Cap and trade system

What Is Cap and trade system?

A cap and trade system is a market mechanism designed to control pollution control by providing economic incentives for reducing the emission of pollutants. Falling under the broader category of market-based environmental regulation, it sets an overall limit, or "cap," on the amount of a specific pollutant that can be emitted. Within this cap, permits or allowances are created, each typically representing the right to emit one unit of the pollutant (e.g., one ton of carbon emissions). These allowances can then be bought and sold in a market, allowing companies flexibility in how they achieve compliance. The cap gradually decreases over time, driving down overall emissions.

History and Origin

The concept of emissions trading, which forms the basis of the cap and trade system, began to gain traction in the late 20th century as policymakers sought more economically efficient ways to address environmental issues than traditional "command-and-control" regulations. One of the earliest and most successful implementations of a cap and trade system in the United States was the Acid Rain Program, established by Title IV of the 1990 Clean Air Act. This program targeted sulfur dioxide (SO2) and nitrogen oxides (NOx) emissions from power plants, which were major contributors to acid rain. The U.S. Environmental Protection Agency (EPA) reported significant reductions in acid rain-causing pollutants and associated environmental benefits under this system.⁹

Internationally, the cap and trade mechanism gained prominence with the adoption of the Kyoto Protocol in 1997. This international treaty committed industrialized nations to binding targets for reducing greenhouse gas emissions.⁸ The Kyoto Protocol established various flexibility mechanisms, including international emissions trading, which allowed countries that had emission units to spare to sell this excess capacity to countries that were over their targets, thereby creating a new commodity in the form of emission reductions.⁷ Following this, the European Union (EU) launched its Emissions Trading System (EU ETS) in 2005, becoming the world's first major carbon market and a cornerstone of the EU's climate policy.⁶,⁵

Key Takeaways

• A cap and trade system sets a limit (cap) on total emissions and allows companies to buy and sell permits (trade) to emit pollutants.
• It is a market-based approach that uses economic incentives to achieve environmental targets.
• The system aims to reduce emissions cost-effectively by allowing those who can reduce pollution cheaply to sell excess allowances to those for whom it is more expensive.
• Successful examples include the U.S. Acid Rain Program and the European Union Emissions Trading System.
• Over time, the cap is typically lowered to encourage further emission reductions.

Interpreting the Cap and trade system

The effectiveness of a cap and trade system is largely interpreted by its ability to achieve mandated emission targets at a lower overall cost to the economy compared to other regulatory approaches. When the price of an allowance in the carbon market rises, it signals that reducing emissions is becoming more valuable, thereby incentivizing investment in cleaner technologies and efficiency improvements. Conversely, a low allowance price might indicate that the cap is not stringent enough, or that there is an oversupply of allowances, which could reduce the incentive for emission reductions. The system's flexibility means that companies can choose between investing in abatement measures or purchasing allowances, based on which option is more cost-effective for them, leading to an overall reduction in pollution at the lowest marginal abatement cost.

Hypothetical Example

Consider a hypothetical country, "Econoville," which implements a cap and trade system to reduce industrial sulfur dioxide emissions. The government sets an annual cap of 10,000 tons of sulfur dioxide, allocating 100 allowances, each permitting 100 tons of emissions, among 10 industrial factories.

Factory A has invested heavily in pollution control technology and can reduce its emissions below its allocated 1,000 tons, perhaps emitting only 600 tons. This leaves Factory A with 400 tons (4 allowances) of unused emission capacity. Factory B, on the other hand, finds it very expensive to reduce its emissions and anticipates exceeding its 1,000-ton allocation, expecting to emit 1,200 tons.

Under the cap and trade system, Factory A can sell its 4 unused allowances to Factory B. If the market price for an allowance is $500 per ton, Factory A earns $2,000, while Factory B pays $2,000 to cover its excess emissions. This transaction benefits both factories: Factory A is rewarded for its early investment in cleaner technology, and Factory B avoids non-compliance penalties by purchasing the necessary allowances. Crucially, the total emissions in Econoville remain at or below the 10,000-ton cap, demonstrating how the system achieves environmental goals while providing economic flexibility.

Practical Applications

Cap and trade systems are primarily applied as a tool within environmental policy to mitigate pollution and address climate change. Beyond the historical U.S. Acid Rain Program, the most prominent example is the European Union Emissions Trading System (EU ETS), which covers over 10,000 power stations and industrial plants across EU member states, plus Iceland, Liechtenstein, and Norway. It is the largest carbon market globally and a key instrument for the EU to achieve its greenhouse gas reduction targets.,⁴

Various regional and national cap and trade trading systems have also been implemented worldwide, including in California, Quebec, and pilot programs in China. These systems provide a framework for industries to manage their carbon footprint while promoting innovation in cleaner production methods. Revenues generated from auctioning allowances are often reinvested in green technologies or climate change adaptation measures. The supply and demand for these allowances create a market price for emissions, influencing business decisions and driving the transition towards a lower-carbon economy. The European Commission provides detailed information on the EU ETS and its impact.³

Limitations and Criticisms

While often lauded for its economic efficiency, the cap and trade system faces several limitations and criticisms. One primary concern is the initial allocation of allowances; if too many allowances are issued, the price of permits can drop too low, weakening the incentive for polluters to reduce emissions. This over-allocation can lead to a surplus of allowances, undermining the system's effectiveness in achieving environmental goals.²

Another critique revolves around the potential for market volatility in allowance prices, which can create uncertainty for businesses making long-term strategic planning and capital budgeting decisions related to emission reductions. There are also concerns about "hot air," which refers to allowances from countries whose emissions targets were set too generously, allowing them to sell excess allowances without making actual emission cuts. Furthermore, some critics argue that a cap and trade system effectively legitimizes the right to pollute and can be politically challenging to implement due to debates over fairness, competitiveness, and the distribution of costs. The Council on Foreign Relations has discussed the complexities and debates surrounding greenhouse gas cap-and-trade programs.¹

Cap and trade system vs. Carbon Tax

The cap and trade system and a carbon tax are both market-based approaches to reducing greenhouse gas emissions, but they operate differently. A cap and trade system directly controls the quantity of emissions by setting a cap, allowing the market to determine the price of emissions allowances through price discovery. This offers certainty in emission reduction outcomes but introduces uncertainty in the cost to emitters.

Conversely, a carbon tax directly controls the price of emissions by imposing a fixed fee per unit of carbon emitted. This provides cost certainty for businesses but offers less certainty regarding the exact level of emission reductions achieved, as it depends on how industries respond to the tax. While a carbon tax simplifies revenue collection and can be easier to implement administratively, a cap and trade system is often preferred when a specific environmental target (the cap) is paramount, and the flexibility of trading allows for potentially lower overall abatement costs. Both mechanisms aim to internalize the externalities associated with pollution, transforming a public good problem into a market-based solution.

FAQs

How does a cap and trade system work?

A cap and trade system involves a government or regulatory body setting an overall limit (cap) on the amount of a specific pollutant that can be emitted. It then issues permits, known as allowances, up to that cap. Companies that need to emit the pollutant must acquire these allowances. If a company emits less than its allocated allowances, it can sell its surplus to other companies that emit more, creating a market for these allowances. Over time, the cap is reduced, leading to fewer available allowances and, consequently, a reduction in total emissions.

What is the goal of a cap and trade system?

The primary goal of a cap and trade system is to reduce specific pollutant emissions to a targeted level in an economically efficient manner. By creating a market for emissions, it incentivizes businesses to find the cheapest ways to reduce their pollution, whether through technological upgrades, process changes, or purchasing allowances from more efficient peers. This system aims to achieve environmental targets while minimizing the overall cost to the economy.

Who benefits from a cap and trade system?

Environmental quality typically benefits from the reduction in pollutants. Economically, companies that can reduce their emissions at a lower cost than the market price of allowances can profit by selling their excess permits. Conversely, companies facing high abatement costs can benefit by purchasing allowances rather than incurring prohibitively expensive emission reduction measures. Ultimately, the system aims for society as a whole to benefit from improved environmental health at a lower economic burden compared to alternative regulatory approaches.

Are cap and trade systems effective?

Proponents point to successful historical examples, such as the U.S. Acid Rain Program, which significantly reduced sulfur dioxide emissions. The EU ETS has also contributed to notable reductions in greenhouse gas emissions within the European Union. However, effectiveness can vary depending on the stringency of the cap, the design of the trading rules, and overall market conditions. Challenges include setting the appropriate cap, managing allowance surpluses, and ensuring robust monitoring and enforcement.

What types of pollutants are typically covered by cap and trade?

Cap and trade systems are most commonly associated with greenhouse gases, particularly carbon dioxide, in efforts to combat climate change. However, they have also been successfully applied to other pollutants, such as sulfur dioxide and nitrogen oxides, which cause acid rain. The system is generally suitable for pollutants that are emitted from numerous sources and can be aggregated and measured, allowing for the creation of a tradable allowance.