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

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.