Prices and Quantities in a Climate Policy Setting

This paper takes its departure in two observations from the EU’s climate policy. First, the EU has adopted a dual approach with a trading scheme covering CO2 emissions from the energy intensive industry, while the remaining emitters are subject to emission taxes. Second, the targets are quantitatively phrased, i.e., there is an upper limit on the total CO2 emissions. These observations are of interest under the realistic assumption of abatement costs being uncertain. Then the dual approach is likely not ex post cost effective. Furthermore, earlier literature suggests that an emissions tax on CO2 yields lower expected efficiency losses than a tradable permit scheme. Thus, quantitative targets, which are easier fulfilled through a trading scheme, stand in contrast to taxes being the preferable policy instrument. The present paper addresses, by the means of a stylized model, the two observations and shows when and why a dual approach is optimal from an efficiency point of view given an upper limit on total emissions. What determines the characteristics of the optimal solution, e.g., size of the trading vs. taxed sector and tax levels, is studied in some detail.