This document provides an overview and comparison of different policy mechanisms for reducing greenhouse gas emissions, including command-and-control regulations, carbon taxes, and cap-and-trade systems. It discusses how both carbon taxes and cap-and-trade systems use a price on carbon to incentivize emissions reductions, but differ in whether they set a fixed price (tax) or fixed quantity (cap). While each approach has advantages and disadvantages depending on design, the document concludes that with proper design specifics, the two could achieve equivalent emissions reductions.

1. 1
Introduction
Climate change remains one of the most urgent challenges facing the world. In a
document entitled 2007 Turning the Corner regulatory framework, Canada committed itself to
reducing its level of greenhouse gas (“GHG”) emissions to 20% of its 2006 level by 20201
(since then reduced to 17% from its 2005 levels, so as to align with the U.S. target)2. As will be
discussed by way of introduction, climate change policies can and often do draw on several
different mechanism to reduce GHG emissions. These include command-and-control
regulations, carbon taxes, cap and trade systems, emission reduction credit systems, clean
energy standards and the elimination of fossil fuel subsidies.3 Several of these methods have
proven successful in addressing other environmental problems, such as the U.S. sulfur dioxide
(SO2) cap and trade program in the 1990s, or the tradeable performance standard in the U.S. lead
phase-down of gasoline in the 1980s.4 However, economists agree that pricing carbon is the
most effective way to bring about the change. It is much less expensive for governments to
charge the private sector with finding the most cost-effective ways find to reduce GHG
emissions (and incidentally develop new technologies), than is possible under direct regulations
such as mandated technologies or performance standards.5 Debate remains as to which of the
two most widely used mechanisms is preferable: a carbon tax or a cap and trade system.6 After
briefly discussing regulatory instruments, this paper will provide an overview of both the cap and
trade and carbon tax policies, highlighting the advantages and disadvantages of each policy. The
1 Courchene, Thomas J. (2008). “Climate Change, Competitiveness and Environmental Federalism: The Case for a
Carbon Tax”. Montreal QC, CAN: Institute for Research on Public Policy. Pg. 2.
2 www.climatechange.gc.ca
3 Aldy, Joseph E. and Stavins, Robert. (2011). « The Promise and Problems of Pricing Carbon : Theory and
Experience » National Bureau of Economic Research. Working Paper 17569. ». Pg. 3.
4 Ibid.
5 Goulder, Lawrence H. and Andrew Schein. (August 2013). “Carbon Taxes vs. Cap and Trade: A Critical
Review”, National Bureau of Economic Research, Working Paper No. 19338. Pg. 1.
6 Supra note 5, pg. 2.

2. 2
paper will then consider the question of whether one policy is more effective than the other, and
finish with a discussion concerning a “hybrid” cap and trade policy.
I. Regulatory Instruments
Regulatory instruments can vary based on compliance options and the reduction target.7
The traditional “command-and-control” regulations are the government prescribed use of either
technology based or performance based standards. Technology based standards require the use
of specified equipment, processes or procedures, such as energy-efficient motors, combustion
processes, or landfill-gas collection techniques.8 Performance based standards leave the specific
methods for achieving a specified allowable level of pollutant emissions up to the regulated
entity. Examples would be maximum allowable grams of CO2 per mile for cars and light duty
vehicles in the U.S. tailpipe emissions standards,9 or Ottawa’s 2008 policy update promising no
dirty coal electricity plants after 2012, as well as vehicle emission standards.10 While effective
to some degree, both technology and performance based standards can only be used in
conjunction with other measures. Criticism of both standards alleges that while the performance
based standard allows some flexibilty in meeting the prescribed outcome, both standards lead to
unsatisfactory cost outcomes where some firms end up reducing emissions in a highly non-cost
effective fashion.11 It is worth noting that more flexible regulatory models have recently been
adopted, for example in Alberta, which has regulated large final emitters since 2008. Alberta
provides four choices for annual compliance: direct emissions reductions, purchasing offset
7 Sustainable Prosperity. (May 2011). “Managing Carbon Revenue: Institutional needs and models”. Ottawa ON,
CAN: Sustainable Prosperity (University of Ottawa). Pg. 3.
8 Supra note 3 at pg. 3.
9 Ibid.
10 Supra note 1 at pg. 2.
11 Supra note 3 at pg. 3.

3. 3
credits, trading emissions credits, or contributing to a technology fund at a price of CAD $15/t
CO2e. Saskatchewan has also introduced legislation featuring regulation of major emitters,
offset trading and carbon compliance payment directly to a non-profit, third party technology
fund.12
It is also alleged that there is no incentive to improve once a firm has met the
performance standard, and technology standards, by definition, impose the use of a certain
technology, potentially at the expense of innovation through a more effective technology.13 For
all of the above reasons, as well as general cost-effectiveness, carbon pricing is the preferred
method of reducing GHG emissions.14
II. Cap and trade
A cap and trade system has been defined as an objective, the “cap”, usually enshrined in a
binding legislative provision, and which can be a quantified target (for example, a certain
percentage of electricity generated from renewable energy sources, or a number of previously
allocated quotas). These quotas represent a fixed volume of GHG emissions, which are to be
redeemed at a fixed time (an allowances system).15 Emissions trading creates a market where
firms can sell or buy carbon allowances (from the government, other firms, or approved “carbon
offset” sources as required), depending on whether they are above or below their allocated level
of carbon emissions. 16 Under a carbon tax, the price of carbon (or of CO2 emissions) is set
directly by the regulatory authority, and it is the tax rate. In contast, under a pure cap and trade
12 Supra note 7 at pg. 4.
13 Supra note 3 at pg. 3.
14 Ibid.
15 Banet, Catherine. “The use of market-based instruments in the transition from a carbon-based economy” in
Donald N. Zillman, ed., (2010). Beyond the Carbon Economy – Energy Law in Transition. Oxford University
Press. Pg. 209.
16 Supra note 1 at pg. 21.

4. 4
system, the price of carbon or CO2 emissions is established indirectly: the regulatory authority
stipulates the allowable overall quantity of emissions; this then yields a price of carbon or CO2
emissions through the market for allowances. Allowance trading is a critical element of a cap
and trade, as it promotes the emergence of a single market price for emissions faced by all
market participants at any given time.17 To fulfil the requirement or redeem the required
allowances, a trading system must be implemented.18 Initial allocations of carbon allowances to
firms can be through free allocation on the basis of historical measures (“grandfathering”) or on
an updated basis (such as output-based allocation), or auctioning (sale of permits).19
The main advantage of cap and trade systems is that the total amount of emissions is
“capped”, thus guaranteeing a positive environmental effect. Given that new taxes generally
generate ill-will among rate-payers, a cap and trade system is also a more politically attractive
option.
The main disadvantages of cap and trade systems are as follows: it stipulates aggregate
emissions, resulting in a general price uncertainty which can make business planning difficult.20
Many business groups argue that this price uncertainty hinders the ability of business to engage
in climate policy, because when future allowance prices are uncertain, it is risky to invest in new
technologies research or engage in fuel substitution.21 Also, cap and trade systems often leave a
significant portion of emissions unpriced (for example, emissions from cars, trucks, office
buildings and smaller industries),22 as they only deal with large emitters at the production end.
17 Supra note 5 at pg. 4.
18 Supra note 15.
19 Supra note 7 at pg. 3.
20 Canadian Chamber of Commerce. (December 2008). “A Carbon Tax vs.Cap-and-Trade”. Policy Brief Economic
Policy Series. Pg. 2.
21 Supra note 5 at pg. 16.
22 Sustainable Prosperity. (2009). “ “Hybrid” Carbon Pricing: Issues to considerwhen carbon taxes and cap and
trade systems interact”. Ottawa ON, CAN: Sustainable Prosperity (University of Ottawa). Pg. 4.

5. 5
In comparison, a carbon tax would be required for the consumption level regardless.23 Cap and
trade systems are subject to lobbying by the big emitters. 24 As will be discussed later on,
transaction costs are higher compared to a carbon tax. This is attributable to the inevitable
requirement for a new institutional infrastructure, including an extensive tracking/administrative
system. There would also need to be a compliance and enforcement function, capable of
applying penalties for fraud and non-compliance.25
However, by far the greatest potential problem with cap and trade systems is the
possibility of extreme price volatility due to improper design. The European Union Emission
Trading Scheme, the world’s largest cap and trade system, was adopted in 2003. In the first
phase, each member state responsible for proposing its own national carbon cap and allowances,
subject to review by the European Commission. Inevitably, individual countries attempted to
protect their national competitiveness, and the result was an aggregate cap that exceeded
“business-as-usual” emissions by 4%.26 In January 2005, the price per ton was approximately
€8/tCO2; by early 2006, it had exceeded €30/tCO2, then fell by about half in one week of April
2006, before fluctuating and returning to about €8/tCO2. This volatility was attributed to the
absence of transparent, precise emissions data at the beginning of the program, a surplus of
allowances, energy price volatility, and a program feature that prevents banking of allowances
from the first phase to the second phase. 27 The issue of banking features in a cap and trade
system will be further expounded upon in the discussion of a “hybrid” cap and trade system.
A second example of extreme price volatility was the energy crisis in California in the
summer of 2000, which gave power companies in the Los Angeles area incentives to bring
23 Supra note 1 at pg. 16.
24 Supra note 1 at pg. 16.
25 Supra note 20 at pg. 3.
26 Supra note 3 at pg. 11.
27 Ibid.

6. 6
online older generators. This led to a significant increase in the demand for NOx emissions
allowances under the Regional Clean Air Incentives Market (RECLAIM) program, since
allowances were needed to validate the emissions produced by these generators. As a
consequence, NOx allowance prices rose from about $400 per ton to an average in the year 2000
of over $40,000 per ton (with the average allowance price reaching $70,000 in the peak month of
2000). 28 As with the European Union example, some have claimed that the volatility in this case
was also attributable to the absence of banking provisions.
III. Carbon Taxes
Some observers have noted that today most taxation is an arbitrary penalty on
employment, and suggest that taxation can instead be used to persuade enterprises and
individuals to consume differently: “A tax on carbon dioxide (CO2) would give everyone an
incentive to emit less of it. It would be simple, direct, transparent.”29 At its most basic, a carbon
tax is where the government levies a fixed sum on the carbon content of fuels, and the revenue is
collected through the existing tax administration infrastructure.30
The main advantage of carbon taxes is for businesses, which may prefer carbon taxes to
other carbon mitigation policies, because taxes provide a certain, long-term price signal that can
be incorporated into projections of operating expenses, whereas prices may not be as well known
with emissions caps.”31 Furthermore, energy-intensive industries or highly competitive
industries that compete with companies in jurisdictions without taxes have been allowed to pay
28 Supra note 5 at pg. 13.
29 Blanco, Elena and Jona Razzaque. (2011). Globalisation and Natural Resources Law – Challenges,Key Issues
and Perspectives. Edward Elgar Publishing Ltd. Cheltenham, U.K. Pg. 109.
30 Supra note 7 at p. 3.
31 Sumner, Jenny,Lori Bird and Hilary Smith. (December 2009). “Carbon Taxes: A Review of Experience and
Policy Design Considerations”. National Renewable Energy Laboratory. Golden, Colorado. Pg. 6.

7. 7
reduced rates.”32 Given that large emitters are often selling their products on an international
market, they may find themselves at a disadvantage when competing with products from other
jurisdictions that are not so taxed. Carbon taxes implemented in European countries often apply
reducted rates or exemptions to large emitters.33
The primary criticism of carbon taxes is they stipulate the price of emissions, but do not
necessarily ensure a certain level of emissions reductions, unlike emissions caps.34 This is a fatal
flaw for some environmental groups, as it may ultimately defeat the purpose of the entire policy
in their eyes. Although carbon taxes can be designed so that tax rates increase automatically if
emission reductions are not met, this practice has not been fully implemented to date,35 which
may reflect the political challenges of passing a tax in the first place. The British Columbia
government has specified that changes to the tax rate will depend on whether GHG emissions are
being met. The B.C. government also intends to take into account the impact of other carbon
policies, the actions other governments are taking, as well as general advice being offered by its
Climate Action Team.”36
Carbon taxes are often seen as less politically acceptable than cap and trade systems
because they are perceived as lacking the ability to achieve a fair distribution of the policy
burden between polluters (firms) and consumers, and disproportionately penalize low-income
households. 37 As such, home heating is a social justice concern that should be considered in the
32 Ibid.
33 Supra note 22 at pg. 6.
34 Supra note 31 at pg. 1.
35 Ibid.
36 Supra note 31 at pg. 21.
37 Supra note 31 at pg. 1.

8. 8
design of a carbon tax.38 Revenue-neutral policies and refunds to low-income consumers are
designed to make carbon tax policies more politically appealing.39
Although a carbon tax is designed to meet the needs of the implementing jurisdiction, the
proper design of all carbon taxes require consideration of which sector to tax and what the tax
rate should be, how the resulting tax revenues would be used and how to ensure emissions
reductions goals would be achieved.40
Carbon taxes are usually placed on gasoline, coal and natural gas, and governments must
also decide whether to place the tax on a source of emission that is “upstream” (at the point of
production) or “downstream” (at the source of consumption). Taxing upstream sources may
provide an administratively efficient method of tax collection, while taxing downstream sources
such as electricity consumption may modify consumption patterns more strongly.”41
There is high variability of tax rates across jurisdictions that tax carbon. Higher carbon
tax rates, such as found in Europe, provide stronger signals to consumers to change behaviour.
Lower rates, such as espoused by California or various state and local governments, provide
funds for carbon mitigation programs or to supplement government budgets. As previously
mentioned, other carbon tax programs, such as in the U.K. and British Columbia, return tax
revenue to customers through other means such as income tax reductions. While these “revenue-
neutral” mechanisms do not raise money for government general funds, a price is placed on
goods that harm the environment and it is argued that lowered income taxes will generate new
employment opportunities.”42
38 Supra note 22 at pg. 7.
39 Supra note 31 at pg. 7.
40 Supra note 31 at pg. iv.
41 Supra note 31 at pg. 3.
42 Supra note 31 at pg. 4.

9. 9
IV. Which is a more effective climate change policy, cap and trade or carbon tax?
The performance of the two approaches depends critically on specifics of design, which
may be as important as the choice between the two instruments.”43 Observers who have
compared the two systems dispel the following arguments which are sometimes advanced to give
one system primacy over the other. The first argument leveled against cap and trade is that any
free allocation eliminates the recipient’s incentive to reduce emissions. Even when allowances
are received for free, each additional unit of emissions carries an opportunity cost. According to
general economic doctrine, one more unit of pollution either reduces the number of allowances
the covered firm can sell, or it raises the number of allowances the firm must purchase to remain
in compliance. “The carbon tax and cap and trade thus offer equivalent incentives to reduce
emissions, regardless of whether the allowances are introduced through auction or free
provision.”44 A second argument, which the observers accept as true, is that emissions pricing
can lead to a very uneven distribution of costs across producing sectors, or between producers
and consumers. In light of this inequity, other observers have suggested that free allowances
should be used to avoid undesirable outcomes, stating that any distributional outcome under cap
and trade can be matched via a carbon tax.45 Finally, the use of offsets (which allow regulated
entities to offset some of their emissions with credits from emission reduction measures lying
outside the cap-and-trade or carbon tax system’s scope of coverage) can be included or excluded
with both a carbon tax or a cap and trade system, to the same effect.46
Although previously mentioned, it bears repeating that one area where a carbon tax may
be preferable to a cap and trade system is its adminstration. The regulator must establish a
43 Supra note 5 at pg. 2.
44 Supra note 5 at pg. 5.
45 Ibid.
46 Supra note 5 at pg. 10.

10. 10
registry for allowances and keep track of allowance trades and the associated changes in
ownership of allowances, in addition to monitoring emissions.47 The cost of administering an
emissions pricing policy is also a function of how many points of regulation there are to monitor,
and whether the system is introduced “upstream” (at or near the point where carbon first enters
the economy, which involves far fewer covered entities to monitor) or “downstream” (at or near
the ultimate point of combustion of the carbon-based fuels, which would potentially cover many
more entities). For example, the authors state that a fully downstream system – one that
considered only the ultimate emitters of CO2 – would involve millions of points of regulation
since it would need to include furnaces and automobile emissions of every household. Thus the
administrative costs associated with monitoring emissions can be considerably lower under an
upstream system. Both a carbon tax and a cap and trade system can be implemented upstream or
further downstream.48
V. The “hybrid” cap and trade
Emissions price volatility is not a problem for a carbon tax, as the tax rate is the
emissions price, and presumably policy makers would ensure relatively smooth changes rather
than sudden jumps. But as seen in previous examples from the European Union and California,
volatility can become a significant issue for a cap and trade system. In economic terms, under
the cap and trade system the supply of allowances is perfectly inelastic, therefore shifts in
demand can cause significant price changes.
Putting an effective price ceiling or “safety valve”, as well as a price floor or “price
collar” in the emission allowance market reflects a “hybrid” approach to climate policy: a cap
47 Supra note 5 at pg. 12.
48 Ibid.

11. 11
and trade system that transitions to a tax in the presence of unexpectedly high mitigation costs,
and a price floor in the form of a minimum price in auction markets or a government
commitment to purchase allowances at a specific price.49 To enforce a price ceiling, the
regulator may also introduce into circulation additional allowances whenever the stipulated
ceiling price is reached so as to prevent allowance prices from rising further, or allow firms to
pay a set fee to emit instead of submitting allowances, if allowances reach a threshold (usually
set at the same price as the fee itself). 50 To enforce a price floor, the regulator may also buy up,
so as to remove from circulation, allowances whenever the floor price is reached, thereby
preventing prices from falling further, or set a fee that purchasers must pay in addition to the
allowance price when allowance prices drop below the stipulated floor level. Various cap-and-
trade programs, such as the one recently set up in California, use an auction reserve price.51
Other cost-containment measures to counter unexpectedly high or volatile allowance
prices and stabilize prices include offsets and allowance banking and borrowing, also known as
strategic allowance reserves, which permit emission trading across time and between compliance
periods by saving an allowance for future use, or bringing a future period allowance forward for
current use, as well as multi-year compliance periods. 52 For example, nearly unlimited banking
in the U.S. sulfur dioxide (SO2) cap and trade program in the 1990s is generally agreed to have
been a successful design feature of that program, as it mitigated issues of price volatility and led
firms to achieve SO2 reductions faster than they would have without banking.53
49 Supra note 3 at pg. 6.
50 Supra note 5 at pg. 14.
51 Supra note 5 at pg. 15.
52 Supra note 7 at pg. 3.
53 Supra note 5 at pg. 14.

12. 12
However effective intertemporal banking may be, it cannot prevent all volatility. SO2
allowance prices were particularly volatile in the late 2000’s as a series of court and regulatory
decisions changed expectations about the future stringency of the cap.54
Furthermore, it should be noted that the hybrid policy also introduces uncertainty about
emission levels, because as previously noted, enforcing the ceiling may entail the introduction of
extra allowances, while enforcing the floor may imply removal of some allowances that were in
circulation. Some economists dismiss these concerns by suggesting that uncertainty about
emissions quantities under the hybrid model can be reduced if policy makers pledge to invest in
other, offset projects to compensate for whatever increase in emissions might otherwise occur as
a result of enforcing the price ceiling, for example. Revenues from emissions allowances sold
could be used to finance some or all of these offset projects.”55
An interesting dilemma has been advanced in the potential situation of a jurisdiction
having both a carbon tax and a cap and trade system in place. The two carbon pricing
mechanisms can be kept separate, with two different carbon prices. However, the two prices can
also be linked, with the carbon tax rate being the price floor or the price ceiling.56 There can also
be a carbon tax added to the cap, which might play out as follows: if emissions are only
sufficiently reduced when there is a cap at $40/tonne, for example, but the carbon tax is
$30/tonne, permit trading has resulted in an extra $10/tonne to the price, and volatility has been
reduced. However, if the carbon tax is set at the maximum trading price, there is no longer an
effective cap on emissions.57
54 Ibid.
55 Supra note 5 at pg. 18.
56 Supra note 22 at pg. 5.
57 Supra note 22 at pg. 5.

13. 13
Conclusion
By establishing a price for emissions of carbon dioxide, carbon taxes and cap and trade
systems (as well as the hybrid cap and trade system) encourage firms to innovate with their
technological processes so as to reduce emissions.58 Consumer behaviour is also modified by
causing the prices of carbon-intensive goods (for example, electricity, aluminum, and gasoline)
to rise relative to those of other goods.59 However, larger questions loom on the horizon, such as
the fact that these two systems are poised to interact. British Columbia and Quebec have already
implemented carbon taxes and are also planning cap and trade systems for large emitters, as are
other provinces.60 How will these two pricing systems function in tandem?61 Should the two
price mechanisms be kept largely separate, with modifications brought to the carbon tax rate on
an ad hoc basis?62 Should the two prices be linked?63 As discussed previously, there are several
ways in which such scenarios might play out.
As Canada and the provinces continue to develop their climate change policies, other
suggestions have been made, such as restructuring the federal fuel excise tax so that it includes
other sources of GHG emissions.64 Ultimately, the novel and untested nature of many climate
change policies suggest it would be prudent to learn from the experiences of other jurisdictions
who are grappling with this very global issue.
58 Supra note 5 at pg. 3.
59 Supra note 5 at pg. 4.
60 Supra note 22 at pg. 4.
61 Ibid.
62 Supra note 22 at pg. 5.
63 Ibid.
64 Supra note 20 at pg. 5.

14. 14
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Experience”, National Bureau of Economic Research, Working Paper No. 17569.
Banet, Catherine. “The use of market-based instruments in the transition from a carbon-based
economy” in Donald N. Zillman, ed., (2010). Beyond the Carbon Economy – Energy
Law in Transition. Oxford University Press.
Blanco, Elena and Jona Razzaque. (2011). Globalisation and Natural Resources Law –
Challenges, Key Issues and Perspectives. Edward Elgar Publishing Ltd. Cheltenham,
U.K.
Canadian Chamber of Commerce. (December 2008). “A Carbon Tax vs. Cap-and-Trade”.
Policy Brief Economic Policy Series.
Courchene, Thomas J. (2008). “Climate Change, Competitiveness and Environmental
Federalism: The Case for a Carbon Tax”. Montreal QC, CAN: Institute for Research on
Public Policy.
Goulder, Lawrence H. and Andrew Schein. (August 2013). “Carbon Taxes vs. Cap and Trade:
A Critical Review”, National Bureau of Economic Research, Working Paper No. 19338.
Sumner, Jenny, Lori Bird and Hilary Smith. (December 2009). “ Carbon Taxes: A Review of
Experience and Policy Design Considerations”. National Renewable Energy Laboratory.
Golden, Colorado.
Sustainable Prosperity. (2009). “ “Hybrid” Carbon Pricing: Issues to consider when carbon
taxes and cap and trade systems interact”. Ottawa ON, CAN: Sustainable Prosperity
(University of Ottawa).
Sustainable Prosperity. (December 2010). “Carbon Pricing, Climate Change, and Fiscal
Sustainability in Canada”. Ottawa ON, CAN: Sustainable Prosperity (University of
Ottawa).
Sustainable Prosperity. (May 2011). “Managing Carbon Revenue: Institutional needs and
models”. Ottawa ON, CAN: Sustainable Prosperity (University of Ottawa).
www.climatechange.gc.ca