A carbon tax imposes a tax on each unit of greenhouse gas emissions and gives firms (and households, depending on the scope) an incentive to reduce pollution whenever doing so would cost less than paying the tax. As such, the quantity of pollution reduced depends on the chosen level of the tax. The tax is set by assessing the cost or damage associated with each unit of pollution and the costs associated with controlling that pollution. Getting the tax level right is key: too low and firms and households are likely to opt for paying the tax and continuing to pollute, over and above what is optimal for society. Too high and the costs will rise higher than necessary to reduce emissions, impacting on profits, jobs and end consumers.
By contrast, a cap-and-trade system sets a maximum level of pollution, a cap, and distributes emissions permits among firms that produce emissions. Companies must have a permit to cover each unit of pollution they produce, and they can obtain these permits either through an initial allocation or auction, or through trading with other firms. Since some firms inevitably find it easier or cheaper to reduce pollution than others, trading takes place. Whilst the maximum pollution quantity is set in advance, the trading price of permits fluctuates, becoming more expensive when demand is high relative to supply(for example when the economy is growing) and cheaper when demand is lower (for example in a recession). A price on pollution is therefore created as a result of setting a ceiling on the overall quantity of emissions.
In certain idealized circumstances, carbon taxes and cap-and-trade have exactly the same outcomes, since they are both ways to price carbon. However, in reality they differ in many ways.
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