Getting the Price Right: Cap and Trade

Last week, I talked about carbon taxes, which is one of the primary methods that governments can monetarily encompass the negative environmental externalities that come from irresponsible production. Now, I will discuss the cap and trade system, also known as emissions trading. The cap and trade system is very interesting in the sense that it literally creates a market for carbon. The government sets an overall cap on emissions and creates limited authorizations to emit, up to the level of the cap. Sources that emit pollution, such as factories, can buy or sell the authorizations or save them to use in the future. Cap and trade programs attempt to limit emissions economy-wide, covering industries such as electric power generation, natural gas, transportation, large manufacturers, and many more. Because there is an all-encompassing cap, the government doesn’t need to regulate how or where reductions are made. The government merely sets the emissions goal and subsequently monitors compliance. This gives the industry flexibility in determining how to comply. Sources can freely buy, sell, or save the permits to pollute. Every year, the government decreases the amount of permits given, so firms have to find innovative ways to decrease their emissions, or pay for additional permits.

One of the first successful cap and trade programs was the United State’s Acid Rain Program (ARP) that was established under the 1990 Clean Air Act. Rather than focusing on CO2 emissions, which is what most programs today concentrate on, the ARP focused on cutting emissions in sulfur dioxide and nitrogen oxides in the power sector, which are the most prominent cause of acid rain. The final 2010 sulfur dioxide cap was set at 8.5 mission tons, which is about one half of the emissions from the power sector in the 1980s according to the U.S. EPA.

The primary benefit of using a cap and trade program is that it’s a system built on using market-based incentives to reduce pollution. This allows the regulated sources the flexibility it needs to find the most cost-effective approach to reduce emissions. Because legislation doesn’t prescribe how emissions should be cut, firms have the flexibility to fulfill the emissions cap virtually any way they want. In the example of the Acid Rain Program, if a power plant facility exceeded the allowances allocated to them, it would reduce emissions either by installing pollution controls, changing the mix of fuels used in inputs, by scaling back operation, or by buying allowances from another firm that was well below the amount of emissions permits they were given.

Although cap and trade systems can be hugely successful in some instances, there are many defects of its implementation. One of the most prominent problems of cap and trade programs is the potential to overestimate the amount of emissions that should be allocated. In the early stages of the European Union Emissions Trading System, there was an over-allocation of emissions credits, which brought the value of the credits to zero and an overall increase in emissions. Obviously, there was substantial political backlash and has tried to be adjusted, but the initial mistake in the amount of permits can have negative effects on both the environment and the industry. Another problem is that many programs don’t have a consistent set of standards for how emissions credits were verified. This is primarily because of challenges with finding accurate methods for measuring emissions and bureaucratic inefficiencies. Fortunately, with improvements in technology, such as using satellite technology to provide more accurate CO2 emissions measurements and improve consistency in how measurements are carried out.

Most recently in the news of cap and trade policy, Xi Jiping announced that in 2017, China will enact an emission trading system designed to cut emissions and follow through with its goal of peaking their level of emissions by 2030. This is substantial because China is responsible for about 30 percent of global greenhouse emissions, so no climate change solution can be truly effective without China playing a central role. Although this is a huge step in the right direction, many are skeptical about whether or not China possesses the administrative ability to manage such a complex system. The cap and trade systems that tend to work best are those in countries that have a relatively small number of large emitters and a well-developed legal system. China is the opposite wherein they have a substantial amount of huge emitters, and their environmental regulatory system has proven to be sub par. Nevertheless, although there are questions about whether China’s carbon trading policy will actually lead to cuts in carbon emissions, it is seen as an important political move that is pushing the momentum forward for the upcoming climate talks in Paris this December.

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