Carbon pricing is one of the most effective climate policies, but whether it succeeds depends on design. Both carbon taxes and cap-and-trade systems can reduce emissions cost-effectively, but the Social Cost of Carbon (SCC) must guide their levels, and strong policy design must ensure predictability, broad coverage, fair use of revenues, and safeguards against leakage (Brookings, 2019).
Carbon pricing matters because climate change is caused by a market failure: the true costs of greenhouse gas emissions are not reflected in the prices of fossil fuels. Pollution causes damages, from rising sea levels to health impacts to lost agricultural output, but emitters don’t pay for them. By putting a price on each ton of CO₂, governments make polluters internalize these costs. This changes incentives across the economy, encouraging cleaner energy, efficiency, and innovation, while leaving it to firms and households to decide how best to respond. Without a price signal, emissions remain artificially cheap, and society pays the hidden bill (RFF, 2021; MIT, 2022).
A carbon tax is the simplest way to correct this. It sets a fixed price per ton of emissions, which gives businesses certainty about their costs and makes long-term planning easier. Firms can weigh the tax against the cost of reducing emissions and invest accordingly (C2ES, 2022). Governments can gradually raise the tax to match updated estimates of the SCC, ensuring the price keeps pace with the true damage caused by emissions. The main advantage of a tax is predictability: companies know the cost of carbon in advance, which makes investment decisions clearer. Its limitation is that while it guarantees a price, it does not guarantee a specific level of emissions reductions.
A cap-and-trade system takes the opposite approach. Instead of setting the price, it sets the total amount of emissions allowed and issues permits equal to that cap. Companies must hold enough permits to cover their emissions, and they can buy or sell them on the market. This guarantees that emissions fall to the targeted level. The price is determined by supply and demand for permits, which means costs can fluctuate. To prevent excessive volatility, well-designed systems include stabilizing features such as banking and borrowing of permits or minimum and maximum price thresholds. The strength of cap-and-trade is environmental certainty , it guarantees reductions, but it can be less predictable for businesses if prices swing widely without safeguards.
The Social Cost of Carbon links both systems. The SCC is an estimate, in dollars, of the economic damage caused by emitting one additional ton of CO₂. It serves as a benchmark for setting carbon prices (Stanford News, 2021). For a tax, policymakers can aim to set the rate equal to the SCC and adjust it as new data improves the estimate. For cap-and-trade, the SCC can guide the use of price floors or help judge whether permit prices reflect the true cost of emissions. Without anchoring to the SCC, either system risks pricing carbon too low and failing to account for the real damages emissions create.
The lesson from experience is that the choice between a tax and a cap matters less than how the system is designed. Economists point to several best practices. First, coverage must be broad. The most effective systems price carbon “upstream,” at the point fossil fuels enter the economy, so the majority of emissions are covered. Second, prices must rise predictably. A tax can increase according to a schedule, while cap-and-trade can use a price collar to prevent crashes or spikes. Third, revenues must be recycled transparently. This means using the money raised in ways that strengthen fairness and efficiency: returning it to households as dividends to offset higher energy costs, reducing other taxes like income or payroll taxes, or investing in clean infrastructure and technology. Without this, carbon pricing can be politically unstable; with it, it can build durable support. Fourth, leakage must be prevented. If industries simply move production to countries without carbon pricing, global emissions don’t fall. Border carbon adjustments, tariffs or credits that level the playing field, are one solution. Finally, pricing should be paired with complementary policies. Research and development support, clean energy standards, and infrastructure investment address gaps where markets alone may under-invest (Brookings, 2019).
The debate is not carbon tax versus cap-and-trade. Both can succeed if designed well. The strongest systems are anchored to the SCC, cover emissions broadly, raise prices predictably, recycle revenues fairly, prevent leakage, and are reinforced with complementary measures. Done this way, carbon pricing is not just an economic concept but one of the most practical and powerful tools for cutting emissions and addressing climate change.
Citations
- Brookings Institution. Pricing Carbon: A Carbon Tax or Cap-And-Trade? Brookings, 23 Sept. 2019, https://www.brookings.edu/articles/pricing-carbon-a-carbon-tax-or-cap-and-trade/.
- Center for Climate and Energy Solutions (C2ES). Carbon Tax Basics. C2ES, 2022, https://www.c2es.org/content/carbon-tax-basics/.
- Resources for the Future (RFF). Carbon Pricing 101. RFF, 2021, https://www.rff.org/publications/explainers/carbon-pricing-101/.
- Stanford University News. “Professors Explain the Social Cost of Carbon.” Stanford News, 7 June 2021, https://news.stanford.edu/stories/2021/06/professors-explain-social-cost-carbon.
- MIT Climate Portal. Carbon Pricing. Massachusetts Institute of Technology, 2022, https://climate.mit.edu/explainers/carbon-pricing.