Question

Compare and contrast: 1) carbon credit system 2) Pigou carbon taxes. Identify the strengths and weaknesses

Answer 1

A carbon credit is a permit that allows the company that holds it to emit a certain amount of carbon dioxide or other greenhouse gases. One credit permits the emission of a mass equal to one ton of carbon dioxide.The carbon credit is one half of a so-called "cap-and-trade" program. Companies that pollute are awarded credits that allow them to continue to pollute up to a certain limit. That limit is reduced periodically. Meanwhile, the company may sell any unneeded credits to another company that needs them.Private companies are thus doubly incentivized to reduce greenhouse emissions. First, they will be fined if they exceed the cap. Second, they can make money by saving and reselling some of their emissions allowances.The ultimate goal of carbon credits is to reduce the emission of greenhouse gases into the atmosphere.Companies or nations are allotted a certain number of credits and may trade them to help balance total worldwide emissions. "Since carbon dioxide is the principal greenhouse gas," the United Nations notes, "people speak simply of trading in carbon."The intention is to reduce the number of credits over time, thus incentivizing companies to find innovative ways to reduce greenhouse gas emissions.

A Pigovian (Pigouvian) tax is a tax assessed against private individuals or businesses for engaging in activities that create adverse side effects for society. Adverse side effects are those costs that are not included as a part of the product's market price. These include environmental pollution, strains on public healthcare from the sale of tobacco products, and any other side effects that have an external, negative impact. Pigovian taxes were named after English economist, Arthur Pigou, a significant contributor to early externality theory.e Pigovian tax is meant to discourage activities that impose a cost of production onto third parties and society as a whole. According to Pigou, negative externalities prevent a market economy from reaching equilibrium when producers do not take on all costs of production. This adverse effect might be corrected, he suggested, by levying taxes equal to the externalized costs. Ideally, the tax would be equivalent to the external damage caused by the producer and thereby reduce the external costs going forward.Negative externalities are not necessarily “bad.” Instead, a negative externality occurs whenever an economic entity does not fully internalize the costs of their activity. In these situations, society, including the environment, bears most of the costs of economic activity.

The Economist has long advocated a carbon tax as the best way to deal with climate change. Carbon taxes are a subspecies of Pigovian tax; taxes that are designed primarily to change behaviour rather than to raise revenue. The idea is to try to manipulate the price of a good or a service in order to capture all the negative externalities it imposes. Pollution is the standard example: neither the owner of a factory nor the buyer of its goods, for example, care very much that the local river is being filled with nasty chemicals as a byproduct of the factory's work. Those who live by the river do care, but, not being party to the transaction, there isn't much they can do about it. The uncompensated costs imposed on locals by the factory-owner's activities represent a market failure. In theory the government would step in and impose a tax on the factory owner designed to compensate the locals for the damage caused by his actions (in the jargon, the government would make sure the private cost of producing the goods was equal to the social cost). The idea was to rebalance the tax system away from taxing "goods" such as income and entrepeneurship, and on to taxing "bads" like pollution, not simply add a new tax on top of the already-existing ones. But although a carbon tax designed to get the country out of its fiscal hole would violate the rule that revenue-raising should not be the main point of the policy, the results of our modeling seem to suggest that it would, nevertheless, be worth a try.