Over time you want to lower the cap and that acts as a real incentive for everyone to find not only efficiency gains but also invest into renewables because they’ll want a piece of the market that will allow them to a) have a piece of the renewables market and b) sell their credits to others to make money (or offset the emissions from their existing activities)

The biggest difficulty is the political difficulty in allocating the permits. If the targets are committed to, and an independent Carbon Central Bank conducts the auction, this is not a problem.

[the government should] make sure they set [the target] right and allocate an appropriate level of credits. In Europe they got it wrong. They allowed everyone to tell them how much they pollute so everyone overstated their emissions, and the governments handed out too many credits and the price plummeted instead of rising. Live and learn though.

Seems to me a big difficulty in the carbon tax would be in setting the price. And then resetting the price to adjust when we over or under shoot our target. To be effective in reducing global climate change, the price setting would all have to be negotiated globally too.

If you set the carbon tax high enough to make renewables competitive, you’d kill fossils straight away and there wouldn’t be time to shift to new energy. The cap and trade gives you time to grow into a new energy economy.

Greg Mankiw, a supporter of the carbon tax, and all things Pigovian:

The economics is straightforward and uncontroversial. Both carbon taxes and cap-and-trade systems put a price on carbon, raising the cost of producing carbon-intensive products such as gasoline. In both cases, this cost will be passed on to consumers. The government can, however, raise revenue through a carbon tax or auction and use that revenue to reduce other taxes and help offset the adverse income effect.

As Mark Thoma over at Economist’s View notes, this view is valid of course if the permit are

simply given to existing emitters, then those profits are pocketed by the firms. If the permits are auctioned off, the price will be bid up, and the government gets the money. [emphasis added]

Lastly, I don’t think Tyler Cowen has it quite right in Robert Samuelson’s defence against the economics mainstream in saying

If you see very high costs from setting the binding cap too low and choking off growth — as Samuelson mentions — you should prefer the carbon tax.

You can see that we are comparing the “growth threshold problem” [carbon tax] to the “environment threshold problem” [CAT]

Cowen and Samuels don’t seem to have much faith that economies can respond to the new incentives. I think we are way past this part of the debate anyway and as Ross Garnaut argues, the longer we wait, the fewer options we are going have.

For a good explanation of the basic economics behind both, see Environmental Economics.

For a well designed cap and trade regime and the discussion of it for Australia, see the Garnaut Climate Review’s Emissions Trading Scheme discussion paper.