Introduction

Most economists and policy makers today seem to find few fundamental differences between setting an emissions tax and setting a cap on total emissions with free trade of emissions rights among emitters, as an effective policy tool for reducing global carbon emissions. This chapter demonstrates that such a view is generally incorrect. The two climate policy instruments are not (and are often far from) equivalent when different groups of countries have antagonistic interests in fuel markets. I will make the assumption, considered realistic, that these markets and policies are dominated by two groups of countries, with clashing interests: one group that consumes most fossil fuels, and that defines and implements climate policy; and another group that produces fossil fuels. Importantly, both producer and consumer countries tend, as groups, when their within-group policies are coordinated, to behave noncompetitively in the fossil fuels markets. I then show that tax solutions typically dominate cap-and-trade solutions, as the most efficient and effective climate policy instruments from the point of view of fuel-consuming countries.

I consider a highly stylized set-up in which the world economy is divided into two blocs. The first bloc, called region A, consumes all fossil fuels and defines and implements a climate policy. I assume that region A consumes two fuels: fuel 1, imported entirely from the other region (think of oil), and fuel 2, produced in its entirety within region A itself (interpreted alternatively as coal, natural gas, or renewables).