Balancing Cost and Emissions Certainty: An Allowance Reserve for Cap-and-Trade

Author(s): Brian C. Murray, Richard G. Newell, and William A. Pizer

Published: January 2009

The economic debate over using taxes versus cap-and-trade to control pollution emissions revolves around the relative merits of using prices versus quantities as the policy instrument. A cap-and-trade system fixes the quantity of emissions allowed but leaves the market price of emissions rights uncertain. In contrast, a tax fixes the price of emissions at the tax rate but leaves the quantity of emissions uncertain. This trade-off raises essential questions for policy design: which form of uncertainty is a greater burden to society?What can be done to minimize that burden or maximize net benefits? A sizable economics literature has addressed these questions, dating back to Weitzman (1974) and others.

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