HKS Authors

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Teresa and John Heinz Professor of the Practice of Environmental Policy


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.


Aldy, Joseph, and Sarah Armitage. "The Cost-Effectiveness Implications of Carbon Price Certainty." American Economic Association Papers and Proceedings 110 (May 2020): 113-118.