First of all: A tax and certificate system is equivalent to some degree. The main difference is that taxes set prices while certificates set quantities. But more on that later. And since taxes are easier to understand I will start with explaining them.
1. Understanding Taxes
Assume you tax every ton of CO2 with 100€. Then every measure to reduce CO2 is taken, which is cheaper than 100€ per ton of CO2 and no other measures. In other words. You guarantee that all measures are taken which are cheaper than a certain threshold.
Now our goal is to limit emissions. So our target is a volume, not a price. So how do you reduce CO2 emissions to a certain volume? Well you could start out with some tax e.g. 50€ and see what the resulting volume is let’s say 100 Ft (Fantasy tons). And the goal is 20Ft. Then you increase the price to 70€. So now all measures are taken which are cheaper than 70€ not 50€. So the volume has to decrease. The question is just by how much? So let’s say it goes down to 50Ft. So you increase the price to 100€ and the volume goes down to 30Ft. So you increase the price again to 120€ and finally the volume of CO2 produced goes down to 20Ft. This seems like a very elaborate process. Is there maybe a shortcut?
2. Understanding Certificates
Instead of adjusting taxes, until the desired quantity is reached, you now instead decide to auction (tradeable) certificates. For an individual company it does not matter whether you pay a tax of 100€ per ton of CO2, or buy a certificate priced at 100€ for every ton of CO2. So what is the difference? Well you release certificates for 20Ft of CO2. During the auction, companies consider how expensive it would be for them to reduce CO2 emissions. So they would bid higher until the certificate price is higher than it costs them to simply reduce their CO2 emissions. So what can we say about the final price? Well we know it already from the tax-case! The price will be 120€. Why is that? Well, assume that the price is lower. For example 100€. Well, we know from the tax example, that people would want to buy 30Ft at 100€. But only 20Ft are auctioned. So people would bid higher. To summarize: all those tax adjustments would happen during the auction. Which is a lot quicker than any policy making process.
Comparison
There is no difference for a company whether it has to buy certificates at a certain price, or pay taxes equal to this price. So certificates and taxes are equivalent in this sense. But CO2 certificates allow the state to set the volume, while taxes are good for setting the price.
But in both cases the end result will be optimal in this sense: The cheapest measures to reduce CO2 will be taken first. Because all measures below the price/tax will be taken and none above. And while there might be market failures which need to be addressed in some cases, no other policy comes close to this efficiency guarantee.
So one should choose certificates if one wants to achieve a certain volume, and one should choose taxes if one wants to achieve a certain price.
What do we want to achieve?
Our stated goal is, to limit global warming between 1.5° and 2°C. The IPCC released a summary for policy makers how much CO2 can be released to achieve this goal (what is the budget). So the total volume is given. What is left to do is to distribute this volume over countries and time.
See this interactive dashboard for possible scenarios.
For comparison: the EU emission trading system covers about 45% of the market and sets a reduction rate of 2.2%. In no scenario is 2.2% sufficient. The reduction rate rather needs to be roughly 10%. No wonder certificates were not effective so far. We did not set ambitious targets. Why should we blame certificates for achieving what we asked them to?
After selecting such a scenario one simply has to emit the certificates calculated by the parameters provided and the market will do the rest.
Summary
Certificates guarantee the most efficient (cheapest) transition to sustainable energy. They allow us to simply input our desired value and automatically set incentives for companies to achieve these values. In this sense climate change is incredibly easy to solve from an economic perspective. The only issue is political will.
Q&A
What happens if a company runs out of certificates?
Q: Is is correct, if all certificates for one year are sold, a company without certificates is not allowed to sell their products? (if they do not have measures to set CO2-emissions to zero?).
A: A company without certificates is a company which did not bid higher, which means the alternative was cheaper (reducing their CO2 emissions). So therefore that company would be able to reduce its emissions. But you can always buy and sell certificates to other companies if you find out later that you misjudged.
Who needs to buy certificates?
Q: How are the CO2-emissions are calculated? Does the bakery in my neighborhood need a certificate or only the big energy/oil companies?
A: Ideally certificates would cover all CO2 emissions. But in order to avoid the bureaucracy you can do the following:
- Assume that fossil fuels will eventually be burned, and since the amount of carbon atoms in these fuels is known and determine the amount of CO2 released, you can sell the certificates together with the fuels at import time/extraction.
- Consumers who buy the fuel would not have to deal with certificates because the filling station already bought the certificates with the gas. And simply sells it to you under the assumption that you are going to burn the fuel.
- So only companies importing or extracting the fuel would actually have to deal with certificates.
- Caveat: If you are a power plant and use carbon capture, then you bought fuel with certificates, but since you captured the CO2, you did not actually release the CO2 as assumed at the beginning. So in this case (if you prove that you captured the CO2), you can resell the certificate. (In this sense it is quite similar to “pre-tax”)