Cap and Trade

Cap and trade is one method for regulating and ultimately reducing the amount of pollution emitted into the atmosphere. It is viewed as a more democratic solution to regulating pollution than a carbon tax as it creates a commodity out of the right to emit carbon and allows the commodity to be traded on the free market.

How Cap and Trade Works

Pros & Cons

The Political Debate

US Legislation

A Successful Example

How It Works

The basic concept involves two parties, the governing body and the regulated companies or units emitting pollution. The government sets a cap on pollution, limiting the amount of carbon dioxide and other harmful output that companies, or other groups, are allowed to release. The government then issues credits which allow companies to pollute a certain amount, as long as the aggregate pollution equals less than the set cap.

Since some companies can reduce polluting emissions more inexpensively than other companies, they may engage in trading any extra permits. Companies that can more efficiently reduce pollution sell permits to companies that cannot easily afford to reduce pollution. The companies that sell the permits are rewarded while those that purchase permits must pay for their negative impact. Applied to climate change, this system would theoretically reduce carbon emissions at the lowest total cost.

Pros & Cons

PROS: The leading legislative bills project a cap and trade system can reduce carbon dioxide by over 80% of 2005 emission levels by 2050 and significantly reduce the rate of global warming. The system will also create billions of dollars for the government to spend on consumer energy programs. Current bills have indicated that government revenues derived from permit sales could be spent on public goods such as road improvements and national parks, as well as the possibility of personal checks being sent to households to offset energy costs.

CONS: What many fear is that if businesses and corporations are financially punished for their pollution emissions, the costs will eventually be handed over to the consumers. Basic economic principles state that if a good’s price increases, demand usually decreases. However, because energy production is an inelastic good, utility companies can drive up their sale price to cover their rising production costs without seeing a decrease in demand from their customers.

One proposed solution to this is for the government to redistribute the raised revenues from the system back into the economy to help alleviate consumers’ costs. For example, if the Environmental Protection Agency raises $1 billion from Cap and trade revenues and fines, they could reinvest that money in fuel efficient cars or another clean technology to ultimately help lower costs for consumers in other energy sectors.

Read more about the proposed policies below in ‘Cap & Trade Legislation’.

The Political Debate around Cap and Trade

Economists debate whether a cap and trade system or a carbon tax is more effective in reducing carbon emissions. Currently, the European Union has instituted an Emissions Trading Scheme that utilizes cap and trade principles, and the same system is favored in American policy debates. Many view the cap and trade system as having the same ultimate effects as the carbon tax, but many politicians have yet to agree.

President Obama favors a cap and trade system of curbing carbon emissions over a direct carbon tax. He also advocates using the revenue generated from this cap and trade system to invest in the development of clean energy and energy efficiency, thus making it a double dividend system.

Successful cap and trade systems need to have an extremely strict and knowledgeable governing body. Accountability on the part of the companies involved is the biggest concern for anyone trusting the cap and trade system to work. Politicians in the past have simply supported or disagreed with cap and trade through discourse, but future legislation could change that.

Present and Future Cap and Trade Legislation

In June of 2009 the Waxman-Markey bill was passed in the U.S. House of Representatives. This bill outlines a broad cap and trade system to regulate CO2 emissions. The target levels start at around a 3% reduction by 2012; 20% by 2020; 42% by 2030; and 83% by 2050.

The goals of the bill sound optimistic, but the costs of the bill are still unclear. Proponents of the bill have touted that the consumer cost per household could be as little as $175 per year for clean energy, while opponents say the price would be much higher, around $1,900 for a family of four.

Private energy utilities are typically against such legislation, fearing that a cap and trade system would only drive up their production costs. Some companies have even threatened their customers with projected, increased bills to try and warn them of the ramifications of such environmental programs.

Another bill that has yet to be introduced to Congress is the Kerry-Boxer “Clean Energy Jobs and American Power Act.” This bill, similar to the Waxman-Markey bill, plans for 80% reduction in CO2 emission levels by 2050 through a market driven solution for pollution reduction. The Kerry-Boxer places a big emphasis on solving America’s homeland security and creating jobs for millions of Americans.

The Waxman-Markey and Kerry-Boxer bills are both examples of cap and trade based pollution reduction programs that attempt to solve other social and health problems as well.

A Successful Cap and Trade Example

In 1995 the United States Environmental Protection Agency became aware of heightened occurrences of acid rain in the Midwest and the Northeast. In response, the EPA created the Acid Rain Program and developed one of the first market based cap and trade mechanisms in the country.

The occurrence of acid rain was attributed to high levels of Sulfur Dioxide (SO2) being emitted from mostly coal burning electric plants across the Midwest. Beginning in 2000 the sources were capped at 9.5 million tons of SO2 (compared to 1980 emission levels of 17.3 million tons) and the plants were held responsible for lowering their levels to those standards from 1995 until 2000. The EPA then issued each plant a certain number of credits, or allowances equal to one ton of SO2 emissions. At the end of every year, each plant would have to report to the EPA whether or not they had enough credits for their emissions, (i.e. a plant that emitted 6,000 tons of SO2 would need to hold 6,000 credits). Those under the cap could save their excess credits for the future, or sell them to other plants that were in danger of going over their limit.

This trading aspect gave the electric plants financial incentives to lower their emissions because each credit held a monetary value on the free market. If a plant went over their limit and was unable to purchase or trade for other credits, they would have to pay a fine to the EPA for each additional ton of SO2 emitted into the atmosphere.

The Acid Rain Program has been an incredible success even to this day, and has been a major influence in lowering the annual SO2 emissions all the way from 17.3 million tons in 1980 to an estimated 8.95 million tons in 2010.


The main goal behind a cap and trade system is to lower greenhouse gas emissions, but it has yet to be decided if it is the best solution. Many economists and politicians say that a carbon tax would work much better, leaving out the chance for a misused market open to being taken advantage of. Almost everyone agrees that greenhouse gas emissions need to be lowered in order to slow down climate change; but there isn’t the same agreement over the best method to do so.

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For More Information
Read about the cap and trade conundrum on ecomii blogs

Read about the vote in the U.S. House of Representatives approving the American Clean Energy and Security Act

Learn what’s happening in the world of clean tech on our renewable energy blog.