Carbon Tax vs Carbon Credits

A beginners guide

Image Credit: Gerd Altmann from Pixabay [1]

If you’ve read about carbon taxes and carbon credits and wondered “what’s the difference?” then this is the article for you. The examples are simplified to illustrate the concepts. Don’t get hung up on the numbers, the scale of the emissions, or the costs.

Let’s pretend there are two companies: Company A and Company B.

Both companies emit 100 units of greenhouse gases each year as a side effect of doing business. These units are measured in ‘tonnes of CO2 equivalent’. The units represent the amount of carbon dioxide gas needed to create the same amount of warming as the greenhouse gas emitted. Comparing other greenhouse gases to carbon dioxide makes it easier to measure emissions.

For example, methane is a more powerful greenhouse gas than carbon dioxide; it is about 25 times stronger [2]. So if a company emits 1 tonne of methane it counts as 25 units or 25 tonnes (t) of CO2 equivalent. This means that Company A could emit 100t of CO2 and Company B could emit 1t of methane and 75t of CO2 but both would be emitting 100 units each.

Options to Reduce Emissions

So what would it take for each company to reduce their emissions? Companies have a range of options: some are cheap and others are expensive.

The options available will depend on the type of business. For example, let’s say Company A is a wholesale warehouse company that only operates during the day. Company A’s emissions come from:

• diesel to run the forklift, and
• electricity for the warehouse lights, air conditioning, security cameras, and computers.

Options for Company A to reduce emissions may include:

• turning off the lights, air conditioning, computers, etc. when not in use,
• switching to energy-efficient LED lights,
• installing insulation,
• upgrading to more energy-efficient equipment,
• upgrading to an electrified forklift and installing solar panels, or
• purchasing green power off a local energy retailer.

The point is, the cost of eliminating the first unit of emissions is low, but it becomes more expensive. For the sake of this example, let’s say that it takes Company A:

• $1 to eliminate the 1st unit of emissions,
• $2 to eliminate the 2nd unit of emissions,
• and so on, etc. and
• $100 to eliminate the 100th unit of emissions.

So added all up it would cost Company A $5,050 to eliminate all 100 units of emissions [3].

To continue the example, let’s say that Company B is a wastewater treatment company that runs 24 hrs a day. Bacteria break down organic material in the wastewater and this produces methane. Company B’s emissions come from:

• the decay of organic material in the wastewater, and
• the electricity to run the lights and treatment plant equipment.

Options for Company B to reduce emissions may include:

• switching to LED lights,
• upgrading to more energy-efficient equipment,
• installing solar panels,
• purchasing green power, or
• changing the plant to a treatment process that doesn’t emit methane.

It is more difficult for Company B to eliminate emissions because they have fewer low-cost options and more expensive high-cost options.

For the sake of this example, let’s say that it takes Company B:

• $2 to eliminate the 1st unit of emissions,
• $4 to eliminate the 2nd unit of emissions,
• and so on, etc. and
• $200 to eliminate the 100th unit of emissions.

So added all up it would cost Company B $10,100 to eliminate all 100 units of emissions.

Figure 1 compares Company A and Company B’s cost of eliminating emissions. The horizontal axis shows the unit emitted, from the 0th unit to the 100th unit. The vertical axis shows the cost of eliminating each unit in dollars. Company A is shown in blue and Company B is shown in orange.

So if you were a government, what could you do to encourage these companies to reduce their emissions? One option is to provide a financial incentive via a carbon tax or a carbon credits scheme.

Figure 1 credit to easycarbonsolutions.com

Carbon Tax

First, let’s consider a carbon tax where the companies pay a tax for every unit that they emit. In this example, the carbon tax is going to be set at $50/unit emitted which is shown in grey in Figure 2. The Companies now have a choice:

• they can either spend money to reduce their emissions, e.g., changing lights to LEDs, etc. or,
• they can pay the $50/unit tax.

For Company A, it only takes $1 to eliminate the first unit of emissions, so it makes sense to do that instead of paying the tax. In fact, it is cheaper to make changes right up to paying $50 to eliminate the 50th unit of emissions. For the 51st unit, it would cost Company A $51 to make changes but only $50 to pay the tax, so it emits the gas and pays the tax. Company A does this for units 51 to 100. Overall, Company A now pays $1,275 to make changes that eliminate units 1 to 50 and $2,500 in tax to emit units 51 to 100. Company A spends a total of $3,775.

For Company B, it only takes $2 to eliminate the first unit of emissions, so it makes sense to do that instead of paying the tax. It is cheaper to make changes up to paying $50 to eliminate the 25th unit of emissions. For the 26th unit, it would cost Company B $52 to make changes but only $50 to pay the tax, so it emits the gas and pays the tax. Company B does this for units 26 to 100. Overall, Company B now pays $650 to make changes that eliminate units 1 to 25 and $3,750 in tax to emit units 26 to 100. Company B spends a total of $4,400.

In short, it makes sense to make changes that eliminate emissions prior to intersecting the grey line on the graph in Figure 2, after that it is cheaper the pay the tax.

The tax encouraged the companies to eliminate 75 units and collected $6,250 in tax on the 125 units emitted. The total cost of the tax is $8,175 based on the tax paid and the companies’ costs of making changes. The question is: how high does the tax need to be to get the emissions reduction the government is after? There is no way of knowing this in advance but economic models can be built to estimate the right level. After that, the tax would need to be adjusted up or down.

Figure 2 credit to easycarbonsolutions.com

Carbon Credits

Now let’s consider a scenario with carbon credits, also known as emissions trading or ‘cap and trade’. Together, Company A and B emitted 200 units last year and the government wants to halve this number. The government decides to issue 100 emissions permits or ‘carbon credits’. These permits give the holder the right to emit 1 unit of emissions. The government gives 50 permits to Company A and 50 permits to Company B since they had equal emissions.

For Company A, it could make changes right up to paying $50 to eliminate the 50th unit of emissions. After that, it could use the carbon credits as permits to emit units 51 to 100. If it did this, Company A would pay $1,275 to eliminate units 1 to 50 and use permits to emit units 51 to 100.

For Company B, it could make changes right up to paying $100 to eliminate the 50th unit of emissions. After that, it could use the carbon credits as permits to emit units 51 to 100. If it did this, Company B would pay $2,550 to eliminate units 1 to 50 and use permits to emit units 51 to 100.

But here’s the catch: Company B is paying $100 to eliminate their 50th unit, but it only cost Company A $51 to eliminate their 51st unit. This opens up the possibility of trade. Company A may be willing to sell their emission permit to Company B for $51. This price covers Company A’s cost of making changes that eliminate their emissions. In reality, Company A may demand a higher price, but to simplify, assume they will accept a price that covers their costs. For each unit that Company A can eliminate more cheaply than Company B, they will trade permits. This means they will trade 17 permits and the last permit will be sold at a price of $67.

You can work this out by flipping the horizontal axis for Company B and plotting it on the graph, as shown in Figure 3. The point where the lines for A and B intersect will be the price of the final permit (shown in grey). This is the ‘carbon price’ in the market.

Figure 3 credit to easycarbonsolutions.com

The table in Figure 4 shows:

• the units that Company A eliminates in blue,
• the units that Company B eliminates in orange,
• the carbon credits/permits transferred from A to B in yellow, and
• the carbon credits/permits allocated to each company (that they used themselves) in grey.

Figure 4 credit to easycarbonsolutions.com

Under the carbon credits scheme:

• Company A will pay $1,275 to eliminate 50 units for itself,
• Company B will pay $1,122 to eliminate 33 units for itself, and
• Company B will pay Company A $1,003 to eliminate 17 units in exchange for the carbon credits / emission permits.

Overall, the carbon credits scheme eliminates 100 units of emissions for $3,400.

Pros and Cons

So why would you choose a carbon tax or a carbon credits scheme? A carbon tax is a simpler, blunter tool which is easier to administer and regulate. The downside is that you need to guess how high to set the tax to get the emission reductions you want. It also costs more to get the same level of reductions so prices may rise more.

A carbon credits scheme is more complex to put in place and regulate. Allocating carbon credits is tricky and open to accusations of being unfair. Allocations based on previous emissions give established companies an advantage over newer start-ups. It also disadvantages proactive companies that have already used their lowest-cost options. Instead, the government could auction permits. But this method also has problems. An auction gives companies with large margins an advantage over smaller companies.

But once the carbon credit scheme is set up, it is more flexible. Companies that offset carbon (e.g., tree planting) could create new carbon credits. These companies could sell these new permits to emitters. As companies create more permits, the government can issue less each year. If offset companies create enough permits to cover all units of emissions then there are net-zero emissions.

References:

1. CO2 Image by Gerd Altmann from Pixabay https://pixabay.com/photos/co2-carbon-dioxide-carbon-oxygen-3139225/

2. Greenhouse Gas Protocol, 2019, “Global Warming Potential Values” https://www.ghgprotocol.org/sites/default/files/ghgp/Global-Warming-Potential-Values%20%28Feb%2016%202016%29_1.pdf
Using the IPCC 100-year time horizon global warming potential (GWP) of Methane relative to CO2 from the Fourth Assessment Report (AR4) — value of 25. The 2019 update uses a value of 28.

3. Calculated using 1 + 2 + 3 + … + N = N*(N+1)/2 as per proof:
https://www.teachoo.com/2275/591/Prove-1---2---3-...---n--n%28n-1%29-2---Mathematical-Induction/category/Theory/