Cap and trade systems

What Is Cap and Trade?

Cap and trade systems are market-based environmental policies designed to reduce pollution, particularly greenhouse gas emissions, by establishing a limit on total emissions and allowing entities to trade emission permits. As a core concept within environmental economics, a cap and trade system operates on two main principles: a "cap" and a "trade." The "cap" sets a mandatory limit on the total amount of a specific pollutant that can be emitted by all regulated sources within a given period. This limit is progressively lowered over time, driving overall emission reductions. The "trade" component allows companies that have reduced their emissions below their allocated permits to sell their surplus allowances to other companies that are exceeding their limits. This creates a carbon market where the allowances are bought and sold, providing a financial incentive for companies to reduce pollution in the most cost-effective way.

History and Origin

The concept of using market mechanisms to address environmental concerns gained traction in the latter half of the 20th century. While early ideas for tradable permits emerged in the 1960s, the first significant application of a cap and trade system was in the United States to reduce acid rain-causing sulfur dioxide emissions under the 1990 Clean Air Act amendments. This program demonstrated the efficacy of market-based approaches in achieving environmental goals efficiently. Internationally, the framework for emissions trading was formalized as one of the flexible market mechanisms under the Kyoto Protocol. Adopted in 1997, the Kyoto Protocol allowed countries with emission units to spare to sell them to countries that were over their targets, thereby creating an international market for carbon.²⁵, ²⁶, ²⁷, ²⁸, ²⁹

The United Nations Framework Convention on Climate Change (UNFCCC) officially recognized emissions trading under Article 17 of the Kyoto Protocol.²³, ²⁴ This established a framework where binding greenhouse gas emission targets for industrialized countries could be met through a combination of domestic action and market-based mechanisms, including the buying and selling of emission units.²⁰, ²¹, ²²

Key Takeaways

• Cap and trade systems set a firm limit (cap) on the total amount of certain pollutants that can be emitted, typically greenhouse gas emissions.
• Companies receive or purchase allowances, each representing the right to emit a specific amount of the pollutant.
• These allowances can be traded in a market, incentivizing companies to reduce their emissions if it is cheaper than buying more allowances.
• The cap is reduced over time, ensuring a progressive decrease in overall pollution.
• The system aims to achieve environmental targets at the lowest possible economic cost by allowing flexibility in where emissions reductions occur.

Formula and Calculation

While there isn't a single "formula" for a cap and trade system in the traditional sense, its operation relies on the interplay of the total emissions cap, the number of allowances, and the resulting market price.

The core principle involves the relationship between a company's actual emissions and the allowances it holds. For compliance, a company must surrender allowances equal to its total emissions:

If a company emits (E) tonnes of carbon dioxide equivalent and holds (A) allowances, its compliance position is:

• If (A > E), the company has surplus allowances that can be sold.
• If (A < E), the company must purchase additional allowances from the market or reduce emissions to achieve compliance.

The market price of an allowance, often referred to as the carbon price, is determined by supply and demand within the trading system.

Interpreting the Cap and Trade System

Interpreting a cap and trade system involves understanding its objective of reducing overall pollution while offering flexibility to emitters. The cap defines the maximum permissible emissions, which provides certainty for environmental outcomes. By lowering this cap over time, the system signals a clear trajectory for emission reductions. The price of allowances in the market serves as a direct indicator of the marginal cost of abatement. A higher allowance price indicates that it is becoming more expensive for companies to reduce their emissions, suggesting a tighter cap or high demand for allowances. Conversely, a lower price might suggest an oversupply of allowances or less stringent reduction efforts. This pricing mechanism incentivizes investment in cleaner technologies and operational efficiencies to avoid the cost of purchasing additional allowances.

Hypothetical Example

Consider "GreenCo" and "PolluteCorp," two manufacturing companies operating under a new cap and trade system where each allowance permits one tonne of carbon dioxide equivalent emission. The initial cap allocates 100 allowances to GreenCo and 100 to PolluteCorp, for a total cap of 200 tonnes.

GreenCo invests in new, more efficient machinery and manages to reduce its emissions to 70 tonnes for the year. It now has 30 surplus allowances (100 allocated - 70 emitted). PolluteCorp, facing higher costs to upgrade its old equipment, emits 120 tonnes. It is short 20 allowances (120 emitted - 100 allocated).

Under the cap and trade system, PolluteCorp can buy the 20 allowances it needs from GreenCo. If they agree on a price of $20 per allowance, GreenCo earns $400 (20 allowances * $20/allowance), rewarding its investment in cleaner technology. PolluteCorp pays $400, which is less than the cost of implementing immediate, expensive emission reductions. The total emissions for the two companies remain at 190 tonnes (70 from GreenCo + 120 from PolluteCorp), which is below the 200-tonne cap, demonstrating how the system achieves the overall environmental goal while providing economic efficiency for participants.

Practical Applications

Cap and trade systems are primarily applied as a significant tool in climate change mitigation efforts, particularly for controlling greenhouse gas emissions. One of the most prominent examples is the European Union Emissions Trading System (EU ETS), established in 2005. It is the world's first and largest international emissions trading system, covering emissions from power and heat generation, energy-intensive industrial sectors, and aviation.¹⁶, ¹⁷, ¹⁸, ¹⁹ The EU ETS plays a central role in the EU's policy framework to combat climate change, with a cap that is reduced annually to achieve emissions reductions.¹⁴, ¹⁵

Another notable application is California's Cap-and-Trade Program, launched in 2013 by the California Air Resources Board (CARB). This program is a cornerstone of California's strategy to reduce greenhouse gas emissions across various sectors, covering approximately 85% of the state's emissions.¹⁰, ¹¹, ¹², ¹³ It provides a declining cap on emissions and generates revenue from auctioning allowances, which is then reinvested into initiatives like renewable energy and energy efficiency programs.⁹

Limitations and Criticisms

Despite their effectiveness, cap and trade systems face several limitations and criticisms. One common critique is the potential for price volatility in the market for allowances, which can create uncertainty for businesses trying to plan long-term investments in emission reduction technologies.⁷, ⁸ If the price of allowances becomes too low, it may not provide sufficient incentive for companies to reduce emissions, as seen in early phases of the EU ETS where an oversupply of permits led to a collapse in carbon prices.⁶

Another significant concern is related to environmental justice. Critics argue that while total emissions may fall, pollution can concentrate in specific communities, particularly near heavy industry, if companies choose to buy allowances rather than reduce local emissions. Studies in California, for instance, have indicated that some low-income and minority communities experienced increased local pollution despite overall state-wide emission reductions.⁵ This highlights the need for place-based safeguards and targeted reinvestments within such systems. Furthermore, the administrative complexity of setting up and maintaining a robust cap and trade system, including monitoring, reporting, and verification processes, can be a challenge.⁴ The initial allocation of allowances can also be a politically contentious issue, as it involves significant distributional impacts.³

Cap and Trade vs. Carbon Tax

Cap and trade systems are often compared to a carbon tax, another market-based approach to pollution control. The fundamental difference lies in how they manage the cost and quantity of emissions. A cap and trade system sets a firm limit (the "cap") on the total quantity of emissions allowed, and the market then determines the price of those emissions (the allowance price). This provides certainty about the maximum level of pollution, but the cost to businesses can fluctuate.

In contrast, a carbon tax directly sets a price per unit of emissions. This provides certainty about the cost of emitting pollution, but the resulting total quantity of emissions is not fixed; it depends on how businesses and consumers respond to that price. While both aim to internalize the cost of pollution and incentivize emissions reductions, cap and trade offers greater certainty over the environmental outcome (the cap), whereas a carbon tax offers greater certainty over the financial burden per unit of emission.

FAQs

What is the main goal of a cap and trade system?

The main goal of a cap and trade system is to reduce the total amount of specific pollutants, like greenhouse gases, released into the atmosphere by setting an overall limit (cap) on emissions and creating a market for pollution allowances. This encourages businesses to find the most cost-effective ways to reduce their emissions.

How do companies comply with a cap and trade system?

Companies comply by ensuring they hold enough emission allowances to cover their total emissions for a given period. If they emit less than their allocated allowances, they can sell the surplus. If they emit more, they must purchase additional allowances from other companies or from government auctions.

Who benefits from cap and trade?

The environment benefits from a guaranteed reduction in overall emissions. Companies that innovate and reduce their emissions efficiently can benefit by selling their surplus allowances. The revenue generated from the auction of allowances can also be used by governments to fund environmental initiatives or provide support for a just economic transition.

Are cap and trade systems effective?

Proponents argue that cap and trade systems can be highly effective in reducing emissions cost-effectively because they leverage market forces to incentivize reductions where they are cheapest. Historical examples, such as the U.S. acid rain program and large-scale initiatives like the EU ETS, demonstrate their capacity to achieve significant environmental improvements.¹, ² However, their success heavily depends on effective policy design, a credible and declining cap, and mechanisms to ensure market stability.

What is an "allowance" in a cap and trade system?

An allowance, often called an emission permit or carbon credit, is a tradable authorization to emit a specific quantity of a pollutant, typically one tonne of carbon dioxide equivalent. Companies must surrender one allowance for each tonne of pollution they emit, making these allowances the currency of the cap and trade market.