Recent events suggest that it may only be a matter of time before the federal government enacts a nationwide program to reduce emissions of carbon dioxide (C[O.sub.2]) and other greenhouse gases. First, several bills to control emissions have recently been introduced in Congress. Second, state action on a variety of fronts is threatening a patchwork approach to greenhouse emissions regulation that would be cumbersome for business. Third, a recent Supreme Court case has indicated that the Environmental Protection Agency already has the authority to regulate greenhouse gas emissions meaning that if Congress does not act, the president can. Meanwhile, recent polls show a new and rising concern among ordinary Americans about climate change, as more C[O.sub.2] accumulates in the atmosphere and the earth continues to warm (see Figure 1).
The favored federal policy to address climate change is a domestic cap-and-trade system that, in time, would naturally link to the emissions trading system recently established in Europe. However, just as the momentum for emissions trading seemed unstoppable, a vocal minority, including Sen. Chris Dodd (D-Conn.) and former vice president Al Gore, as well as Congressmen John Larsen (D-Conn.) and Pete Stark (D-Calif.), have begun arguing in favor of a C[O.sub.2] tax. And on close inspection, C[O.sub.2] taxes seem particularly attractive both for fiscal reasons and because they provide certainty over the price of emissions. So does this mean that policymakers should give up on emissions trading, or are there ways permit systems might be designed to capture the potential advantages of C[O.sub.2] taxes?
To maximize opportunities for cheap emissions reductions, a C[O.sub.2] tax would be imposed upstream in the fossil fuel supply chain, as this encompasses all possible sources of emissions when fuels are later combusted. Limiting the tax to a relatively small number of fossil fuel producers eases administrative burdens on the government. The tax, which would be levied in proportion to a fuel's carbon content, would be passed forward into the price of coal, natural gas, and petroleum products, and therefore ultimately into the price of electricity and other energy-intensive products. Higher energy prices would encourage the adoption of fuel- and energy-saving technologies across the economy and promote switching from carbon-intensive fuels like coal to less carbon-intensive natural gas and to carbon-free fuels such as nuclear and renewables.
In these regards, a C[O.sub.2] tax closely resembles an upstream emissions-trading system where firms require permits to cover the carbon content of fuels they mine or process and the market price of permits is passed forward into fuel prices. Moreover, through tax credits or emissions offset provisions, both approaches can incorporate incentives for downstream activities that partly offset emissions releases, such as carbon capture and storage at power plants and industrial facilities, forestry expansion on farmland, and other fugitive emissions reductions. And from a standpoint of reducing emissions at the lowest possible cost, market-based instruments like C[O.sub.2] taxes and emissions permit systems are typically superior to "command and control" approaches (e.g., vehicle fuel economy requirements, emissions standards for electricity generation, energy efficiency requirements for household appliances). By raising fossil fuel prices, market-based instruments encourage all options for low-cost emissions reductions across the economy; in contrast, command-and-control approaches tend to overly burden specific sectors, firms, or abatement activities, while failing to take advantage of abatement opportunities elsewhere in the economy.
PRICE According to standard economic theory, the appropriate C[O.sub.2] tax, or permit price under emissions trading, should reflect the …