ABSTRACT
Climate change is a market externality. Market actors emit GHGs leading to costs in terms of climate change damages that are not borne by the emitters themselves but by others. This results in an overproduction of GHG emissions as compared to the socially efficient choice of an emissions’ level that fully accounts for the external costs. Market inefficiencies due to pollution externalities are well characterized in environmental economics, and various instruments to remove such externalities have been proposed. In theory, market instruments internalizing the costs of pollution are suited best to re-establish the socially efficient level of pollution. Two major types of market instruments have been proposed: Pigovian pollution taxes (a price signal) and tradable pollution permits (a quantity signal). The idea of Pigovian taxes is to make the polluter pay the external costs of pollution, thus bringing together the social and private rate of return on the polluting activity and inducing an adjustment of pollution to the socially efficient level. The key difficulty of Pigovian taxes is calculating what level of tax will counterbalance the pollution externality. In contrast, tradable pollution permits will give rise to a price on pollution that reflects the relative scarcity of pollution allowances. The key difficulty here is to set the overall pollution quantity to a socially efficient level. It has been shown that implementing a Pigovian tax or a tradable pollution permit system
(cap-and-trade) are equivalent under perfect market conditions and perfect foresight. In practice, however, such conditions are never met. There is therefore a long-standing debate in environmental economics over which of the two instruments is superior in which circumstances. The answer will ultimately depend on the nature of the pollution problem and the specific design of the tax or permit system and the assumptions about the game theoretic information structure that changes the strategic behaviour of agents. Although the focus of this chapter is on tax designs for reducing GHG emissions and limiting climate change, we take up this debate wherever it is appropriate. We show that the debate yields important insights into questions of design for both taxes and quantities.
