Economics Instruments for Pollution Abatement: Tradable Permits Versus Carbon Taxes

Abstract

Contemporary energy policy issues are dominated, directly and indirectly, by major concerns at both local and global levels of environmental degradation arising from combustion of fossil fuels. The advent of “carbon pricing” (either through an emissions trading scheme or a carbon tax) represents an attempt to impose a cost on consumers that will limit such degradation (i.e. the deleterious impacts of climate change) to scientifically-determined “acceptable” levels. The resulting higher cost of fossil fuel combustion for power generation should induce a reduction in the demand for power (the “demand effect”) whilst simultaneously stimulating investment in competitively-priced low carbon power generation technologies (the “supply effect”). At least in theory, the trading of emission permits can be shown to be a least-cost economic instrument for meeting a specified level of reduction of carbon dioxide. However, a carbon tax possesses the same property. In this chapter the relative merits of these two instruments will be assessed, paying particular attention to factors that could, in practice, lead to significant levels of inefficiency for one instrument relative to the other.

The author acknowledges financial research support from Santos Ltd.