The Cost-Effectiveness Implications of Carbon Price Certainty

While a firm knows the carbon price with certainty under a tax, it must form an expectation about future allowance prices to identify its cost-effective abatement investment under a cap-and-trade program. We illustrate graphically how errors in forming this expectation increase the costs of irreversible pollution abatement investment under cap-and-trade relative to a tax. We describe empirical "cost-effectiveness anomalies" in allowance markets that may be attributed to cap-and-trade's inherent uncertainty. We model investment under simulated US carbon tax and cap-and-trade policies and find that allowance price uncertainty can increase resource costs 20 percent for a given quantity of emission abatement.