A carbon tax sets a price per ton of CO2 or CO2e emitted, and charges emitters based on their total emissions. In the best designs, the tax is administered upstream on the largest emitters, and the cost is partially passed through based on the carbon content of products or input fuels. Maximum coverage of GHG emission sources, ideally capturing 100 percent of the market—and therefore reduction opportunities—reduces the scope for emissions leakage and promotes the policy’s efficiency.
Under a carbon tax, the price of emissions is set by policymakers, and the corresponding carbon reductions are determined by the market. A carbon tax has the benefit of enabling broad coverage of many sectors of the economy. Making polluters begin to pay directly for previously-externalized carbon costs affects both production and consumption decisions. Economy-wide coverage provides an incentive for the market to balance carbon reductions across economic sectors in an efficient way.
An economy-wide carbon tax influences both upfront purchasing decisions and operation of energy-using technology. A carbon tax provides an incentive both for equipment buyers to choose higher efficiency technology and for equipment owners and operators to save energy by limiting equipment usage. Manufacturers are rewarded for offering more efficient technology and investing in R&D aimed at improving future emissions performance.
A carbon tax on GHG emissions with a future schedule for increasing the price sets clear goals and incorporates continuous improvement. With consistent, predictable rules, market participants will have the necessary information to forecast market prices and plan their strategy for emission reductions.
The impact on consumers of paying the cost of a carbon tax can be reduced by redistributing the revenues to consumers. In the case of energy-intensive, trade-exposed industries, providing subsidies that are not linked to a company’s specific level of emissions (to help industries be competitive without removing the economic incentive to reduce emissions) may be appropriate to limit leakage. The best programs also use a portion of the funds for investments in technologies to reduce emissions, to encourage deployment of existing improved technologies and R&D, and to generate future options for efficient emissions reduction.
Carbon taxes should also be designed to adapt or repair themselves over time, with built-in evaluation and adjustment mechanisms. As tax programs evolve and the markets mature, adjustments can be made based on evaluation results.
Finally, by sending a consistent price signal and making emissions sources responsible for emissions reductions, carbon taxes support private sector investment and innovation. Market participants that can reduce emissions at the lowest cost can minimize their compliance costs and even earn profits from selling allowances or low-carbon technology.
Similar results can be achieved via a carbon cap-and-trade policy. In a cap-and-trade policy, the total allowable emissions are set by policymakers and the corresponding price per ton of emissions reductions is determined by the market. An effective cap-and-trade policy has some of the same design principles as a good carbon tax: The program should be administered upstream on the largest emitters, covering as close to 100 percent of the market as possible. Additionally, auction revenues should be partially distributed to consumers and trade-exposed industries, and partially invested in emissions-reducing technologies.
For a more detailed discussion, see the applicable chapter of Designing Climate Solutions, our book on smart energy and climate policy design.