After eight years of inaction, carbon emissions policy may finally take a reality-based turn. Both Republican senator John McCain and Democratic senator Barack Obama have proposed "cap-and-trade" (CAT) plans. While McCain's running mate, Alaska governor Sarah Palin, recently declared she doesn't believe climate change is "man-made", I'll assume that McCain continues to support his plan.

There are two key differences between the candidates' plans. First, by 2050, Obama would reduce emissions by 80% of 1990 levels. McCain stops at 60%. Second, Obama would use a market-based auction to allocate permits that power CAT policy, while McCain would simply give them to polluters, providing huge annual handouts to a favoured few at everyone else's expense. Let's see why.

When you burn fossil fuels, emitted carbon harms the environment for everyone around you. Because you don't bear the costs you impose on others, they're "external", and this is known as a negative externality. Economists have known for eons that with negative externalities, leaving a market alone - "free-market" policy - causes inefficiency in the form of too much pollution. The only way to avoid this outcome is some sort of government intervention. Period.

Under old-style "command-and-control" regulations, the government told polluters how much to emit, and that was that. Pollution stays below the desired level, but this policy is inefficient, since some companies can reduce their carbon footprints more cheaply than others, and all that matters is the total amount emitted. An alternative policy doesn't restrict emissions, but imposes a per-pound tax on emitted carbon. Producers that can reduce emissions for less than the tax will do so, while others will produce carbon and pay the tax. In principle, the tax can be set to achieve any desired level of emissions reduction.

But the government might screw up. Too high a tax brings unnecessarily high reductions in economic production. Given today's tax-phobic political climate, it's more likely that the government would set the tax too low, with disastrous climatic results.

Enter cap-and-trade. Government chooses the total quantity of carbon emissions (cap) and issues permits that companies can buy and sell (trade). Once permits are allocated, supply and demand determine the price of a permit, which acts just like a carbon tax: companies that can reduce emissions cheaply will sell permits and reduce emissions, while companies on the opposite side of the ledger will buy permits and keep emitting carbon. The lower the cap, the higher the price. CAT provides the benefits of both command-and-control and taxes: emissions won't top the cap, and the "right" companies will do the reduction.

Research suggests those permits will be worth real money - perhaps as much as $50-$300bn per year by 2020. That's enough money to pay for an awful lot of campaign promises.

Obama would auction off the permits, using the proceeds for taxpayer rebates and investments in green energy sources to help offset CAT-induced increases in production costs, which themselves will lead to reduced employment and higher prices. Basic fairness and common sense suggest that whatever pain CAT causes should be salved with shared benefits.

By contrast, McCain's plan fails this fairness test. While average taxpayers adjust to higher prices due to higher production costs, McCain would shower windfall profits on polluters' shareholders. As noted above, CAT is just like imposing a tax, together with a clever mechanism to ensure the chosen reduction in total emissions. Refusing to auction off the permits, though, is just like letting polluters keep the revenue from a carbon tax. Would anyone support that?

Now, it's true that CAT will increase polluters' costs, reducing shareholder value. But we could compensate shareholders with just 15% of the permits' value - a far cry from McCain's 100% gift.

Let's leave aside the fact that McCain would reduce emissions by considerably less than Obama. The simple fact is that McCain's plan would provide the mother of all handouts, for no good reason. An annual giveaway of hundreds of billions of dollars to polluters - just because they are polluters - is most certainly not the change anyone should believe in.

[Note: due to an editing error, the second sentence of the second paragraph previously read "...reduce emissions to 80% of 1990 levels". It should have read: "...reduce emissions by 80% of 1990 levels". Apologies.]