Carbon Cap and Trade Systems
How It Works
The US Environmental Protection Agency (EPA) determines an acceptable level of carbon emissions and sets a limit, or cap, on these emissions. Depending upon their policy stance, the limit can be set to reduce emissions or prevent an increase in emissions (i.e. prevent future growth in emissions).
Permits are then issued to industries allowing for an emissions level in accordance with the desired cap. Industries are allowed to buy and sell permits to/from each other and a market emerges ensuring an efficient allocation of the permits.
The industries that emit less carbon will sell their permits while those that emit more will purchase those permits. Meanwhile, total carbon emissions in the US remain under the cap.
In theory, the system can be used to control all carbon emissions, including automobile emissions. Initiating a carbon cap and trade system can be done via two methods: auctioning off an initial set of permits or freely distributing the permits among current polluters.
Cost of Implementation 2
Administrative costs could be similar to a feebate system - a self-financed system of government imposed fees and rebates that are used to shift market purchasing preferences toward an economically, socially or politically desired goal - but the sale of permits could be used to boost government revenue.
Environmental Impact 2
As with the feebate system, certain energy sources can be discouraged, but investment into new technologies and new sources can be promoted.
Foreign Energy Useage 4
Some changes in energy importation may be made but change depends more on how willing industries or consumers are to buying new technologies.
Implementation 3
The United States' experience with an SO2 cap and trade system has primed it for a CO2 cap and trade system.
Political Toxicity 1
Politicians and the public have largely embraced the cap and trade system despite economists' misgivings.
Barriers to Future Use
- Industry lobby could act against an auction of initial permits, effectively taking away one of the two ways to distribute permits.
- Carbon emissions are a global problem, but emerging economies such as China would resist emission levels that are lower than those of the US (Mankiw, 2007).
Pros of Use
- Costs are internalized: Industries pay for the increased risk of harm to society.
- If auctioned the government can raise revenue via the sale of permits without a new tax (Baumol and Oats, 1988).
- On the other hand, the cost to industries is low if permits are freely distributed.
- The system has already been in use for SO2 (Sulfur dioxide) emissions (USEPA, 2002).
- Industries have an incentive to reduce costs by reducing pollution.
Cons of Use
- Industries face increased costs when searching for permit sellers (Portney, 2003).
- Strategic behavior of some industries may prevent an efficient market for the permits.
- Raising government revenue entails an increase in costs to industries.
- Industry lobby could unduly influence who gets the initial set of permits.
- It is difficult to adjust emissions levels incrementally when there is a large initial distribution of permits.
Case Studies
EU Inaugurates Multi-Nation Carbon Market
In January of 2005, the European Union introduced its Greenhouse Gas Emission Trading Scheme, the largest multi-country and multi-sector carbon cap and trade program in the world. An electronic registry similar to a modern banking system monitors all allowances and transactions. While still in the testing phase in the United Kingdom and Denmark, this mass experiment in cap and trade should prove a strong policy testing ground for carbon cap and trade systems.
For the full academic report submitted by EU Applicants, click here.
For more information on the EU's progress, click here.
Most Important Fact
The cap and trade system has been used in the US and in Europe with much success. It allows for a precise emissions level to be set, as in a legal mandate system, but accommodates industry by creating a market for the permits.
Bottom Line
Economists like the idea because it somewhat internalizes the social cost of pollution. That is, industries must pay to emit possibly harmful greenhouse gasses. If the cost is external, the industry pays no expense yet there is an increased risk of harm to society. There is a tradeoff between government revenue and the cost to industry. The government raises revenue if the initial set of permits is auctioned. If the initial set of permits are not auctioned, but instead given away, the government raises no revenue, but the cost to industries is lower.
