ECONOMIC AND BUDGET ISSUE BRIEF

Limiting Carbon Dioxide Emissions:

Prices Versus Caps

Scientists have identified carbon dioxide—which is emitted during the combustion of fossil fuels (oil, natural gas, 

and coal)—as a key greenhouse gas that can affect the 

Earth's climate. Experts disagree about the potential 

damages that might result from those emissions, with 

some projecting modest damages and others projecting 

potentially abrupt and catastrophic effects. Given that 

range of projections, people disagree about whether anything should be done to limit emissions and if so, how 

much to limit them. However, one area of consensus is 

that any steps taken to control emissions should do so at 

the lowest possible cost. Two different forms of economic 

incentives could achieve that goal: one would reduce 

emissions by setting a price on them, and the other would 

cap the overall level of emissions. But given current information about the potential for near-term emissions to 

trigger abrupt and catastrophic damages, the price approach is more likely than a cap to maximize the difference between the policy's total benefits and total costs.

This brief illustrates the advantage of a price-based incentive using an example contrasting policies that would set 

a price for U.S. fossil fuel-related emissions of carbon dioxide with policies that would cap such emissions. The 

United States is the country that emits the largest amount 

of carbon dioxide, but to varying degrees all nations emit 

greenhouse gases and could potentially benefit from their 

control. 

How Emission Prices and

Emission Caps Would Work

Putting a price on carbon dioxide emissions—essentially 

taxing those emissions— would boost their cost, thereby 

encouraging firms as well as households to limit emissions (by using smaller amounts of fossil fuels or by relying on fossil fuels with relatively low carbon content) as 

long as the cost of doing so was below the tax or price. 

That price-based approach would establish an upper limit 

on the cost of individual emission reductions—the level 

of the price—but would not ensure that any particular 

emission target was met. That approach would balance 

expected benefits and actual costs provided that the price 

per ton was set equal to the expected benefits resulting 

from eliminating a ton of carbon emissions.

Cap-and-trade programs, in contrast, offer a way to set an 

overall limit on the level of carbon dioxide emissions 

while relying on economic incentives to determine where 

and how emission controls take place. Under such a program, policymakers would establish an overall cap on 

emissions but allow firms to trade rights to those emissions, called allowances. Trading would allow firms that 

could control their emissions most cheaply to do so in order to sell some of their allowances at a profit to firms 

that face higher costs to limit their emissions. Furthermore, the price increases that would result from the cap 

would encourage households to consume smaller 

amounts of fossil fuels, thus leading to lower carbon 

emissions. A cap-and-trade program would achieve the 

emission target at the lowest possible cost, but (as described below) it would not necessarily balance actual 

costs with the expected benefits achieved by the target.

A cap-and-trade program with a “safety valve” combines 

an overall cap on total emissions with a ceiling on the allowance price. Under that hybrid approach, policymakers 

would establish an overall cap and allow firms to trade allowances, but they would also set an upper limit on the 

price for allowances, referred to as the safety-valve price. 

If the price of allowances rose to the safety-valve price, the 

government would sell as many allowances as was necessary to maintain that price. Thus, if the safety valve was 

triggered, the actual level of emissions would exceed the 

cap. The cap would be met only if the price of allowances 

never rose above the safety-valve price.

CBO A series of issue summaries from

the Congressional Budget Office

MARCH 15, 2005
2 CONGRESSIONAL BUDGET OFFICE

ECONOMIC AND BUDGET ISSUE BRIEF

Emission Prices Are More Efficient 

than Emission Caps

If policymakers had complete and accurate information 

on both the costs and benefits of achieving various limits 

on emissions, they could achieve the limit that best balanced costs and benefits using either an emission price or 

an emission cap. With full information, policymakers 

could set the price or cap to the level at which the cost of 

the last reduction was equal to the benefit from that reduction. However, neither the costs nor the benefits are 

known with certainty. For that reason, the best policymakers can do is to choose the policy instrument that is 

most likely to minimize the cost of making a “wrong” 

choice. Choosing policies that are too stringent (by setting too high a price or too tight a cap) would result in 

excess costs that are not justified by their benefits. Alternatively, choosing policies that are too lenient (by setting 

too low a price or too loose a cap) would result in forgone 

benefits that would have outweighed the cost of obtaining them. 

Analysts generally conclude that uncertainty about the 

cost of controlling carbon dioxide emissions makes price 

instruments preferable to quantity instruments because 

they are much more likely to minimize the adverse consequences (excess costs or forgone benefits) of choosing the 

wrong level of control.1 The price approach would motivate people to control emissions up to the point where 

the cost of doing so was equal to the emission price. If actual costs were less than, or greater than, anticipated, people would limit emissions more than, or less than, policymakers projected. However, emissions would be reduced 

up to the point at which the cost of doing so was equal to 

the expected benefits, provided that the emission price 

was set equal to the expected benefits of reducing a ton of 

carbon dioxide emissions. In contrast, a strict cap on 

emissions could result in actual costs that were far greater 

(or less) than expected and that therefore exceeded, or fell 

below, the expected benefits. 

The advantages of a price-based approach stem mainly 

from the fact that the cost of limiting a ton of emissions is 

expected to rise as the limit becomes more stringent, 

while the expected benefit of each ton of carbon reduced 

is roughly constant across the range of potential emission 

limitations in a given year. That constancy occurs because 

climate effects are driven by the total amount of carbon 

dioxide in the atmosphere, and emissions in any given 

year are a small portion of that total. Further, reductions 

in any given year probably would fall considerably short 

of total baseline emissions for that year. 

An Illustrative Example

The example below demonstrates the advantage of an 

emission price over an emission cap when the per-ton 

benefit of limiting current emissions is expected to be 

roughly constant over the range of possible reductions 

(see Table 1). Considerable uncertainty surrounds the 

benefit of limiting carbon emissions, but the example arbitrarily assumes that the value is $10 per metric ton.2

The example shows outcomes for two domestic policies—a tax on emissions and a cap on emissions—that 

are designed to produce the same level of emission reductions (and thus, the same expected costs and benefits). If 

policymakers charged a tax of $10 per ton on carbon 

(based on the expectation that the benefits of eliminating 

a ton of carbon emissions is $10), and if the cost of limiting emissions was what they had anticipated, the $10 tax 

would result in 29 million fewer metric tons of carbon 

(mtc) in the first year of the policy and provide a net benefit of $143 million.

If, however, the cost of controlling emissions by that 

amount was 50 percent lower than anticipated, firms 

would find it advantageous to undertake additional lowcost reductions—nearly twice as many as policymakers 

had anticipated—in lieu of paying the tax on those emissions. As a result, actual net benefits would be $280 million, which is $137 million greater than anticipated. Similarly, if costs were 50 percent higher than anticipated, 

firms would limit their emissions by a smaller amount—

by 19 million mtc instead of 29 million mtc. The level of 

net benefits also would be lower than expected—but not 

as low as it would have been if firms had been forced to 

make the full 29 million mtc cut in emissions that policymakers had expected to result from the tax. Furthermore, 

given that firms would limit emissions up to the point at 

1. Uncertainty about the benefits of limiting emissions can lead to 

the wrong level of control as well. However, the adverse consequences of having chosen the wrong level of control because of 

underestimating or overestimating benefits are expected to be the 

same under both price and quantity instruments. For a more 

detailed discussion, see Congressional Budget Office, Uncertainty 

in Analyzing Climate Change: Policy Implications (January 2005).

2. Furthermore, the example assumes that firms would minimize 

their compliance costs—by equating their marginal cost of reducing emissions either to the tax or to the allowance price. 
ECONOMIC AND BUDGET ISSUE BRIEF

LIMITING CARBON DIOXIDE EMISSIONS: PRICES VERSUS CAPS 3

Table 1.

An Example of the Advantage of Using a Tax, Rather Than a Cap, to Reduce

Carbon Emissions

Source: Congressional Budget Office.

Notes: This example arbitrarily assumes that the benefit of reducing carbon emissions is $10 per metric ton. It examines the net benefits that 

would result in the first year of each policy, assuming that the policy would apply only to the United States, that the initial year would 

be 2010, and that the policy would have been announced 10 years earlier. The cost of firms’ emission reductions (and the response to 

various taxes) is derived from Mark Lasky, The Economic Costs of Reducing Emissions of Greenhouse Gases: A Survey of Economic 

Models, CBO Technical Paper No. 2003-03 (May 2003), available at www.cbo.gov/Tech.cfm.

n.a.=not applicable.

a. The actual marginal cost of reducing 29 million metric tons of carbon (mtc) is $5, but the tax induces reductions up to 56 million mtc, at 

a marginal cost of $10.

b. The actual marginal cost of reducing 29 million mtc is $15, but the tax induces fewer reductions (19 million mtc instead of 29 million 

mtc), up to a marginal cost of $10.

which the actual cost of the last ton of carbon emissions 

eliminated was equal to the expected benefit (because the 

tax had been set equal to that expected benefit), the value 

of total benefits minus total costs (that is, net benefits) 

would be maximized, regardless of whether the actual 

costs were higher or lower than anticipated.

Suppose, in contrast, that policymakers set an emission 

cap that they believed would limit emissions by the same 

amount as the $10 tax—a 29 million metric ton reduction from the baseline level. The cap would allow no flexibility if actual costs turned out to be different from the 

anticipated costs. If the marginal cost of meeting that cap 

Actual Outcomes

Expected Outcomes

 If the Cost of Reducing

Emissions Was 50 Percent 

Lower Than Expected

If the Cost of Reducing

Emissions Was 50 Percent 

Higher Than Expected

Set a Tax of $10 per Ton of Carbon

Marginal Cost (Dollars) 10 10a 10b

Emission Reduction (Millions 

of metric tons) 29 56 19

Net Benefit (Millions of 

dollars) 143 280 96

Set a Cap to Reduce Carbon Emissions by 29 Million Metric Tons

Marginal Cost (Dollars) 10 5 15

Emission Reduction (Millions 

of metric tons) 29 29 29

Net Benefit (Millions of 

dollars) 143 215 72

Memorandum:

Percentage Increase in

Net Benefit from a Tax 

Rather Than a Cap n.a. 30 34
4 CONGRESSIONAL BUDGET OFFICE

ECONOMIC AND BUDGET ISSUE BRIEF

turned out to be 50 percent lower than expected, for example, then actual net benefits, at $215 million, would 

be greater than expected—but still significantly lower 

than the $280 million in net benefits from the tax, because the cap would not induce firms to undertake any 

additional beneficial reductions.

Likewise, if the cost of meeting the cap was higher than 

anticipated, firms would still be required to limit emissions by 29 million mtc, even though each cut beyond a 

19 million mtc reduction (the amount induced by a $10 

tax) would cost more than the benefit that it created. As a 

consequence of that inflexibility, the net benefits from the 

cap would be 34 percent lower than the net benefits from 

the tax.

The safety-valve approach would provide some, but not 

all, of the advantages of a tax. Specifically, the safety valve 

would protect against excess costs (and thus would provide greater net benefits than a fixed cap) in the case in 

which the marginal cost of meeting the cap was greater 

than anticipated. The safety valve would not, however, 

lead to more reductions than those required under the 

cap if the cost of emission reductions turned out to be less 

than anticipated. Thus, unlike the tax, the safety valve 

would not maximize net benefits in that case. 

The less information policymakers have about the cost of 

meeting a particular emission cap, the greater the advantage offered by an emission price. The cost of meeting a 

given cap on carbon emissions is likely to be difficult to 

estimate for at least three reasons. First, the cost of meeting a future cap would vary significantly with the amount 

of growth in carbon emissions in the interim. Those 

emissions are difficult to predict: they are a function of 

numerous factors, including population trends, economic 

growth, and energy prices. Second, policymakers have 

less information about the cost of controlling emissions 

than do the firms that create them. Third, the cost of 

meeting the future cap will depend on the technologies 

that are developed to reduce carbon dioxide emissions 

and the economic consequences of adopting those 

technologies—neither of which can be predicted with 

certainty. 

Is Setting a Price on Emissions Still 

Preferred When the Potential for 

Abrupt Climate Change Is Taken into 

Account? 

Intuitively, the case for a cap on emissions would appear 

to be much stronger if there were evidence that temperature increases above a certain threshold would cause catastrophic damages—especially given the inertia of the climate system and the long adjustment to changes in 

concentrations. That possibility might seem to call for a 

cap on emissions to avoid crossing the threshold. But that 

intuition holds true only under a very restrictive set of 

circumstances:3

B There must be a trigger temperature that, if exceeded, 

results in a steep increase in damages; 

B Policymakers must have clear information about what 

that trigger temperature is; and 

B The threshold must be sufficiently near so that policymakers would want to virtually shut down emissions—regardless of the cost—to avoid, or delay, 

crossing it.

Under those circumstances, either an emission price or an 

emission cap (appropriately set) would probably yield 

very large net benefits, but the expected net benefits from 

using an emission cap would be greater.

If there is uncertainty about either the existence or the 

level of a trigger temperature—as is currently the case—

the potential advantages of an emission cap decline.

Under those circumstances, it is no longer clear whether, 

or at what level, to set a cap to avoid a catastrophic outcome. Thus, setting an upper limit on the incremental 

cost of reducing emissions via an emission price (even 

though that limit may be high) becomes relatively more 

important.

Similarly, a price instrument is generally superior if damages are expected to grow, but at a gradual rate of increase 

3. See William A. Pizer, Climate Change Catastrophes, Discussion 

Paper 03-31 (Washington, D.C.: Resources for the Future, May 

2003).
ECONOMIC AND BUDGET ISSUE BRIEF

LIMITING CARBON DIOXIDE EMISSIONS: PRICES VERSUS CAPS 5

(rather than increasing very rapidly beyond a known temperature threshold). Under those circumstances, being 

able to control emissions precisely is less critical (because 

there is less concern about passing a trigger point).

Finally, a price instrument is preferred if modest emission 

reductions are called for. If policymakers wished to slow 

the increase of carbon dioxide in the atmosphere (or stabilize that level after a period of several decades), then 

there would be considerable leeway about when reductions occurred. Costs would be minimized by making 

cuts when it was least expensive to do so. A price instrument would allow for such flexibility in timing, whereas a 

short-term emission cap would not. Such a cap would become desirable only if extremely large cuts in current 

emissions were required to quickly stabilize the atmospheric stock to avoid crossing a threshold. 

Related CBO Publications: In addition to the publications listed in footnote 1 and Table 1 of this brief, see The 

Economics of Climate Change: A Primer (April 2003); An Evaluation of Cap-and-Trade Programs for Reducing U.S. 

Carbon Emissions (June 2001); and Who Gains and Who Pays Under Carbon-Allowance Trading? The Distributional 

Effects of Alternative Policy Designs (June 2000). 

This issue brief was prepared by Terry M. Dinan and Robert Shackleton, Jr. It and other CBO publications are 

available at the agency’s Web site (www.cbo.gov).

Related CBO Publications: In addition to the publications listed in footnote 1 and Table 1 of this brief, see The 

Economics of Climate Change: A Primer (April 2003); An Evaluation of Cap-and-Trade Programs for Reducing U.S. 

Carbon Emissions (June 2001); and Who Gains and Who Pays Under Carbon-Allowance Trading? The Distributional 

Effects of Alternative Policy Designs (June 2000). 

This issue brief was prepared by Terry M. Dinan and Robert Shackleton, Jr. It and other CBO publications are 

available at the agency’s Web site (www.cbo.gov).