If you tried to dump harmful waste on the property next door, your neighbor would either stop you or require you to pay a fee. But if you dump carbon dioxide into the air, no one charges you a penny because no one, as yet, owns the air. This free ride results in what economists call a market failure. The actual costs of polluting the atmosphere are enormous, but polluters don’t pay them. Instead future generations are stuck with the tab.

A carbon tax, or a carbon cap-and-trade system, can fix this market failure, but because American politicians are loath to impose taxes, a cap is far more likely. Under a cap, government sets a limit on total carbon emissions and issues tradable permits up to the limit. Each year the number of permits declines, reducing emissions over time. Permits can be issued to companies that emit carbon dioxide or to those that supply it for burning—oil, coal and natural gas firms. Issuing permits to suppliers is easier to administer because no smokestacks need to be monitored.

Cap and trade may sound simple, but it’s not. A trillion-dollar question lurks below the surface: Who will own the air? Capping emissions makes carbon scarcer and lets private companies raise the carbon price, which companies will likely pass on to consumers. But who ultimately gets the extra money depends on who has the initial rights to the air. It might seem self-evident that the air belongs to everyone, but when capping was first proposed, the assumption was that polluting companies would be given permits for free. Europe, which operates the world’s leading cap-and-trade system, did just that. Not surprisingly, this led to higher prices for consumers and profits for polluters.

Seeing this, several U.S. states that wanted to cap carbon dioxide decided to auction permits rather than handing them to companies for free. In this approach the auction revenue goes to government, which ostensibly uses it to improve air quality. But consumers still pay higher prices, and many families are hit hard. According to the Congressional Budget Office, the average American family would pay $1,160 in higher prices if carbon emissions had to be cut 15 percent. And that burden would get heavier as the cap got tighter.

Dividends Instead
To offset the load placed on consumers, a third form of carbon capping, known as cap and dividend, has gained support. Under this plan, permits are auctioned, but the revenues do not go to the government; they go back to citizens in the form of dividends, distributed equally among everyone, perhaps even wired directly to people’s bank accounts or debit cards. The plan is modeled after the Alaska Permanent Fund, which pays equal dividends to Alaskan residents from the proceeds generated from state oil leases.

In essence, cap and dividend treats the air as a managed commons in which everyone owns a share. Liberals such as former secretary of labor Robert Reich and conservatives such as Senator Bob Corker of Tennessee support the approach, as do a growing number of climate scientists and economists. Some U.S. states as well as other countries are also considering the idea.

As in other forms of capping, carbon emissions prices will rise as the cap declines, spurring private capital to flow into clean alternatives such as wind and solar power. The crucial difference is that the dividends should rise along with the carbon prices, easing the impact on consumers.

This approach also relieves pressure on politicians who want to do something about global warming but don’t want to impose burdens on the public, a key consideration at a time when high fuel prices and the economy are explosive issues. And the system is simple to understand and administer.

Cap and dividend has another advantage: it creates a virtuous circle, in which how people fare depends on what they do. The more carbon any company or individual burns (directly or indirectly), the more that company or individual pays. Because everybody gets the same amount back, people gain if they conserve and lose if they guzzle. This is fair to all, and the poor come out ahead because they burn less carbon than other people do. Because the transition to a far more carbon-free economy will be long and difficult, it is vital to operate a system in which everyone has a chance to win. Otherwise people will get angry, and political support will crumble.

The next president and congress will have one chance to turn the tide on climate change. Modest measures won’t be enough. We need to install an economy-wide system that ratchets down carbon emissions, spurs investment in clean energy alternatives and simultaneously protects household incomes.

Cap and dividend would achieve all these goals. Just as important, it would unite Americans in the fight against climate change in a way that no other policy would—as citizens who are all co-owners and caretakers of the air.

Note: This article was originally printed with the title, "Cap and Dividend, Not Trade".