Abstract: This essay revisits the question of instrument choice for the regulation of externalities in
the context of climate change. The central point is that the Pigouvian prescription to equate
marginal control costs with the expected marginal benefits of damage reduction should guide the
design of both carbon taxes and permit schemes. Because expected marginal damage rises
nonlinearly, a corresponding nonlinear tax – or an equivalent price implemented through a
quantity-adjusted permit scheme – is second best. Also considered are political factors,
distinctive features of regulating a stock pollutant, and ex ante distortions due to the anticipation
of transition relief (such as by receiving more free permits for greater emissions). Finally,
distributive concerns are examined, with emphasis on the conceptual and practical benefits of
addressing distributive issues with the tax and transfer system rather through adjustments to
regulatory schemes that usually render them less effective.