Under a tax, a levy would be imposed on each ton of CO2 emissions or on each ton of carbon that is contained in fossil fuels (and which is ultimately released in the form of CO2).The simplest quantity-based mechanism would be a cap-and-trade program. Under such a program, policymakers would set a limit (cap) on total emissions during some period and would require regulated entities to hold rights, or allowances, to the emissions permitted under that cap. After allowances were initially distributed, entities would be free to buy and sell them (the trade part of the program). Reducing emissions to the level required by the cap would be accomplished mainly by reducing demand for carbon-based energy through increasing its price. Those price increases could provide an effective financial incentive for firms and households throughout the economy to take actions that would decrease emissions.The size of the required price increase would depend on the extent to which emissions had to be reduced-larger reductions would require larger price increases to reduce demand sufficiently.
Policymakers would have several key decisions to make in designing a cap-and trade program. One such decision would be whether to sell emission allowances or give them away. Policymakers' decisions about how to allocate the allowances could have significant effects on the overall economic cost of achieving a given cap on CO2 emissions, as well as on the distribution of gains and losses among U.S. households.