in the other countries, concluding that the power sector in both Chile and Colombia is neutral with regard to choice of policy instrument, although industry and mining are more supportive of cap-and-trade, believing that the latter is more capable to address their competitiveness concerns through a free allocation of allowances.

More on the project

The Enel Foundation and the Enel Endowment for Environmental Economics at Harvard University have supported a series of annual discussion papers on climate-change policy and related topics in energy policy, prepared by the Harvard Project on Climate Agreements, of which Stavins’ contribution is the ninth and most recent paper.

The goal of the Harvard Project on Climate Agreements, which was established in 2007, is to identify and advance scientifically sound, economically sensible, and politically pragmatic public policy options for addressing global climate change. Drawing upon leading thinkers from around the world, the Project conducts research on policy architecture, key design elements, and institutional dimensions of international and domestic climate-change policy.