There is broad consensus among those engaged in climate policy analysis—from academia, government, NGOs, and industry—that any domestic climate policy should include, at its core, market-based policy instruments targeting greenhouse gas (GHGs) emissions, because no other approach can do the job and do it at acceptable cost. By “putting a price on carbon,” market-based polices harness the power of our free enterprise system to reduce pollution at the lowest costs. Recent concern, however, about the role of financial markets—and specific fraudulent investment vehicles—in the recent recession have raised questions among the public about the efficacy and functioning of markets. Not surprisingly, some have questioned the wisdom of employing market mechanisms to tackle climate change. Critics ask, how can market-based policy instruments be trusted to look after the public’s welfare with regard to global-warming pollution (or anything else, for that matter)?

When it comes to climate change and environmental issues more generally, environmental economists recognize that the source of many problems is not markets per se, but the absence of markets for environmental goods and services, such as clean air and water. In the absence of prices (costs) associated with environmental damages, producers and consumers need not account for such damages in their activities and choices. Environmental damage is thus an unintentional byproduct of decisions to produce or consume. Because these negative consequences are external to the firm or individual creating them, economists refer to them as externalities. They are one category of market failures; in this case, the failure of existing markets to price accurately the full costs to society of producing and consuming goods that create a pollution externality.

In the case of climate change, the burning of fossil fuels and other activities that release GHGs into the atmosphere are associated with increasing global temperatures. The costs of these impacts, including an increase in extreme weather events, rising sea levels, loss of biodiversity, and other effects, are borne by society as a whole, including future generations. In the absence of a price on carbon, these environmental costs are not included in the prices of GHG-based goods—thus there is no direct cost for emitting GHG pollution into the atmosphere. From a societal perspective, this leads to an inefficient use of resources, excessive emissions, and a buildup of excess concentrations of GHGs in the atmosphere.

The current status quo or “laissez-faire” approach to dealing (or rather failing to deal) with GHG pollution results in an outcome that is not in the interest of society. For this reason, many people have advocated putting a price on GHG emissions to cause market participants to confront or “internalize” the costs of their actions and choices. A policy instrument that puts a price on GHG emissions would, for example, raise the cost of coal-generated electricity, relative to electricity generated with natural gas, because coal as a fuel emits more carbon dioxide (CO2) per unit of energy. Producers and consumers would take this relative cost differential into account when deciding how much electricity to produce and what fuels to use in producing it. That is the point — to make the cost of emitting carbon explicit, so that it becomes part of the everyday decisionmaking process.

Two alternative market-based mechanisms can be used to put a price on emissions of GHGs—cap and trade and carbon taxes. With cap and trade, an upper limit or “cap” on emissions is established. Emission allowances that equal the cap are distributed (either freely or through auction) to regulated sources which are allowed to trade them; supply and demand for these allowances determine their price. Sources which face higher abatement costs have an incentive to reduce their abatement burden by purchasing additional allowances, and sources which face lower abatement costs have an incentive to reduce more and sell their excess allowances. Thus, the government establishes the environmental goal (the cap), but the market sets the price.

In contrast, a carbon tax sets a price on emissions, but leaves the environmental outcome uncertain. The tax creates an incentive for firms to reduce their emissions up to the point where the cost of reductions is equivalent to the tax. If the tax is low, fewer reductions will result; if the tax is high, more abatement effort will be forthcoming. Given the real-world U.S. political context, the more promising of the two market-based approaches to addressing climate change is clearly cap and trade, which creates a market for GHG reductions.

While the common sense justification for putting a price on carbon emissions seems straightforward, some of the public and even some policy makers are questioning whether creating a market for GHG reductions is a cure worse than the disease itself. Some questions and concerns include the following:

• Why employ market-based approaches to GHG emission reductions, when markets are subject to manipulation?
• Would a market-based approach to reducing GHG emissions be a corporate handout?
• Can markets be trusted to reduce emissions?
• Will a market-based approach, such as cap and trade, be too costly?
• Are other approaches—including conventional regulation and taxes—likely to be more effective and less complicated?

Our goal in this paper is to address the questions above, and—we hope—leave the reader with a better understanding of the issues, the rhetoric, and the fundamental reasons why cap and trade is the most promising approach to address the threat of climate change. We believe that past concerns about how markets operate can be effectively addressed and result in a policy that is both environmentally and economically superior to alternative approaches.