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Cap and Trade

Contents

Introduction

Cap-and-trade refers to a class of regulatory instruments that create a property right for the ability to pollute, and distribute permits to that right up to a regulatory limit. For climate change, the limit usually applies to carbon-equivalent emissions of greenhouse gases.

Theory

The original theory underpinning cap-and-trade regulatory systems was developed by W. David Mongeomery in the early 1970s.[1] It operates by converting a social bad - pollution of common airspace - into a private property right, namely the right to pollute a certain amount. That property right is embodied in permits to pollute a certain quantity, which are assigned through one or several mechanisms to major polluters. Emissions control is achieved by capping the number of permits available at the desired level of pollution.

Permit assignment can have significant distributional effects. The creation of a permitting or allowance system also creates a property right with economic value. Allocation schemes are thus different ways of distributing this value. Free allocation based on historic baseline emissions effectively transfers most of the value of the ability to pollute to historic high-emitters; auctioning permits, on the other hand, can capture some of the commons value for society, which can then be used in various other ways. Allocation schemes may also have distributional consequences at the individual level; research suggests that higher-income individuals benefit from free allocation more than lower-income individuals. Proponents of permit auctioning suggest that the revenues from auctions be allocated to offset the distributional effects of higher energy and goods prices that result from firms passing on higher energy costs to consumers.[2] Most policy options under serious consideration combine free allocation with auctioning. For instance, the European Union allows up to 10% of permits to be auctioned off in the present phase of operations; that ceiling is set to rise in future periods.

Economic theory suggests that, whether permits are sold or given away, the effect on end-consumer prices in competitive industries will remain the same. The creation of a property right will also create a value for that property. If firms must acquire that right on the market, they will pass on the cost of acquisition to consumers at a rate determined by the price elasticity of demand for their products. In the case of very inelastic demand, such as for electricity, consumers will bear most of the permit cost. If firms are given permits for free, they still face a decision between using those permits themselves, or selling the asset on the market. The opportunity cost of either choice will be incorporated into the prices that consumers will pay for that good.[3] The exception to this general principle comes in the regulated utilities sector. Burtraw and Palmer have shown that free allocation of permits to monopoly utilities with regulated prices will compensate end-users for most of their losses, while in unregulated markets it results in a significant overcompensation of firms for their costs.[4]

Where the cap should be set remains a topic of significant debate. More stringent caps earlier on may prevent additional damange to the environment, but can impose large economic costs. Firms may find that they are unable to immediately make the necessary investments to reduce emissions while maintaining production levels, resulting in job losses and potential firm failure. Alternatively, the technologies required to achieve significant emissions reductions may not be immediately available. Indeed, creating incentives to develop these technologies is one purpose of imposing the cap.

For these reasons, most cap-and-trade systems impose relatively liberal caps at the start of the program, which then become more stringent over time. If the policy of increased stringency has credibility, companies will invest in R&D early in the program, with the expectation that tigher caps in the future will create markets for those technologies.


Comparison with Carbon Taxation

In theory, regulations using quantity instruments like caps are equivalent to regulations that use price instruments, such as taxation. In practice, where markets and information are imperfect, this may not be the case. Martin Weitzman has shown that the choice of a cap versus a tax should depend on how the nature of the problem affects the potential costs of getting the cap or tax level wrong.[5] For instance, if there are large costs of pollution exceeding a certain level, then a hard cap may be the best regulatory method of avoiding these costs. In contrast, if errors in the cap level may impose very large economic costs, then the tax provides a way of guaranteeing the approximate economic cost while ensuring some level of pollution reduction. To account for the potentially rapid cost increases of a emissions cap set too low, some cap-and-trade system designs include a permit price ceiling, at which the government intervenes to issue additional permits to hold down overall economic cost.[6]

Implementation

Other pollution problems

The most successful use of cap-and-trade systems has been the United States acid rain program, which sought to reduce emissions of acid-rain-causing sulfur dioxide and nitrous oxides in the northeastern United States. The program became part of the 1990 Clean Air Act. Over the intervening 19 years, covered emissions have falled by . The United States Environmental Protection Agency estimates the benefit-to-cost ratio of the acid rain reduction program at more than 40:1.[7] The success of emissions trading for these emissions made the acid rain program a model for future programs like the Emissions Trading Scheme.[8]

Climate Change

Existing climate change policy has favored cap-and-trade systems over carbon taxation. Only one major industrialized nation, Sweden, has a significant carbon tax.

Economic theory aside, taxation has been viewed as preferable to cap-and-trade systems on the grounds that it is harder to circumvent or manipulate; and that circumvention or manipulation are more obvious when they do occur. Cap-and-trade systems require several new institutions to administer the cap, monitor compliance with it, and auction or otherwise assign the permits. These institutions, like all governmental institutions, are vulnerable to influence, capture by special interests, and corruption.

Cap-and-trade also has numerous potential complexities that may create additional administrative costs or disguise abuses. Many cap-and-trade designs provide for banking of pollution permits over time, which can make the level of emissions in any period unpredictable. The creation of new markets for trading of pollution permits will inevitably lead to the creation of new financial instruments for hedging, short selling, and speculation on the value of pollution permits. In perfect markets these instruments can push the market toward equilibrium. However, experiences in the financial markets have suggested that these features can also result in market distortions that risk major downsides.

In practice, political factors have superseded these regulatory problems. For instance, concerns about political sovereignty and the concentration of power in Brussels have traditionally led European Union member states to prevent Brussels from assessing its own taxes. Taxes remain one of the areas of European Union policy that require unanimous rather than majority votes. Evidence suggests that European policymakers understood the potential benefits of a carbon tax, but viewed unanimous consent as an impossibility. Cap-and-trade legislation, in contrast, could pass with only majority approval in the European Parliament.[9] For better or for worse, cap-and-trade systems provide more visible evidence of potential emissions reduction while obscuring the cost of implementation. Firms also prefer cap-and-trade because it becomes much more likely that at least a portion of their emissions can continue cost-free under grandfathered permits. For instance, in Europe, the initial two periods of the ETS grandfathered at least 90% of all permits. Only a few countries chose to auction off the remaining 10%.


Evidence of results

Because operating carbon cap-and-trade systems have existed for only brief periods, their full effect is difficult to quantify. Currently, significant emissions trading regimes operate in Europe, the United Kingdom, and New South Wales. Canada is in the process of developing an emissions market that will begin operations in 2010.[10] Finally, the Chicago Climate Exchange operates a purely voluntary private market for industrial members.

European Emissions Trading Scheme

The European Emissions Trading Scheme (ETS) intends to target the Kyoto Treaty goal of emissions reductions to 1990 levels by 2020. All European Union member states are required to participate, though obligations differ based on level of economic development and whether the members are former Soviet satelites. The ETS is presently in its second 4-year operations period; the third will begin in 2012. The first period was intended only as a trial, and targeted minimal emissions reductions. The second period was to begin serious emissions reductions, which will continue in the future.

The ETS targets emissions from industrial operations and electricity generation. Transportation is presently not included. The European Commission has published a white paper outlining options for including aviation in the Trading Scheme for the third assessment period.[11]

Permits and Allocation

Permits in the ETS originate from two primary sources. The first and most significant source are emissions allowances distributed by the governments of the European Union member states. Member states can choose to allocate permits, known as European Union Allowances, through either free distribution or auction; the percentage available for auction was set very low for Phase I but will increase to 10% for Phase II and continue to rise for Phase III and beyond.

In addition to internal allocation, the ETS participates in the Clean Development Mechanism (CDM). The CDM allows emitters in advanced industrial countries to earn emissions credits through investment in clean technologies in developing countries. It operates on the theory that such investments avoid the emissions that would have been incurred if those countries had built the same power or industrial capacity themselves, using cheaper but dirtier options. These projects may also be more economically efficient than projects in the firm's home country.

Percentagewise, European Union Allowances constitute approximately 19% of the total volume of transactions within the ETS for 2007.[12]

Emissions Pricing

Initial results have been mixed. The initial years of operation suffered from over-allocation of permits that made permit prices extremely volatile. Uncertainty about future permit allocation caused firms to initially hoard permits, driving their price up; when those permits were later dumped on the trading market, the price plummeted to near-zero levels.

European Union Allocation prices on the European Carbon Exchange, .
European Union Allocation prices on the European Carbon Exchange, .


This extreme price volatility in early periods works against the intended effect of encouraging long-run changes to investment decisions. Prices for the second period, beginning in 2008, have behaved with greater predictability, suggesting that regulators and firms have learned from earlier bouts of overallocation-induced price instability. There remains some concern that Phase II has underallocated permits relative to its intended cap, which may cause much higher prices for traded allocations later in the period.[13]

Emissions reductions

Emissions reduction results are difficult to establish. The first period of the EU ETS was not intended to accomplish significant emissions reductions. Ellerman and Buchner[14] find that emissions trading in the period may have contributed to an emissions reduction of 0.4-8.1% depending on assumptions about well baseline emissions data would predict emissions behavior in the absence of the carbon price.

The second period, beginning in 2008, had more stringent caps for emissions and a higher percentage of auctioned emissions permits. The emissions outcomes of this period await additional evidence before they can be fully assessed. On paper, the planned cap would achieve a 6% reduction in emissions compared with verified 2005 levels.[15] The reductions will disproportionately come from the EU-15 advanced industrial economies. The newer EU-12 members, nearly all of whom continue to recover from communism, will be allowed to increase their overall emissions level by approximately 3.6% over the 2005 benchmark.

New South Wales Emissions Market

The New South Wales (NSW)emissions market began operations on 1 January 2003 and covers emissions from electricity generation only. It was to operate until 2021, or until the establishment of a nationwide emissions trading scheme. With the announcement of such a scheme by the outgoing Howard government in late 2007, and reconfirmation by the Rudd government, the NSW will eventually merge with a national Australian system.

Permits and Allocation

The NSW scheme set benchmark levels for participating producers. Emissions in excess of these benchmarks incurred fines equivalent to a per-ton price on carbon. Producers could avoid these fines by generating permits through investments in emissions abatement. These could be either demand-side investments in energy efficiency or supply-side investments in low-emissions energy production. Producers who generated abatement credits in excess of their need could trade credits with other producers.

History of Operations

The NSW permit scheme operated from 2003 to mid-2007. As of mid-2007, the incoming Rudd government indicated that a national carbon regulation system would eventually subsume the NSW system. Reports suggest that the uncertainty created by this announcement led to the collapse in NSW permit prices, which fell from a high of approximately AU $12/ton to $6/ton.[16]

Chicago Climate Exchange

The Chicago Climate Exchange is a purely voluntary carbon market for American corporations. Operations began in late 2003. As of 2007, it claimed 51 voluntary members with independently verified carbon emissions performance.

Separately, the Chicago Climate Exchange also provides services for trading sulfur dioxide permits used under the United States Environmental Protection Agency's Acid Rain Program, and Ozone Season permits issued under Environmental Protection Agency's NOx Budget Trading Program.

Permits and Allocation

The Chicago Climate Exchange generates permits in a manner similar to the NSW scheme. Members agree to a pre-set emissions reduction baseline and are issued Exchange Allowances equivalent to that reduction schedule. Reductions below that baseline generate credits that can be sold through the exchange. Further credits can be earned through the purchase of emissions offsets from third-party providers, or investment in offset projects. Year-end audits establish whether a participant's emissions reduction performance plus acquired offsets meets the emissions target.

All emissions by participating firms, regardless of geographic location, fall under CCX caps.

Emissions pricing

Emissions pricing under the CCX is a purely market-determined price under a voluntary cap. Operational prices have fluctuated in the $1-7 range since its inception.

CCX carbon futures pricing for the entire history of operations.
CCX carbon futures pricing for the entire history of operations.

Emissions reductions

CCX emissions reductions were established for two baseline periods: , and . Phase I reduction goals were set at 4% relative to baseline. Phase II called for a further reduction to 6$ below baseline for continuing members; new members had weaker requirements. Baselines were established based on historical emissions for .

The CCX uses outside emissions audits to establish its effect on emissions against a historical baseline. As of 2007, its auditors reported that CCX members emitted 467 million metric tons carbon dioxide equivalent, 4.2% below the targeted 487 million metric ton target for the year.[17]

Potential United States action

The United States is a signatory to the 1998 Kyoto Treaty, but the Executive Branch has never submitted the treaty for Senate ratification. At present, no national carbon emissions control mechanism operates in the United States. Several states, including California, Oregon, ***, have state-level greenhouse gas abatement mechanisms that make use of caps. These programs are in their infancy.

As of May 2009, the United States Congress was debating the Waxman-Markey bill, which included a cap-and-trade scheme for United States carbon emissions.[18] The final status of that bill remains unclear. Presently, it antcipates free allocation of permits up to 90% of the emissions level of electrical power producers, and numerous additional free allocation of allowances to offset costs of investments in alternative energy, to protect trade-exposed jobs, and to protect consumers from final price increases. These allocations are subject to expiration or renewal pending future assessment of need.[19]


  1. ↑ "Markets in licenses and efficient pollution control programs" Journal of Economic Theory , pp 395-418.
  2. ↑ For a short discussion of these issues, see Joseph Aldy and William Pizer, "Issues in Designing U.S. Climate Policy" Resources for the Future Discussion Paper RFF-DP-08-20, available at [[1]]
  3. ↑ Terry Dinan, "Trade-offs in Allocating Allowances for CO2 Emissions", Congressional Budget Office, 25 April 2007. Available at [[2]]. Last accessed 20 May 2009.
  4. ↑ Dallas Burtaw and Karen Palmer, "Compensation Rules for Climate Policy in the Energy Sector", Resources for the Future Discussion Paper RFF-DP-07-41. Available at [[3]]. Last accessed 20 May 2009.
  5. ↑ Martin L. Weitzman, "Prices vs. Quantities" The Review of Economic Studies 41(4) (October 1974), pp. 477-491.
  6. ↑ Such a provision was part of Senate Bill S.1766, which set an initial price ceiling at $12/ton CO2e, with subsequent increases at a real rate of 5%. S.2191 did not include a price ceiling. Presently, the Waxman-Markey bill in the United States Congress
  7. ↑ "Acid Rain Program 2007 Progress Report", United States Environmental Protection Agency. 2007. Available at [[4]]. Last accessed 17 May 2009.
  8. ↑ Frank Convery, Denny Ellerman, and Christian de Perthus "The European Carbon Market in Action: Lessons from the First Trading Period." CEEPR Working Paper WP-. Available at [[5]]
  9. ↑ Donald MacKenzie, "The Political Economy of Carbon Trading" London Review of Books 5 April 2007.
  10. ↑ "Turning the Corner: Regulatory Framework for Industrial Greenhouse Gas Emissions", Environment Canada, March 2008. Available at [[6]]. Last accessed 21 May 2009.
  11. ↑ [[7]]
  12. ↑ Calculations based on figures provided in Karen Capoor and Philippe Ambrosi, "State and Trends of the Carbon Market 2008" The World Bank, 2008.
  13. ↑ Financial analysts estimate potential shortfalls at between 90-200 MtCO2e for Phase II, and 200-400 MtCO2e for Phase III. See table 4 in Karen Capoor and Philippe Ambrosi, "State and Trends of the Carbon Market 2008" The World Bank, 2008.
  14. ↑ "Overallocation or Abatement? A Preliminary Analysis of the EU ETS Based on Emissions Data" Environmental and Resource Economics 41:267-287. 2008.
  15. ↑ Karen Capoor and Philippe Ambrosi, "State and Trends of the Carbon Market 2008" The World Bank, 2008. pp 9.
  16. ↑ Marian Wilkinson, "It's not easy being green" Sydney Morning Herald 14 September 2008. Available at [[8]]. Last accessed 21 May 2009.
  17. ↑ "2007 Program-wide Compliance Report". Chicago Climate Exchange, 31 December 2008. Available at [9]
  18. ↑ House Resolution 2454, "The American Clean Energy and Security Act". Draft for Public Comment. At [10]. See also updates as of 18 May 2009, at [11].
  19. ↑ Chairman Harry A. Waxman and Chairman Edward J. Markey, "Proposed Allocation Allowance", 14 May 2009, at [12]. Last referenced 18 May 2009.
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