Cap and Trade

A Cap and Trade system is a market-based policy tool usually used by a state or central government to reduce the overall carbon dioxide or other greenhouse gas emissions. It is one of two major market-based options to lower emissions, the other being a carbon tax. In a cap and trade system a central authority sets a limit, or a cap, on the overall amount of pollutants that are allowed to emit in one certain area and allocates permits representing the right to emit a specific amount of pollutants to companies. Companies then can trade permits on a created market. Over time, the limit or the cap becomes stricter, allowing less and less pollutions, until the final reduction goal is met.¹

The government can choose to "grandfather" allowances to polluting firms in proportion to historical emissions or auction those permits to companies. The permits can be traded through a created market. The idea of carbon trading is similar to the trading of securities or commodities in a marketplace. Carbon is given an economic value, allowing people, companies or nations to trade it. A party who buys it will get the rights to burn it, and a party selling carbon gives up its rights to burn it. More efficient companies, which emit less than their permit can sell their permits to companies that are not able to reduce pollutants easily. Through this transfer, efficient companies are rewarded for having reduced emissions and overall reduction goal is met at a lower cost to the economy.

While there is a consensus in the scientific community that the increasing of CO2 emissions are destabilizing global climate patterns and threatening ecosystems, there is much discussion about what approaches should be taken to reduce emissions. Some economists and environmentalists favor a carbon tax for its simplicity and rapid effect, whereas others favor a cap-and-trade system, often citing its flexibility and political feasibility. In the U.S., a cap-and-trade system is currently more politically favored than the carbon tax.

Background

The “cap and trade” approach to reduce air pollution was first demonstrated in a series of micro-economic computer simulation studies for the National Air Pollution Control Administration (predecessor to the EPA Air Office) by Ellison Burton and William Sanjour between 1967 and 1970. These studies used mathematical models of several cities and their emission sources to compare the cost and effectiveness of various control strategies. The results showed that “cap and trade” is the “lest cost solution” for a given level of abatement.²

The development of the concept can be divided into four phases:³

Gestation: Theoretical articulation of the instrument by Coase, Dales, Montgomery etc and, independent of the former, tinkering with "flexible regulation" at the US Environmental Protection Agency (EPA)
Proof of Principle: First developments towards trading of emission certificates based on the "offset-mechanism" taken up in Clean Air Act in 1977.
Prototype: Launching of a first "cap and trade" system as part of US Acid Rain Program, officially announced as a paradigm shift in environmental policy, as prepared by "Project 88", a network building effort to bring together environmental and industrial interests in the US
Regime Formation: branching out from US clean air policy to global climate policy, and from there to the European Union, along with the expectation of an emerging global carbon market and the formation of the "carbon industry".

Acid Rain Program

A similar successful trading program in the US is the Acid Rain Program, which initially targeted sulfur dioxide and later on set a decreasing cap on total SO2 emissions. The Acid Rain Program was created by the US EPA according to Title IV of the 1990 Clean Air Act in an effort to reduce emissions of sulfur dioxide (SO2) and nitrogen oxides (NOx).

Acid Rain Program created a market-based allowance trading system to comply with the SO2- emission requirements of Title IV. Unites that reduce their emissions below the number of allowances that they hold may trade allowances with other unites in their system, sell them to other utilities on the open market or through EPA auctions, or bank them to cover emissions in future years.⁴

Chicago Climate Exchange

Chicago Climate Exchange (CCX) is another regional example of cap and trade system currently being used. CCX was launched in 2003⁵ and it is the world's first and North America's only voluntary, legally binding integrated trading system to reduce emissions of all six major greenhouse gases, with offset projects in North America and Brazil.

Elements to cap and trade program

As discussed by Rachel Cleetus, an economist from the Union of Concerned Scientists (UCS), Cap-and-trade programs require a number of elements to function properly. ⁶ Some of these standard requirements are:

Strict limits on emissions yielding dramatic pollution reductions;
High levels of compliance, transparency, and complete accountability;
Regulatory certainty and flexibility for sources;
Incentives for early pollution reduction and innovations in control technologies;
Compatibility with state and local programs;
Significant, widespread, and guaranteed human health and environmental benefits;
Efficient use of government resources, andMore benefits at less cost.⁷

Advantages

As a market based tool to deal with emission reduction, the cap and trade system has been favored by many people because it is flexible and politically acceptable.

Setting a target for overall emission can lead to the final goal of reduction of GHG emissions. Many people argue it is the realistic way to reach the goal of emission reductions. As a market based system, cap and trade system provides flexibility to businesses, therefore it gains support from businesses. With the creation of a market for mandatory trading of carbon dioxide emissions within the Kyoto Protocol, the London financial marketplace has established itself as the center of the carbon finance market, and is expected to have grown into a market valued at $60 billion in 2007.⁸
Compared to carbon tax, cap-and-trade system is more politically viable since it does not result in significant rise of energy price and will more likely to be accepted by voters.

Disadvantages

However, there are still significant criticisms of cap and trade system. Economists argue that cap-and-trade system make the price of energy unpredictable and the build up of infrastructure for the system is costly. Other people also argue that the complexity of the system offers the opportunities for manipulation by special interests.

Critics argue that emissions trading does little to solve pollution problems overall, as groups that do not pollute sell their conservation to the highest bidder. Overall reductions should come from a sufficient and challenging reduction of allowances.
Regulatory agencies run the risk of issuing too many emission credits, diluting the effectiveness of regulation, and practically removing the cap. In this case, instead of any net reduction in carbon dioxide emissions, beneficiaries of emissions trading simply do more of the polluting activity. The National Allocation Plans by member governments of the European Union Emission Trading Scheme were criticized for this when it became apparent that actual emissions would be less than the government-issued carbon allowances at the end of Phase I of the scheme.
Cap and trade systems will do little to mitigate the price volatility that historically has discouraged investments in less carbon-intensive electricity generation, carbon-reducing energy efficiency and carbon-replacing renewable energy.⁹
Building a new market for carbon trading requires infrastructures, rule making as well as monitoring , which can be time and money consuming.
Some carbon tax supporters also argue that the complexity of the system provides opportunities for manipulation from certain interest groups.

Cap and trade vs. carbon tax

A graphic from the Union of Concerned Scientists illustrates how cap-and-trade works.

Source: Earth News. Author: Union of Concerned Scientists. Permission: the Creative Commons Attribution-Share Alike license..

The debate over cap-and-trade and carbon tax is heated among policymakers and economists. Cap and trade policy is sometimes accepted as a better approach than a direct carbon tax for its reliance on market power to reward efficient players and reduce overall emissions at a lower cost. The policy is also more political viable compared to carbon tax, which results in a significant rise of the price of energy produced from fossil fuels and more likely gains political resentment.¹⁰ Whereas carbon tax supporters argue that a carbon tax system will lead to a predictable energy price in the long term to avoid volatile prices and the tax revenue collected can be used to offset other tax such as compensating low-income households. They also argue the carbon tax system is simple, straightforward and transparent, avoiding manipulation by special interests.

US President Barack Obama has indicated to favor a cap and trade policy in which all pollution credits are being auctioned.¹¹

Footnotes

1. Cap-and-Trade 101, Center for American Progress, P1.

2. Burton, Ellison, and William Sanjour. (1967). An Economic Analysis of the Control of Sulphur Oxides Air Pollution. DHEW Program Analysis Report No. 1967-69. Washington, DC: Ernst and Ernst.

3. Voss, Jan-Peter (2007): Innovation processes in governance: the development of 'emissions trading' as a new policy instrument. In: Science and Public Policy 34 (5), pp. 329-343

4. SO2 Reductions and Allowance Trading Under the Acid Rain Program, Clean Air Marke.

5. History, chicagoclimatex.com

6. Rachel Cleetus, UCS climate economistm, We Need a Well-Designed Cap-and-Trade Program to Fight Global Warming

7. "Cap and Trade", Clean Air Market, EPA.org.

8. Caebon Point News.

9. Cap-and-Trade Problems, Carbon Tax Center.

10. Tom Redburn,"The Real Climate Debate: To Cap or to Tax?", New York Times, November 2, 2007.

11. Part I: President Obama's roadmap to cap-and-trade,Grist,Environmental News and Commentary.

Resources

Institutions:

Carbon Tax Center:The Carbon Tax Center ("CTC") was launched in January 2007 to give voice to Americans who believe that taxing emissions of carbon dioxide -- the primary greenhouse gas -- is imperative to reduce global warming.
Clean Air Market: Clean air markets include various market-based regulatory programs designed to improve air quality by reducing outdoor concentrations of fine particles, sulfur dioxide, nitrogen oxides, and mercury.
Chicago Climate Exchange: Chicago Climate Exchange (CCX), launched in 2003, is the world’s first and North America’s only active voluntary, legally binding integrated trading system to reduce emissions of all six major greenhouse gases (GHGs), with offset projects worldwide.

Papers and reports

Combining Rate-Based and Cap-and-Trade Emissions Polices, Resources for the Future
Allocation of CO2 Emission Allowances in the Regional Greenhouse Gas Cap-and-Trade Program, Resources for the future
Assessment of U.S Cap-and-Trade Proposals, Social Science Research Network, MIT

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Tags: Cap and Trade, Finance, Mitigation, Policy
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