by Hannah Stewart –
Credited with ending the problem of acid rain and predicted to help solve climate change, cap and trade is a market-based approach to environmental regulation. Under cap and trade programs, governments set limits, or “caps,” to how many pollutants an industry is allowed to emit. Any company that releases fewer emissions can sell its unused allotment at market value to other companies in the industry who are struggling to meet the cap.
Supporters of a cap and trade system argue that gives companies some degree of flexibility in achieving emission reductions, encourages companies to reduce emissions faster, and reward innovations that cut emissions in new, cost-efficient ways.
Reducing Emissions for a Profit
As mentioned earlier, cap and trade is a type of market-based environmental policy. Unlike command-and-control approaches, which set rigid performance standards or dictate the use of specific technologies, cap and trade allows individual companies to decide for themselves how they can most cost-effectively meet the cap.
Prior to the start of the program, governments need to set an emission cap, or how many total tons of emissions per year will be permitted across the entire industry. Ideally, this decision will be made with guidance from environmental scientists and other experts in the field and could potentially be used to regulate any kind of pollution. Historically, the U.S. has experienced great success with sulfur dioxide; Now, in the U.S. and in other countries, cap and trade is being used to limit carbon dioxide and other greenhouse gas emissions.
Once the cap is decided and the program begins, emitters will be required to hold “allowances” in order to stay in operation. Each allowance permits companies to release one ton of emissions. For context, you would need to drive from New York to Las Vegas, which is 2,400 miles, in order to release the same amount of carbon dioxide.
In some cases, a government may choose to give away a few strategic allowances to certain companies in order to prevent emission “leakage,” which is when emissions are released from unregulated industries. However, it is far more common for allowances to be sold or auctioned off. The price of each allowance is determined by economic supply and demand on the open market.
Since allowances do not mandate that companies use a specific method in order to meet the cap, companies can choose whatever strategy best works for their unique financial situation.
Some emitters will succeed in reducing their emissions far below the cap. When this happens, those companies are allowed to sell their excess allowance allotment to any other company that may be struggling to meet the cap. Once again, the value of this extra allowance is decided by market supply and demand, which means that overachieving companies may be able to turn a profit by coming in under the emissions cap.
A Practical Example: Cap and Trade vs Command-and-Control
The above chart from Encyclopaedia Brittanica uses two electrical plants to demonstrate the financial benefits of cap and trade over command-and-control.
In this example, prior to the implementation of any new regulations, Plant A and Plant B each produce 100 tons of emissions. Under a command-and-control system, new governmental regulations would require each plant to cut their emissions in half. It costs Plant A $100 to reduce 1 ton of emissions, which results in a total cost of $5,000 in order to meet the new regulations. For Plant B, however, it costs $200 to reduce 1 ton of emissions for a total of $10,000. This difference could be because Plant B is an older building or because Plant B is further away from resources and thus has higher expenses. In any case, in order to reduce total emissions by 100 tons, Plants A and B would need to spend $15,000.
Now, let’s try this scenario again, but with a cap and trade program instead. Plants A and B each still start off emitting 100 tons of emissions and they still need to reduce their total emissions by 100 tons. This time, though, each plant holds an allowance for 50 tons. Plant A is still more efficient, can reduce its emissions for $100/ton. However, Plant A now has an incentive to reduce its emissions further. Any further reduction that the plant achieves can be sold on the open market to other, less efficient plants like Plant B. Since Plant B either doesn’t want to or can’t afford to spend $10,000 on emission reductions, they will buy Plant A’s excess allowance. In this example, Plant B will be allowed to release a total of 75 tons of emissions this year, which would only cost them $5,000 (plus the price of the allowance they bought from Plant A). At the end of the year, both plants have collectively reduced their total emissions to the 100-ton cap, but only spent $12,500 to do it.
Over time, the industry cap is going to shrink and fewer allowances will be available for purchase. This incentivizes companies to continue to reduce their emissions while keeping their own costs down.
Successful implementation requires continuous and accurate monitoring. According to the U.S. Environmental Protection Agency, “Those that don’t have enough allowances to cover their annual emissions are automatically fined and must surrender future year allowances to cover any shortfall.”
Conservative Government and the Environmental Defense Fund: An Unlikely Alliance
Although recent political campaigns and debates have framed conservation and climate change as “left” or Democratic issues, the United States’ first national cap and trade system was drafted and passed by conservative governments.
In the 1980s, new air quality data blamed fossil fuel-burning power plants in the Midwest for the acid rain that was killing forests and lakes in the Northeast and Canada. President George H. W. Bush had vowed to cut acid rain in half during his election campaign, but did not yet have a plan to make it happen. Environmentalists at the time called for the Environmental Protection Agency to enforce a command-and-control approach that required emitters to install scrubbers on their smokestacks. In contrast, utility companies feared the cost of installing the scrubbers, in the political sphere, command-and-control had already fallen out of favor during the Reagan administration. As a Conservative, President Bush wanted a strategy that came at the least cost to industry.
Boyden Gray, a White House lawyer during the Reagan and H. W. Bush administrations and heir to a multimillion-dollar tobacco fortune, suggested that the government could use the free market to incentivize reducing emissions. Gray invited Fred-Krupp, President of the Environmental Defense Fund, to collaborate on developing a program that they called “emissions trading.”
The Environmental Protection Agency and environmentalists initially distrusted the idea of emissions trading. Early small-scale experiments had failed and many feared that allowances would become a way for polluters to buy their way out of fixing the problem.
On the other side, utilities worried that a single allowance would trade for $500-$1,000, costing them $5 billion – $25 billion each year.
Cap and trade got the chance to prove its worth in 1989 when President Bush’s administration proposed amendments to the Clean Air Act. Unlike the earlier small-scale experiments conducted by the Environmental Protection Agency, the amendment eliminated the bureaucratic overhead formed from a complicated system of permits and credits. All that government regulators could do in this version was monitor emissions and administer financial penalties to any emitters that exceeded their limit.
This version passed and became known as the Clean Air Act of 1990.
This bill established a cap on sulfur dioxide emissions that would go into effect in 1995. Power plants were required to collectively cut their sulfur dioxide emissions by 10 million tons per year.
For the first few years after the act passed, utilities remained skittish about buying allowances and fretted about the risk. It wasn’t until the White House ordered the Tennessee Valley Authority, a federally-owned power plant, to start buying allowances for $250 in 1992 that the market began to run with the cap and trade system.
In 1995, emissions fell by 3 million tons, already far ahead of the target schedule. In the following decade, emissions were down by 40%. Utility compliance had cost only $3 billion, which is one-fourth the projected cost.
Cap and Trade vs Carbon Tax
When the government and other policy-makers debate different ways to address environmental problems, cap and trade is often contrasted against carbon tax programs. The two are considered inverses of each other.
As we’ve seen, cap and trade is designed around knowing what future overall emissions are going to be while the price of those emissions is up for the market to decide.
Carbon tax, on the other hand, is a price set by the government that emitters must pay for each ton of greenhouse gas emissions they release. In other words, the price of the emissions is already known, but the future quantity that will be released is variable. The assumption behind carbon tax policies is that companies will want to reduce their emissions in order to reduce their costs over time, but this is not guaranteed.
Carbon tax proposals have been presented to Congress several times, but none have passed yet. British Colombia, Alberta, Canada, and Boulder, Colorado all currently have carbon taxes at a local level.
Cap and Trade in Action
Since 2012, in collaboration with the Environmental Defense Fund, California has been using an expansive cap and trade system to reduce its greenhouse gas emissions, specifically carbon dioxide (There are several different kinds of greenhouse gases, but Earth has more carbon dioxide in its atmosphere than any other kind). This impressively broad program covers 80% of the state’s total emissions. The program went into effect in 2013 for electricity generators and large industrial facilities and, starting in 2015, began to impact “distributors of transportation, natural gas, and other fuels.” The California Air Resources Board lowers the emissions cap by 2%-3% each year.
California raised its goal in 2016 and now aims to reduce its total carbon dioxide emissions to 40% lower than what the state was emitting in 1990 by the year 2030.
Due to the program’s success, California linked its cap and trade program with Québec, meaning that companies in each region can now trade emission allowances with each other.
On an international scale, China, the current leader in greenhouse gas emissions, launched a national carbon market in 2017. This cap and trade program is going to be the largest emissions trading system in the world, covering 2,600 companies and 258 million people. The first phase of the program only covers power plants, but China’s energy sector produces 65% of its energy from fossil fuels and releases 3.5 gigatons of carbon dioxide emissions each year. This cap and trade program is also expected to boost already growing clean energy industry.
Potential Downfalls to Cap and Trade
So far, this article has presented cap and trade as unilaterally good: it can prevent global warming and other environmental disasters by reducing emissions, it rewards innovative companies for finding cost-effective methods and technologies, and it has a proven history of success at multiple scales.
However, “the devil is in the details.” Cap and trade programs are not easy to design or implement. There are many ways to go wrong. For example, as seen with the Environmental Protection Agency’s early experiments, the system doesn’t work if the government needs to approve each trade before it goes into effect. That level of oversight increases transaction costs above what the market would be otherwise willing to buy and sell them for.
Additionally, cap and trade runs the risk of exacerbating leakage issues. If the market value of allowances is too high or if changing their behavior is too expensive, some industries may decide to move their business to another area that is not covered by the cap and trade program. Emissions will “leak” out of the system if businesses attempt to continue as normal.
Cap and trade may also face an uphill battle in the public eye. Many people see allowances as “the right to pollute.” It can be extremely difficult to generate support for a program that appears to permit businesses to continue to release pollutants with minimal government oversight.
At the end of the day, and with 30 years of experience to look back on, cap and trade is neither a panacea guaranteed to fix all our environmental problems and nor is it permission for companies to continue “business as usual” without repercussions. Cap and trade is a clever environmental policy measure that was created by stakeholders that normally operate on opposite ends of the political spectrum. There are several successful historical and current examples of how cap and trade can work, but they tend to be very complicated. If cap and trade is going to save the world, it will succeed by itself; it will need support from the government, industry, and the public.
Is cap and trade effective?
It can be. Cap and trade programs are usually quite complicated and are often combined with other programs, such as offsets, which offer companies another way to comply with the emission cap, even if they can’t reduce their own emissions enough. Effective cap and trade programs need careful consideration, minimal government oversight, and support from utilities. Without that support, some companies may leak out of the system in order to avoid needing to comply.
Who supports cap and trade?
Economically-oriented environmental organizations, like the Environmental Defense Fund, helped found America’s first cap and trade system and believe in cap and trade’s potential to reduce environmental disasters like climate change. The Environmental Defense Fund is also currently involved in developing other cap and trade programs.
Conservative-leaning politicians are also likely to support cap and trade. This style of policy measure thrives on minimal government regulation and prioritizes the advantages of a free market.
What is the earliest use of cap and trade?
While there are records of economists theorizing about the success of similar systems since the early twentieth century, cap and trade as it is known today was first implemented in the United States as part of the Clean Air Act of 1990. This act was a response to sulfur dioxide pollution from fossil fuel power plants in the Midwest killing forests and aquatic life in the Northeast and Canada. The bill cut emissions in half, at one-quarter the cost, and faster than predicted. Since then, multiple countries have implemented their own cap and trade programs.
Is cap and trade a law?
Cap and trade is a regulatory law in some countries, in some states, and for some industries. Cap and trade systems are currently in place for sulfur dioxide in the United States, for carbon dioxide in California, nationally in China, in the European Union, and in 12 New England and Mid-Atlantic states.