The difference between a carbon tax and an ETS

The proposed carbon pricing policy in Australia is now routinely referred to as a “carbon tax” by both government and opposition.

This is odd, because the proposed scheme is not actually a tax.

How does an ETS work?
It seems reasonably likely that Australia will, sooner or later, end up with an emissions trading scheme (ETS) for CO₂.

An ETS works by setting a cap on emissions and requiring emitters to hold a permit for each tonne of CO₂ that they emit. The level of the cap determines the number of permits available.

If emitters don’t already hold a permit, they must either cut back on their emissions or buy a permit from another emitter, who must then cut back.

This means that a cost is imposed on emissions, equal to the price of buying or selling a permit.

But importantly it’s not actually the price that causes the overall cuts in emissions. The cap determines the level of emissions, and the required cuts in emissions cause the price.

That is, permits have a value because they allow you to avoid making cuts in emissions.

How does this differ from a carbon tax?
A carbon tax is sort of the opposite. A cost is added to all emissions, equal to the level of the tax, and this causes people to cut back.

There is no cap on emissions in a tax-based system. People are free to emit as much or as little as they like, but if they do emit, they must pay the tax.

Unlike an ETS, under a carbon tax it is the price that determines the level of emissions.
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