Carbon Tax or Emission Trading Scheme: Which is Better to Reduce Carbon Emission?

Abstract

This paper examines the effectiveness of two carbon pricing measures, i.e., carbon tax and emission trading scheme (ETS), in reducing carbon emissions based on 133 countries’ annual panel data from 1990 to 2014. We demonstrate that carbon pricing system effectively reduced carbon emissions in the entire sample data of 133 countries and was more effective in higher income countries. More specifically, the carbon tax system was effective in reducing carbon emissions in the upper-middle and high income group, while ETS was more effective in both upper-middle and high income group with higher statistical significance. The results support the economic intuition that ETS can be more effective in reducing quantity uncertainty of emission reduction, especially facing informational barriers that make it difficult for a carbon tax rate to be set equal to the marginal social cost of carbon emission. In addition, the empirical findings also confirm that the carbon tax system involves higher quantity uncertainty in emission reduction. The results implicate that ETS might be more effective in reducing carbon emission facing informational barriers on the marginal social benefit of emission reduction.

Keywords: Carbon pricing to reduce carbon emission, Carbon tax, Emission trading scheme, Uncertainty and volatility in the quantity of emission reduced