Carbon taxes and cap-and-trade polices are usually discussed in terms of their differences, but many of the same design questions need to be resolved for each. Some of the key questions are discussed below.
Cap-and-trade policies that cover only CO2 may be administratively convenient, but they do not represent the best long-term solution. The Kyoto Protocol, for example, identifies six GHGs, which can be included in a single pricing system by translating them into CO2 equivalents. In practice, this is accomplished using global warming potentials (GWPs), defined as the cumulative radiative forcing effects of a unit mass of gas relative to CO2 over a specified time horizon (commonly 100 years). Including multiple gases under a single cap has the advantage of significantly reducing the cost of reaching a specific concentration target (Reilly et al., 1999; Weyant et al., 2006). Disadvantages include controversies over whether GWPs are an appropriate metric to account for the differing impacts among GHGs, and the fact that some types of GHG emissions (e.g., those stemming from land-use and agricultural practices) are quite difficult to monitor.
For maximizing GHG emissions reductions at minimum cost, more universal coverage is better. Yet no existing program involves universal coverage of GHG sources. As two key examples, the Regional Greenhouse Gas Initiative (RGGI) in the Northeast covers only large power generators, and the European Union Emissions Trading Scheme (EU ETS) covers only power generators and combustion installations, production and processing of ferrous metals, pulp, and paper, and some mineral industries such as cement (and for each sector, only facilities over a specified size are typically covered); in addition, aviation will be covered starting in 2012.
Extending coverage beyond these typical sectors does present challenges. Omitting non-CO2 GHGs and emissions and sequestration in the agricultural and forestry sectors is generally motivated by concerns about political feasibility, impressions that sequestration is a means of avoiding needed emissions cuts, and uncertainties in the magnitudes of potential reductions from particular sectors. In addition, smaller sources may face unreasonably high transaction costs in complying with a one-size-fits-all program. Below we discuss how these challenges can be addressed through the proper design of pricing mechanisms and how offsets can be used to address some sources not directly covered in a cap-and-trade policy.