In general, there are two market-based approaches for adding a price on emissions. Policy makers can set a limit on the amount of emissions (a cap or limit on the quantity of emissions) and allow emitters to buy and sell permits to emit. This approach (often called cap and trade) leaves it to the market to determine the price of emitting. Alternatively, policy makers can determine the price that emitters must pay when they emit (a fee or a corrective tax). This approach leaves it to the market to determine the quantity of emissions. Notably, these two approaches have much in common because emission prices and quantities are linked and both are market mechanisms for addressing climate change.
Hybrid approaches that combine elements of both approaches are also possible. For example, cap and trade can include a price ceiling (an upper limit on prices at which additional permits are always sold) or a price floor (a minimum price on emissions at which permits are always purchased). Similarly, a fee-based hybrid might include automatic increases in the price if emissions quantities exceed an upper limit (Higgins 2013).
These policy approaches must determine the initial price (or quantity) of a pricing mechanism and the rate that it changes over time (Higgins 2010, from which the remainder of this section is adapted). Higher prices (or lower quantities) translate into larger, faster emission reductions but may trigger larger price increases for energy and transportation.
Emission fees or permits can be collected at the oil well, coal mine, or point of entry for imports (upstream), closer to where the actual emissions occur (i.e., the individual vehicle or power plant—downstream), or in between (e.g., petroleum refineries). Upstream implementation helps ensure comprehensive coverage of emissions, generally reduces the administrative burden placed on regulators and emitters, and minimizes transaction costs. Notably, the point where a fee or permit is collected determines only the entity that is responsible for compliance. It does not determine who ultimately must pay the cost associated with emissions because market forces generally determine how that cost is shared between producers and consumers.
Revenues generated from adding a price on emissions could be used in a wide range of ways. For example, revenues could be used to lower existing taxes, to invest in research and development of low-emission technologies, to assist those most heavily hit by the fee, or be returned in a lump-sum payments to people, amongst other options.
How these revenues are used can reduce or exacerbate distributional consequences. For example, a tax shift—one that applies the revenue generated from a fee to lowering existing taxes—or the lump-sum return of revenues to people on an equal per capita basis would increase the progressivity of the approach. Similarly, the disproportionate impact on heavy emitters can be softened by providing a small number of permits freely (cap and trade) or by directing some of the revenue generated by a fee to hard-hit sectors.
Emission pricing can include offsets or credits for emissions reductions that occur elsewhere (e.g., carbon capture and sequestration, forestry projects, and international mitigation efforts) and the banking or borrowing of permits. Offsets can encourage emission reductions, and reduce the costs of achieving a given level of climate protection. However, offsets also pose challenges because seemingly legitimate reductions may not last over time. Borrowing and banking help even out potential price fluctuations in a cap- and-trade system.