Comparative Study of Carbon Tax and Carbon Credit


There has been a tremendous change in the Earth's atmosphere since mid 20th Century. The average temperature of Earth has increased during the last century. The Intergovernmental Panel on Climate Change concludes that increasing industrial activities and human activities have given rise to increasing Greenhouse Gas Emissions which has increased the surface temperature of the Earth. This basic conclusion has been endorsed by almost all the scientific societies and academies of science all over the world including every national academies of science of the major industrialized countries.

Climate model projections point out that global surface temperature will probably rise a further more during the twenty first century. The warming is expected to continue even beyond 2100 because of the large heat capacity of the oceans and the long life time of Carbon di oxide in the atmosphere.
Global temperature rise will have catastrophic effects which include sea level rise, expansion of subtropical deserts, continuing retreat of glaciers, permafrost. Other likely effects include increase in the intensity of extreme weather, species extinctions and reduce agricultural yields.

Political and public debates continue regarding the climate change but the actions to take to substantially curb the rising presence of Greenhouse Gases have not yet been finalized. Governments are working out on various mechanisms to curb the rising Carbon dioxide levels and have come out with two models which can be used effectively to reduce and slow down the process of Carbon Dioxide emissions. One mechanism is taxing Carbon and the other is capping the emission of Carbon.

Carbon Credit

Carbon credits is a mechanism adopted by national and international governments to mitigate the effects of Green House Gases(GHGs). One Carbon Credit is equal to one ton of Carbon. Capped Greenhouse Gases are traded in the market to regulate the emissions from the sources. The idea is to allow market mechanisms to drive industrial and commercial processes in the direction of low Greenhouse Gases(GHGs). These mitigation projects generate credits, which can be traded in the international markets for monetary benefits.

There are also many companies that sell carbon credits to commercial and individual customers who are interested in lowering their carbon footprint on a voluntary basis. These carbon credits are bought from an investment fund or a carbon development company that has aggregated the credits from individual projects. The quality of the credits is based in on the validation process and sophistication of the fund or development company that acted as the sponsor to the carbon project. Voluntary units typically have less value than the units sold through the rigorously-validated Clean Development Mechanism].


Fossil Fuels are the major source of Greenhouse Gas Emissions. Industries such as Power, Textile, Fertilizer use fossil fuels for their high volumes of operations. The major greenhouse gases emitted by these industries are carbon dioxide, methane, nitrous oxide, hydrofluorocarbons (HFCs), etc, all of which can increase the temperature of Earth's Atmosphere by trapping Infrared radiations from the Sun.

The increasing awareness about the environmental degradation gave rise to the concept called Carbon Credit. The Intergovernmental Panel on Climate Change(IPCC) has observed that:

Mechanism/ Policies that provide a price of carbon could create incentives for producers and consumers to significantly invest in low-GreenHouseGas products, technologies and processes. Such policies could include financial instruments, government funding and regulation,while noting that a market based trading system is one of the policy instruments that has been shown to be environmentally effective in the industrial sector, as long as there are reasonable levels of predictability over the initial allocation mechanism and price.

The mechanism was formalized in the Kyoto Protocol, an international agreement between more than 170 countries, and the market mechanisms were agreed through the subsequent Accords.

Emission allowances

The Protocol sets up 'caps'(quotas) on the maximum amount of Greenhouse gases for developed and developing countries. These countries subsequently set quotas on the emissions of installations run by local business, industries and other organizations. The industries which come under the purview of the Government Regulated Environmental policies are termed as ‘Operators'. Countries manage this through ‘registries' that are set up, which are required to be validated and monitored for compliance by the UNFCCC. Each operator has an allowance of credits, where each allowance gives the owner the right to emit one metric tonne of carbon dioxide or other equivalent greenhouse gas. Operators that have not used up their quotas can sell their unused allowances as carbon credits whereas businesses that are about to exceed their quotas can buy the extra allowances as credits on the open market. As demand for energy grows over time, the total emissions must still stay within the cap. However it allows industry some flexibility and predictability in its planning to accommodate this so that emissions remain under control.

The allowances are bought and sold in Carbon Markets in such a way that an operator can seek the most effective way of reducing emissions. They either invest in ‘cleaner' machinery and practices or purchase allowances from other operators who would have under used the quotas given to him.

The countries which fall under European Union are trading Carbon under European Trading Scheme(ETS). They have adopted Kyoto mechanism since 2005. From the year 2008, European Union participants have traded Greenhouse Gases with the other developed countries who have ratified Kyoto Protocol. The US which has not ratified Kyoto and Australia whose ratification happened in 2008, similar schemes are being considered.

Kyoto's 'Flexible mechanisms'

A credit is an emissions allowance which was allocated originally or auctioned by the national administrators of a cap-and-trade program. It can also be an offset of emissions. Offsetting and mitigating activities can occur in any developing country which has ratified the Kyoto Protocol, provided the country has a national agreement in place to validate its carbon project through one of the United Nation Framework Convention for Climate Change's(UNFCC) approved mechanisms. Post Approval, these units are termed Certified Emission Reductions, or CERs. The Protocol allows these projects to be constructed and credited in advance of the Kyoto trading period.

The Kyoto Protocol can be used in three ways that can enable countries or operators in developed countries to acquire Greenhouse Gas credits.

• Under Joint Implementation (JI) a developed country which incurs high cost in the reduction of GHGs would set a project in another developed country.
• Under the Clean Development Mechanism (CDM) a developed country can fund the projects in developing country where the cost of funding is relatively. The developed country would be given credits for carrying out projects which would reduce emissions and help in meeting its emission reduction targets, while the developing country would benefit from the capital investment and .
• Under International Emissions Trading (IET) countries can trade in the international carbon credit market to cover their shortfall in allowances. Countries which have under used the credits can sell the remaining credits in the markets and countries which have fully used their credits can buy the credits from other players in the market.
These carbon projects can be created by a national government or by an operator within the country.

Emission markets

One allowance or Carbon Emission Reductions (CER) is equivalent to one metric ton of Carbon Dioxide emissions. These allowances can be traded privately or in the international market at the prevailing market price. Each international transfer is validated by the UNFCCC.

Exchanges have been established to provide market for allowances which will help to discover the current market prices and maintain liquidity. Carbon prices are measured in Euros per tone of Carbon dioxide. Other GHGs can also be traded

Many companies now engage in emissions reductions, offsetting, and sequestration programs so that credits are generated which can then be sold in international markets.
Market price for carbon

Energy usage and emissions should be kept under constant check else they will only rise over time. Hence the number of companies needing to buy credits will increase over the period of time. This Supply-Demand for credits will determine the price of the Carbon which will in turn encourage companies to go cleaner.

An allowance, such as a Kyoto Assigned Amount Unit (AAU) or its near-equivalent European Union Allowance (EUA), may have a different value in the market to an offset such as a Carbon Emission Reduction(CER). This is mainly because of the lack of a mature secondary market for CERs and a lack of homogeneity between projects which causes difficulty in pricing. Moreover offsets generated by a carbon project under Clean Development Mechanism are under limited in value mainly because the operators in European Union European Trading System (EU ETS) are restricted as to what percentage of allowances can be generated by Clean Development Mechanism (CDM).

Raising price of carbon achieves four goals. First, the consumers will get informed about the goods which are high in carbon or which utilized high carbon and therefore would drive customers to use the products more sparingly. Second, it would drive producers to use inputs which are less in carbon content which results in companies using low carbon substitutes. Third, it would foster innovation in coming up with technologies which are cleaner and efficient. Fourth it would incentivize everyone who are involved in reduction of Greenhouse Gases.


Environmental restrictions and activities have been imposed on businesses through regulation. Many are uneasy with this approach to managing emissions.

The only internationally agreed mechanism for Carbon Credit Regulation is Kyoto-Protocol and Its supporting organisation, the UNFCCC, is the only organisation with a global say on the overall effectiveness of emission control systems, although application of decisions is entirely dependent on national co-operation. The Kyoto trading period applies for five years between 2008 and 2012. Phase 1 of the EU ETS system started before then, and is expected to continue in a third phase afterwards, and may co-ordinate with whatever is internationally-agreed at but there is general uncertainty as to what will be agreed in Post-Kyoto Protocol negotiations on greenhouse gas emissions. Business investment runs over large number of years, this adds uncertainity to their plans. As many big players such as US and China who are responsible for large proportions of emissions, have avoided mandatory caps, this also means that businesses in capped countries may see themselves to be working at a competitive.
A key concept behind the cap and trade system is that national quotas should be chosen to represent fairly correct, genuine and meaningful reductions in national output of emissions. This would ensure reduction in overall emissions along with the facts that costs of trading is carries across to all the trading parties. However, governments of capped countries may seek to unilaterally weaken their commitments, as evidenced by the 2006 and 2007 National Allocation Plans for several countries in the EU ETS.
A question has been raised over deviating from the rules of allowances. Countries within the European Union have granted their incumbent businesses most or all of their allowances for free. This can sometimes be perceived as a protectionist obstacle to new entrants into their markets. There have also been accusations of power generators getting a heavy profit by passing on these emissions 'charges' to their customers. As the EU ETS moves into its second phase and joins up with Kyoto, it seems likely that these problems will be reduced as more allowances will be auctioned.

Establishing a meaningful offset project is complex: voluntary offsetting activities outside the CDM mechanism are unregulated and there have been criticisms of offsetting in these unregulated activities. This particularly applies to some voluntary corporate schemes in uncapped countries and for some personal carbon offsetting schemes.
Concerns have also been raised over the validation of CDM credits. One is to the accurate assessment of additionality. Others relate to the complexities involved to get a project approved. Questions may also be raised about the validation of the effectiveness of some projects; it appears that many projects do not achieve the expected benefit after they have been audited, and the CDM board can only approve a lower amount of CER credits. For example, it may take longer to roll out a project than originally planned, or an afforestation project may be reduced by disease or fire. For these reasons some countries place additional restrictions on their local implementations and will not allow credits for some types of carbon sink activity, such as forestry or land use projects.

Carbon Tax

Carbon tax is a form of pollution tax. The fee is determined by assessment of the amount of carbon released into the atmosphere on combustion . The government sets a price per ton on carbon.
Carbon tax is based on the economic principle of negative externalities. Externalities are costs or benefits generated by the production of goods and services. Negative externalities are costs that are not paid for. When utilities, businesses or homeowners consume fossil fuels, they create pollution that has a societal cost; everyone suffers from the effects of pollution. Proponents of a carbon tax believe that the price of fossil fuels should account for these societal costs.


The primary purpose of carbon tax is to lower greenhouse-gas emissions. The tax is based on the carbon content of the fuel that was involved in combustion. This would encourage businesses and individuals to reduce the consumption of Carbon rich substances. As the tax get imposed, a number of steps that can be taken to reduce costs can be envisaged. For Example: People may switch to fluorescent lamps from incandescent bulbs, a business may try to install newer appliances which are cleaner and efficient. And since carbon tax sets a definite price on carbon, there is a guaranteed return on expensive efficiency investments.

Carbon tax also encourages alternative energy by making it cost-competitive with cheaper fuels. A tax on a carbon rich and inexpensive fuel such as coal raises its per British Thermal Unit (Btu) price to one comparable with cleaner forms of power The money that is raised by taxes can be used to subsidize environment friendly projects or can be used to rebate taxes. Many fans of carbon tax believe in progressive tax-shifting. This would mean that some of the tax burden would be takes off from federal taxes and sales taxes.

Predictability is what makes Carbon taxes likeable among economists. The prices of carbon under Cap and Trade policy may vary due to weather and economic conditions. This is because cap-and-trade schemes set a definite limit on emissions, not a definite price on carbon. Carbon tax is stable. Businesses and utilities would know the price of carbon and where it was headed. They could then invest in alternative energy and increased energy efficiency based on that knowledge. Since Carbon tax is simple, it is easily comprehendible.

Price Determination

The carbon content of oil, coal and gas varies. Proponents of a carbon tax want to encourage the use of efficient fuels. Tax based on the carbon content would fairly reflect the prices and hence carbon content has to be the basis for price determination instead of weights and volumes.

Each fuel variety also has its own carbon content. Bituminous coal, for instance, contains considerably more carbon than lignite coal. Residual fuel oil contains more carbon than gasoline. Every fuel variety needs to have its own rate based on its Btu heat content.

Carbon tax can be applied at different points of production and consumption. Some taxes target the top end of the supply chain -- the transaction between producers like coal mines and oil wellheads and suppliers like coal shippers and oil refiners whereas some taxes charge distributors -- the oil companies and utilities. And other taxes charge consumers directly through electric bills. Different carbon taxes, both real and theoretical, support varying points of implementation.
People in a city called Boulder in the US are charged Carbon tax as a municipal tax in their Electricity bill based on the number of kilowatt hours of electricity they use.
Similarly Sweden also taxes the consumption end. The national carbon tax charges householders a full rate and halves it for industry. Utilities are not charged at all. Majority of Swedish power consumption goes to heat and with renewable sources of energy are exempted from taxes, the biofuel industry has blossomed since 1991. This goes on to show that Carbon tax encourage people and industry to use cleaner forms of energy

Even if the tax is charged for the companies, they will pass on some of the cost to consumers by increasing the cost of energy.
Consumption can be charged easily than production without majorly affecting the economy of a country. Consumers are willing to pay extra charge annually whereas producers usually are not. Taxation on production may also result in higher domestic energy prices which would encourage foreign imports. Hence it is consumers who are targeted for Carbon taxes.

Carbon tax is not a widely accepted mechanism around the world. Wide acceptance is only in the Northern European countries such as Demark, Finland, the Netherlands, Sweden, Norway and Poland.

Carbon Tax Vs Carbon Credit

Carbon Tax is better alternative than Carbon Credit mainly because of the following six reasons

1. Energy Prices are easily predictable by the mechanism of tax than by the mechanism of Cap and Trade. The high volatility of the carbon credits that are generated by the mechanism of Cap and Trade has consistently discouraged energy efficient schemes.
2. Tax system can be quickly implemented than Cap and Trade. Since the environment is getting polluted at a faster rate, it is high time that necessary actions are taken quickly and efficiently. Tax system
3. Carbon taxes are transparent and easily understandable, making them more likely to garner public support than complex Cap and Trade.
4. Carbon taxes cannot be easily manipulated and hence cannot be easily exploited whereas the complexity of Cap and Trade always provides room for exploitation for special interests
5. Carbon taxes address emissions of carbon from every sector, whereas some cap-and-trade systems discussed to date have only targeted the electricity industry.
6. Carbon tax revenues would most likely be returned to the public through dividends or progressive tax-shifting, while the costs of cap-and-trade systems are likely to become a hidden tax as dollars flow to market participants, lawyers and consultants.

Carbon Taxes Will Lend Predictability to Energy Prices.

Carbon taxes being ramped up through a multi-year phase-in it makes the prediction of future energy and power prices easy. Once the prediction of prices become easy, it will give rise to millions of energy decisions that could have a major impact on how we use energy and design systems that use energy — from the design of new electricity generating plants to the purchase of the family car to the materials used in commercial airframes — to be made with full consideration given to the price of Carbon.

Cap and trade on the other hand will worsen the volatility of the prices as the price of carbon allowances varies with the fluctuations in weather and economic factors. These factors affect the demand for energy. Energy emission in the future cannot be predicted with fair certainty as there is no agreed-upon path of emissions for achieving climate stability.

Carbon Taxes Will Provide Quicker Results.

Taxes are simple and are designed to be simple and to be easily adopted. On the other hand, Cap-and-trade systems are highly complex and will take years to develop and implement. Disruptive issues must be addressed intellectually and resolved politically; the appropriate level of the cap, timing, allowance allocations, certification procedures, regional conflicts, penalties, standards for use of offsets, the inevitable requests for exceptions by affected parties and a several other complex issues must all be thought and resolved before cap-and-trade systems can be implemented successfully. Meanwhile polluters are not charged for the pollution that they create.

Carbon Taxes Are Transparent and Are Easier to Understand than Cap-and-Trade.

A carbon tax is simple, transparent and easy to comprehend. The government simply imposes a tax on a ton of carbon emitted, which is easily translated into a tax per kWh of electricity, gallon of gasoline or therm of natural gas.
By contrast, the prices which are set for carbon credits under cap and trade systems with high market fluctuations and hence difficult to predict. Cap and trade requires understanding and resolution of complex issues in order to achieve minimization in distortions and significant reduction in carbon emissions.

A Carbon Tax's Simplicity prevents it Against Incentives and Potential for vested interests that Will Accompany Cap-and-Trade.

Carbon Tax is simple and hence not many negotiations are required for the implementation of carbon tax. Carbon tax is simple and straightforward.
By Contrast the lengthy negotiations required for the implementation of Cap and trade system will always provide opportunities for the industry and invested parties to shape a system that maximizes their financial position without them giving much back to the societal and environmental well-being.

Carbon Taxes Encompasses All Sectors and Activities Producing Carbon Emissions.

Carbon taxes are applicable to all the sectors – energy, industry, transportation whereas most of the cap and trade is applicable to the electric industry. Industries apart from power sector contribute more than 50% of the emissions and hence it is necessary that these sectors are targeted for the significant reduction in Carbon emissions.

Carbon Taxes Can Result in a Far More Equitable Result than Cap-and-Trade.

Revenues generated from Carbon tax can be returned back to the public through dividends or it can be used to offset some of the other taxes such as sales tax or federal tax (Progressive tax shifting) . The costs that would be incurred by Cap and trade mechanism to use newer technologies to replace older ones, are far more likely to be imposed on the consumers with less possibility of rebating or tax shifting. The problem gets even more compounded when a fair price of Carbon is dependent on market participants.