07/12/2011 05:46 pm ET Updated Sep 10, 2011

Cap-And-Trade vs. Carbon Tax: New Study Suggests Free System Prevails

This story comes to us courtesy of California Watch.

By Susanne Rust

As governments try to figure out the best way to get carbon polluters to invest in and produce cleaner energy, two scenarios continue to come forward: cap and trade vs. carbon tax.

A new study from UC Merced and the University of New South Wales in Australia suggests that a free and uninhibited cap-and-trade system is the best way to go.

The authors argue such a system will "trigger adoption of clean technologies at a considerably lower level of carbon prices" as compared with a tax system.

In addition, the study concludes that the higher risk and volatility of an unhindered market "are likely to induce suppliers to take early action to hedge against carbon risks."

The study appears in The Energy Journal.

Here's how the authors came up with their conclusion: Yihsu Chen of UC Merced and Chung-Li Tseng of New South Wales created a scenario in which a small firm that owns a coal-fired power plant considers investing in a clean technology to provide electricity for its customers.

In this case, the authors chose a natural gas-fired power plant. The authors then asked, which scenario - a cap-and-trade or a tax system - would provide a better incentive to go forward with clean energy?

Using a variety of models and contingencies, the authors found that cap and trade provided the best incentive.

Cap and trade, or emissions trading, is a market-based system in which the government sets a limit, or cap, on the amount of pollutants an industry, manufacturer or other entity can emit.

The government then issues the company a set number of permits based on this cap. If the company reduces its emissions so it is below its cap, it can then trade the excess permits on a market with other companies that may need more permits, because they have exceeded their cap.

In the tax system, companies are taxed for a set amount of emissions.

In the case study the authors created, the cap-and-trade system allowed for less-expensive energy and an incentive to get into greener technology early.

How? Politicians and tax-system proponents have argued that a tax system provides predictability to the system. An investor would know the future costs of permits and not have to worry about risk. And that should provide confidence for industry to make long-term investments.

But according to the authors, it's the risk that makes the cap-and-trade system so much more effective.

Consider plug-in hybrid cars, said Chen.

"You can run the car on gas if the electricity price is too high," he said. "Or you can run the car on electricity if the gas price is too high. It is the flexibility or options value associated with this 'dual system' together, with uncertain permit prices, that makes firms willing to invest in clean technologies in a cap-and-trade system."

In other words, he said, "firms can actually benefit from uncertain permit prices."

The Climate Action Reserve, a national offsets program based in California, would not comment on the study.

California plans to have a cap-and-trade system in place by 2013.