"Cap and Trade": Market Based Solutions to Climate Change
While there are many policy options to reduce greenhouse gas emissions and combat global climate change, all serious climate change policy recommendations have identified "cap-and-trade" as the regulatory mechanism of choice. A cap and trade policy utilizes market forces to achieve cost-effective environmental protection. The United States was at the forefront in designing and implementing cap and trade policy as part of the 1990 Clean Air Act to combat acid rain. The Economist magazine called the success of the cap and trade Acid Rain Program "probably the greatest green success story of the past decade."
Why do market-based environmental protections work so well?
- They increase environmental effectiveness and achieve superior environmental protection as compared to traditional command-and-control approaches. They achieve these dramatic environmental protection results by turning pollution reduction into marketable assets.
- Businesses have the flexibility to find the lowest-cost reductions and have direct financial incentives to find newer, better, faster, cheaper, and more innovative ways to reduce pollution. In addition, cap and trade programs create financial rewards for environmental performance.
- Because cap-and-trade gives pollution reductions a value in the marketplace, cap-and-trade prompt technological and process innovations that reduce pollution down to - and even below - required levels.
- An active cap-and-trade market enables those who can reduce pollution cheaply to earn a return on their pollution reduction investment by selling extra allowances. It enables those who can't reduce pollution as cheaply to purchase allowances at a lower cost than reducing their own emissions. It enables all participants to meet the total emissions cap cost effectively. And it gives all emitters incentives to innovate to find the least-cost solutions for total pollution control.
What are the key features of a 'Cap and Trade' policy?
- A mandatory emissions "cap" - This is a limit on the total tons of emissions that can be emitted. It provides the standard by which environmental progress is measured.
- Emission allowances - Each emission source is allocated emission allowances; each allowance represents a defined unit of pollution. To be in compliance a source must possess emission allowance equaled to or in excess of its current emissions. The difference between a source's allocated allowances and current emissions can be thought of as its regulatory burden or requirement. Allocation of allowances can occur via a number of different formulas; allocated based on historic emission levels and allocation auction are two possible formulas.
- Trading and Banking - A source that reduces its emissions below its allowances level may sell the extra allowances to another source. A source that finds it is more expensive to reduce emissions below its emissions allocation may purchase allowances from another source. Buyers and sellers may "bank" any unused allowances for future use.
- Clear performance criteria - At the end of the compliance period, each source must hold a number of allowances equal to its tons of emissions for that period, and must have measured its emissions accurately and reported them transparently.
- Flexibility - Sources have flexibility to decide when, where, and how to reduce emissions.