The differences between cap and trade and carbon taxes can be difficult to understand. Both greenhouse gas reduction systems have similarities, which can add difficulties distinguishing between the two. However, there are key differences that set the two systems apart.
In the way of similarities, both systems aim to correct a market failure. The market failure is that GHG emitters are not responsible to quantify and pay for damages imposed on society. Another similarity is that both place a price on carbon, which is meant to correct the market failure. Another similarity is that both system taken advantage of market efficiencies by using market forces to obtain GHG reduction instead of government regulation.
Another similarity is that both can generate revenue. Taxes are designed to create revenue; however revenue growth under cap and trade is less clear. Revenue can be achieved with cap and trade through direct rebate to consumers, using part of the revenue to ease into a low carbon economy, and more.
Focus on a limited number of sources to maximize cost efficiency and GHG reduction is another similarity. Also, both require provisions to decrease negative effects on states, companies, and workers such as special tax provisions or allowance values. Avoiding GHG requirements on feedstock production is an example. Finally, both systems require diligent monitoring and analysis to ensure efficient operation.
Despite the similarities, key differences exist. Cap and trade provides certainty reaching GHG reduction goals by setting a carbon cap and issuing finite amounts of permits. However, the costs of reaching goals are determined by market forces. A carbon tax does the opposite. A tax system provides certainty on cost of compliance while market forces determine resulting GHG reductions.
Flexibility for firms is another difference. Cap and trade systems involve trading, banking, and extended compliance periods which allow compliance planning to span over many years. A carbon tax system provides less flexibility, requiring sources to make reduction decisions yearly.
The way each system responds to economic shifts is another difference. In cap and trade systems, market forces determine cost. Therefore, prices would increase during economic booms and decrease during economic downturns (self-adjusting). Carbon taxes are not self adjusting. Rates would stay the same in booms or recessions unless the government intervenes.
Another difference worth mentioning is that cap and trade is more prevalent across the world. Not only are these systems more prevalent than taxation, they have been generally more successful. Thus, one may theorize that implementation of a cap and trade system in the US would provide a foundation for establishing a global price on carbon. However, advocating for multilateral GHG agreements is another discussion altogether.
For more information on this subject see the PEW reports related to the issue.