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Carbon Cap and Trade
CLIMATE CHANGE AND POLICY
Contents Carbon Cap and Trade Carbon Offsets Carbon Taxes Clean Development Mechanism Climate Change and Food Situation Dealing with the Uncertainty about Climate Change Double Dividend Economics of Forest Carbon Sequestration as a Climate Change Mitigation Strategy Intergovernmental Panel on Climate Change (IPCC) International Climate Treaties and Coalition Building
Carbon Cap and Trade G Wagner, Environmental Defense Fund, New York, NY, USA; Columbia University’s School of International and Public Affairs, New York, NY, USA ã 2013 Elsevier Inc. All rights reserved.
Glossary Banking Saving carbon allowances for future use within a cap-and-trade system, decreasing emissions earlier than mandated by the cap. Borrowing Using carbon allowances from future years to comply with earlier emissions reduction goals, increasing emissions in early years and leading to steeper reductions later. Carbon allowance A permit to emit one metric ton of carbon dioxide or carbon dioxide equivalent greenhouse gas emissions. Leakage Carbon emissions moving from under a cap to outside the system due to differential incentives, increasing total emissions in the process. Linkage Formal or informal connection across cap-andtrade systems to allow use of allowances generated in one jurisdiction for compliance in another; has the effect of equilibrating prices assuming full fungibility.
Cap and trade is just this: a cap on total emissions and a system that allows trading to achieve that limit as costeffectively as possible (Figure 1). It creates a market and a price on emissions, where there typically was none before. This article surveys cap and trade for carbon dioxide and greenhouse gases more broadly: how it works in theory, how it compares to other policy approaches, how it ought to be designed given particular objectives, and how it has been applied in practice.
Encyclopedia of Energy, Natural Resource and Environmental Economics
Market failure In this context, a situation when markets allow participants to pass costs of their activities onto others without immediate economic repercussions, typically associated with situations where some parties benefit from a particular activity, while others pay for the consequences. Offsets Use of emissions reductions generated outside the cap-and-trade system to comply with the cap (can apply either to reductions from sources in an uncapped jurisdiction or from uncapped sources within a capped jurisdiction). Upstream Point of regulation near the point of fuel extraction and processing, where the number of regulated entities is small and prices will be passed down throughout the entire economy. Contrast with downstream point of regulation, closer to the fuel consumers and (indirect) emitters.
Cap and Trade Defined Global warming is the result of one of the largest market failures facing the planet. We all benefit from activities that pollute the atmosphere without taking these consequences into account in our economic decisions. Energy generation tops that list. Fossil fuels have long provided the cheapest form of energy, but it is only so cheap when we do not account for the consequences of pollution.
http://dx.doi.org/10.1016/B978-0-12-375067-9.00071-1
1
Climate Change and Policy | Carbon Cap and Trade
Price of emissions reductions
2
Be n m efit or s re e u of o n du n ct it of e ion s
A 2
e on of it of s t n s u ns Co ore ctio m edu r
Carbon tax sets price... ...resulting in carbon price. B ...resulting in quantity abated. 1
Carbon cap sets quantity...
Quantity of emissions reductions
Figure 1 Carbon cap and trade explained (illustration by Jonathan Fetter-Vorm). Reproduced from Wagner G (2011) But Will the Planet Notice? New York: Hill & Wang, with permission.
Carbon cap and trade enables us to take these consequences into account. It is commonly described as a ‘market-based’ solution to environmental problems. In fact, it is a market. Cap and trade removes the market failure by creating a market for emissions, limiting total pollution while making polluting costly and pollution reduction pay. The idea comes in two parts: a cap on pollution and the flexibility to meet it. Government – backed by climate science – sets the limit on overall pollution. It sells or freely distributes allowances, each representing the right to emit 1 ton of carbon dioxide, the total number adding up to the size of the cap for that year. Allowance recipients are free to trade the allowances among themselves and with other market participants. That flexibility is the ingredient that creates markets and empowers everyone to act in his or her own self-interest, while reducing overall emissions. The cap is typically set to decline over time, ensuring that overall carbon emissions do, too. Assuming that all innovation has been fully anticipated, a declining cap would go hand in hand with increasing allowance prices over time, making carbon emissions increasingly costly. That need not and should not be the case. In a well-designed program, the cap’s declining path is set well in advance to enable businesses to plan ahead and invest and innovate accordingly. As a result, carbon prices may decline hand in hand with carbon emissions. The carbon allowance price will be as high as necessary and as low as possible to achieve emissions reductions set by the declining cap. In the end, the goal is a low cap and a low price. That is one key difference from a carbon tax, which sets ever higher prices for carbon emissions.
Cap and Trade Versus Tax Cap and trade on the one hand and taxes on the other represent two sides of the same graph (Figure 2). One regulates the quantity emitted, with the price being set through the market. The other sets the price, with the quantity emitted being determined by how businesses react to the new price for pollution.
Figure 2 In theory, carbon caps and taxes are equivalent absent uncertainties and market frictions.
Figure 2 translates these quantities emitted into resulting emissions reductions. If the costs of decreasing carbon emissions were known and did not change over time, absent uncertainties and other market frictions, carbon caps and carbon taxes would be the same. In practice (as well as theory), there are some significant differences. Since regulators will know neither the benefits nor costs of emissions reductions with certainty, the ratio of their relative uncertainties matters. A tax will tend to be preferred on economic efficiency grounds when the benefits curve is relatively flatter and smoother than the cost curve, giving the regulator more confidence that its estimated price will produce approximately the right quantity despite inherent uncertainties. A cap will tend to be better when the benefit curve of abatement is steeper than the cost curve, making getting the quantity right more important. Carbon accumulates in the atmosphere and remains there for a long time. That stock nature of carbon pollution tends to flatten the benefits curve for emissions reductions, favoring taxes. The underlying scientific uncertainty around the exact benefits of carbon abatement and the possible existence of unknown and often unknowable thresholds points toward steeper benefit curves for cumulative emissions, favoring caps. Similarly, proper cap-and-trade design, in particular banking and borrowing of allowances (see section Cap-andTrade Design Principles), will tend to smooth cost curves and again favor caps (Figure 3). Political economy is another important factor. Here, too, the final verdict depends on the particular circumstances. What is the likelihood that the political process will yield a carbon tax that is too low compared to what is necessary? What is the likelihood that the same process will yield a carbon cap that is set too high? One political economy argument clearly favors caps: Regardless of how the regulator chooses to allocate individual allowances among businesses and other stakeholders and how allowance prices develop over time, a cap ensures the environmental integrity of the system. The upper limit stays in place. Industry might find cheap ways to comply with overall emissions limits, driving compliance costs and the resulting carbon price down – yet overall emissions still fall to the level of the
Climate Change and Policy | Carbon Cap and Trade
3
Small potential uncertainty around carbon price
1
Steep abatement benefits due to uncertain thresholds... 2
3
...and flat costs due to cap-and-trade design...
...favor setting carbon caps over prices.
Large potential uncertainty around quantity abated Figure 3 Inherent scientific uncertainties around benefits tend to favor properly designed cap-and-trade systems, depicted by the relative slope of benefit and cost curves in this graph.
cap. With a tax, the lower the price on carbon, the more is being emitted. Every tax credit, every form of tax relief increases overall emissions. In the long run, a cap-and-trade system could have stringent limits and low prices. Under a tax, the price would remain high unless and until politics decreases the tax level. And once it does, emissions may increase again.
Cap-and-Trade Design Principles Successful cap-and-trade systems share several important features. The emissions cap needs to be based on science, decline over time, be predictable and known well in advance, and be strictly monitored and enforced to ensure compliance. The range of compliance options and trading components ought to be as broad and flexible as possible (while remaining as tightly enforced as necessary), enabling carbon allowances to be traded across covered businesses, geographies, sectors, and time. The more flexible the system, the cheaper it will be to comply, which in turn enables more ambitious emissions reduction targets. The fundamental goal of a cap-and-trade system is to limit emissions. For carbon cap and trade, the goal is limiting emissions enough to avoid dangerous global warming as indicated by the best available climate science. Given the global nature of the problem, the ideal carbon cap-and-trade system would therefore establish global emissions reduction goals. The limited progress in the United Nations climate negotiations process has increasingly prompted action at the national level, as well as by multinational regions (notably the European Union – EU) and by subnational jurisdictions such as states, provinces, and cities. In this case, the individual caps ought to not only follow climate science but also notions of fairness of how much each jurisdiction needs to reduce its emissions as part of a wider global effort. Predictability is key. Knowing the path of the overall cap well in advance allows businesses to plan investment decisions, which decreases compliance costs. Coupled with trading allowances across time, it allows smoother allowance price
paths by letting allowance holders bank allowances for the future or borrow them to use sooner. Banking allowances implies greater emissions reductions sooner; borrowing allowances implies more emissions today in exchange for steeper reductions going forward. Other more intricate design features may also be important to the success of a cap-and-trade system. One important decision is around the points of regulation: upstream in the economy at the level of energy and fuel producers or distributors with fewer covered entities, or further downstream at the level of individual emitting facilities with more covered entities and possibly more flexibility. Another is the allocation of allowances: carbon allowances are valuable commodities. Each allows for 1 ton of carbon dioxide emissions and, thus, equals the value polluters are willing to pay in order to emit that ton. How allowances are distributed turns out to have little bearing on the final environmental outcome. The overall cap remains in place regardless of who gets the individual allowances. If allowances are given to polluters, they obtain the right to pollute at low or even negative cost. If allowances are auctioned by the government or given to other stakeholders, polluters pay for each ton emitted, while government or others such as households collect the revenues. The allocation mechanism could follow either of these two cases or some combination of the two. Similarly, governments can decide what to do with the collected revenue from auctioned allowances: refund the money directly to households, reduce taxes, spend it, or pursue more than one. Flexibility is key in controlling costs. Other features may be able to help reduce costs even further. ‘Allowance reserves’ are pools of allowances under the total cap that are not distributed to businesses right away. These allowances can then be offered for sale at strategic times, such as to moderate volatility in allowance prices. Another potential cost-control mechanism is allowing purchases of reductions made outside the cap-and-trade system, often called ‘offsets.’ That could happen either through government funds or by covered businesses themselves. The atmosphere does not notice where on the planet carbon
Climate Change and Policy | Carbon Cap and Trade
emissions are being reduced. In principle, emissions reductions outside the cap have the same environmental effect as if covered businesses reduce their own emissions. An important design decision is what criteria to use in crediting these offsets, as well as potentially how many offsets to allow inside the capand-trade system. The atmosphere certainly does notice if overall emissions go up, so offset programs need to be structured in a way that encourages nations and other jurisdictions to adopt overall caps of their own. One possible mechanism to that effect is to phase out the use of offsets from jurisdictions that have not capped overall emissions by a particular time. Lastly, it is essential that any offsets program include rigorous elements to ensure offset quality and protect against conflicts of interest to make sure that offsets constitute real reductions. Similarly, ‘linkages’ of cap-and-trade systems allow increased flexibility of compliance by enabling businesses covered under one jurisdiction’s cap to trade with businesses or other entities covered by a cap-and-trade system elsewhere. Linking multiple cap-and-trade systems ensures that the widest possible array of people are developing and sharing low-cost ways to reduce emissions. In the end, linkages enable more flexibility while, once again, keeping total reductions the same. As long as some countries cap emissions while others do not, some businesses will face the right incentives to decrease their emissions but not others. That is likely to lead to competitiveness concerns, and a need to combat emissions ‘leakage’: instead of operating in a place that has a cap-and-trade system, one could imagine a company moving abroad and then exporting its products back to the home market to reach the same consumers. In fact, companies are moving across borders but most often for other reasons. In any case, a simple way to reduce leakage is to require importers to hold the same allowances as domestic producers on the basis of their products sold. These border carbon adjustments reduce incentives for businesses to move abroad and, properly designed, may also motivate other countries to put in place cap-and-trade systems of their own.
Lastly, every cap-and-trade system requires proper regulation and oversight. Authorities ought to prevent those trying to corner the market or exhibit other forms of anticompetitive or abusive behavior. This is clearly not unique to cap and trade, and it is similar to regulatory oversight of any market. An essential element of accountability is ensuring that all emitters subject to the cap are held responsible for meeting their emissions reductions obligations, and face stiff penalties for any emissions in excess of the allowances they hold (as well as obligations to make up the difference). A further element for consideration could be a system of ‘buyer liability,’ where it is in the interest of the buyer of allowances to ensure the integrity of those allowances – whether they are from within the system, from other systems via linkage, or in the form of offsets. Buyer liability comes into play because ultimately it is the holder of the allowance who needs to be able to submit it for compliance with the regulator.
Cap-and-Trade Experience An increasing number of countries and regions are implementing and planning carbon cap-and-trade systems: from the EU to Australia and New Zealand to the Northeastern United States and California to cities such as Tokyo. The European Union’s Emissions Trading Scheme (EU ETS) is the world’s largest carbon cap-and-trade system involving individual companies. It was designed as a part of a broader cap-and-trade system established under the Kyoto Protocol at the level of countries. The EU program began full operations in 2008. Even before, during the 3-year initial trial phase, which was marked by an overallocation of allowances that caused the price to plummet once it was revealed, the EU ETS reduced emissions by between 2% and 5% relative to what emissions would have been otherwise. The declining cap during the compliance period all but guarantees further emissions reductions (Figure 4).
11
Carbon emissions (million tonnes)
2700
10 2500 9 2300
8 7
2100 6 1900
5 4
EU real GDP (trillions)
4
1700 3 1500
1990
1995
2000 Counterfactual emissions The cap
2005
2010
2015
2
ETS emissions EU GDP (2000$, trillion)
Figure 4 Emissions decreases within the European Union Emissions Trading Scheme. Source: EU Emissions Data: A. Denny Ellerman, unpublished manuscript, reviewed November 2011. EU GDP data: World Bank.
Climate Change and Policy | Carbon Cap and Trade
The EU ETS has achieved those reductions at lower than projected costs, which has led to significant criticism around its low carbon price not sending a sufficiently strong price signal. Low carbon prices in many ways point to a feature of cap and trade rather than a flaw. Still, they do point to significant emissions reductions potential and suggest that it may be possible to tighten the EU cap sooner than currently mandated by law. The Regional Greenhouse Gas Initiative (RGGI) covers power generators in the Northeastern United States. It has been in operation since 2009 and has provided valuable benefits to the region as well as policy lessons. Its emissions reductions have come at very low cost, most often attributed to an overallocation of allowances in the system, indicating a clear need to lower the actual cap. While RGGI was always meant to be a precursor for a US national system, California’s system scheduled to begin in 2013 is to date the most comprehensive and ambitious US cap-and-trade system. It encompasses greenhouse gases beyond carbon as well as likely linkages with other jurisdictions and is the flagship policy as part of a whole-scale initiative to decarbonize California’s economy akin to the EU’s efforts. Australia for its part is designing a hybrid cap-and-trade and price system, beginning with a carbon price in mid-2012 and transitioning into cap and trade by 2015. New Zealand’s system has been fully operational since 2010 and harbors its own important policy lessons, with a design focused on upstream regulations and comprising forestry emissions under its cap. Moreover, several other countries and regions are looking into implementing cap and trade. China is piloting regional cap-and-trade systems as part of its twelfth 5-year-plan, and other countries, regions, and cities are at various stages of developing a program. All told, the policy community is learning valuable lessons on the design and operation of carbon cap-and-trade systems, and beginning to achieve significant emissions reductions in the process.
Summary Carbon cap and trade is an important policy tool in the attempt to hold polluters accountable for their pollution and limit overall greenhouse gas emissions. Differences with carbon taxes may seem arcane but are important for the final outcome. Caps limit emissions; taxes set the price. Limiting emissions, of course, also sets a price, which is key to
5
incorporating a particular cost of pollution that provides incentives for polluters to reduce emissions. The two mechanisms are not mutually exclusive and, in a vacuum, they have the exact same effect. In practice, there are important differences. The final verdict will depend on particular political circumstances. Policy design is at least as important as policy choice. Successful cap-and-trade systems share some key characteristics comprised of policy predictability to enable long-term planning and investments, flexible mechanisms to decrease compliance costs, and appropriate competitiveness provisions. In the end, the most important feature for achieving the environmental goal is a firm, strictly enforced, declining cap on emissions.
See also: Allocation Tools: Environmental and Natural Resource Economics: Decisions Under Risk and Uncertainty; Climate Change and Policy: Carbon Taxes; Clean Development Mechanism; Dealing with the Uncertainty about Climate Change; Double Dividend; Markets/Technology Innovation/Adoption/Diffusion: Policy Incentives for Energy and Environmental Technological Innovation: Lessons from the Empirical Evidence; Technological Change and Climate Change Policy; Technology and Environmental Policy; Policies/Incentives: European Union’s Emissions Trading System; Green Tax Design in the Real (Second-Best) World; Price Instruments; Prices versus Quantities; Quantity Instruments; SO2 Program; Policy Tools: Individual Transferable Quotas in Fisheries; Political Economy: Political Economy of Instrument Choice; Strategic Environmental Policy.
Further Reading Aldy JE, Krupnick AJ, Newell RG, Parry IWH, and Pizer WA (2010) Designing climate mitigation policy. Journal of Economic Literature 48(4): 903–934. Aldy JE and Stavins RN (2012) Using the market to address climate change: Insights from theory and experience. Daedalus 141(2): 45–60. Ellerman AD, Convery FJ, and de Perthuis C (2010) Pricing Carbon: The European Union Emissions Trading Scheme. Cambridge: Cambridge University Press. Keohane NO (2009) Cap and trade, rehabilitated: Using tradable permits to control U.S. greenhouse gases. Review of Environmental Economics and Policy 3(1): 42–62. Nordhaus WD (2007) To tax or not to tax: Alternative approaches to slowing global warming. Review of Environmental Economics and Policy 1: 26–44. Nordhaus WD (2008) A Question of Balance. New Haven, CT: Yale University Press. Wagner G (2011) But Will the Planet Notice? New York: Hill & Wang. Weitzman ML (1974) Prices vs. quantities. Review of Economic Studies 41(4): 477–491.
Contents Carbon Cap and Trade Carbon Offsets Carbon Taxes Clean Development Mechanism Climate Change and Food Situation Dealing with the Uncertainty about Climate Change Double Dividend Economics of Forest Carbon Sequestration as a Climate Change Mitigation Strategy Intergovernmental Panel on Climate Change (IPCC) International Climate Treaties and Coalition Building
Carbon Cap and Trade G Wagner, Environmental Defense Fund, New York, NY, USA; Columbia University’s School of International and Public Affairs, New York, NY, USA ã 2013 Elsevier Inc. All rights reserved.
Glossary Banking Saving carbon allowances for future use within a cap-and-trade system, decreasing emissions earlier than mandated by the cap. Borrowing Using carbon allowances from future years to comply with earlier emissions reduction goals, increasing emissions in early years and leading to steeper reductions later. Carbon allowance A permit to emit one metric ton of carbon dioxide or carbon dioxide equivalent greenhouse gas emissions. Leakage Carbon emissions moving from under a cap to outside the system due to differential incentives, increasing total emissions in the process. Linkage Formal or informal connection across cap-andtrade systems to allow use of allowances generated in one jurisdiction for compliance in another; has the effect of equilibrating prices assuming full fungibility.
Cap and trade is just this: a cap on total emissions and a system that allows trading to achieve that limit as costeffectively as possible (Figure 1). It creates a market and a price on emissions, where there typically was none before. This article surveys cap and trade for carbon dioxide and greenhouse gases more broadly: how it works in theory, how it compares to other policy approaches, how it ought to be designed given particular objectives, and how it has been applied in practice.
Encyclopedia of Energy, Natural Resource and Environmental Economics
Market failure In this context, a situation when markets allow participants to pass costs of their activities onto others without immediate economic repercussions, typically associated with situations where some parties benefit from a particular activity, while others pay for the consequences. Offsets Use of emissions reductions generated outside the cap-and-trade system to comply with the cap (can apply either to reductions from sources in an uncapped jurisdiction or from uncapped sources within a capped jurisdiction). Upstream Point of regulation near the point of fuel extraction and processing, where the number of regulated entities is small and prices will be passed down throughout the entire economy. Contrast with downstream point of regulation, closer to the fuel consumers and (indirect) emitters.
Cap and Trade Defined Global warming is the result of one of the largest market failures facing the planet. We all benefit from activities that pollute the atmosphere without taking these consequences into account in our economic decisions. Energy generation tops that list. Fossil fuels have long provided the cheapest form of energy, but it is only so cheap when we do not account for the consequences of pollution.
http://dx.doi.org/10.1016/B978-0-12-375067-9.00071-1
1
Climate Change and Policy | Carbon Cap and Trade
Price of emissions reductions
2
Be n m efit or s re e u of o n du n ct it of e ion s
A 2
e on of it of s t n s u ns Co ore ctio m edu r
Carbon tax sets price... ...resulting in carbon price. B ...resulting in quantity abated. 1
Carbon cap sets quantity...
Quantity of emissions reductions
Figure 1 Carbon cap and trade explained (illustration by Jonathan Fetter-Vorm). Reproduced from Wagner G (2011) But Will the Planet Notice? New York: Hill & Wang, with permission.
Carbon cap and trade enables us to take these consequences into account. It is commonly described as a ‘market-based’ solution to environmental problems. In fact, it is a market. Cap and trade removes the market failure by creating a market for emissions, limiting total pollution while making polluting costly and pollution reduction pay. The idea comes in two parts: a cap on pollution and the flexibility to meet it. Government – backed by climate science – sets the limit on overall pollution. It sells or freely distributes allowances, each representing the right to emit 1 ton of carbon dioxide, the total number adding up to the size of the cap for that year. Allowance recipients are free to trade the allowances among themselves and with other market participants. That flexibility is the ingredient that creates markets and empowers everyone to act in his or her own self-interest, while reducing overall emissions. The cap is typically set to decline over time, ensuring that overall carbon emissions do, too. Assuming that all innovation has been fully anticipated, a declining cap would go hand in hand with increasing allowance prices over time, making carbon emissions increasingly costly. That need not and should not be the case. In a well-designed program, the cap’s declining path is set well in advance to enable businesses to plan ahead and invest and innovate accordingly. As a result, carbon prices may decline hand in hand with carbon emissions. The carbon allowance price will be as high as necessary and as low as possible to achieve emissions reductions set by the declining cap. In the end, the goal is a low cap and a low price. That is one key difference from a carbon tax, which sets ever higher prices for carbon emissions.
Cap and Trade Versus Tax Cap and trade on the one hand and taxes on the other represent two sides of the same graph (Figure 2). One regulates the quantity emitted, with the price being set through the market. The other sets the price, with the quantity emitted being determined by how businesses react to the new price for pollution.
Figure 2 In theory, carbon caps and taxes are equivalent absent uncertainties and market frictions.
Figure 2 translates these quantities emitted into resulting emissions reductions. If the costs of decreasing carbon emissions were known and did not change over time, absent uncertainties and other market frictions, carbon caps and carbon taxes would be the same. In practice (as well as theory), there are some significant differences. Since regulators will know neither the benefits nor costs of emissions reductions with certainty, the ratio of their relative uncertainties matters. A tax will tend to be preferred on economic efficiency grounds when the benefits curve is relatively flatter and smoother than the cost curve, giving the regulator more confidence that its estimated price will produce approximately the right quantity despite inherent uncertainties. A cap will tend to be better when the benefit curve of abatement is steeper than the cost curve, making getting the quantity right more important. Carbon accumulates in the atmosphere and remains there for a long time. That stock nature of carbon pollution tends to flatten the benefits curve for emissions reductions, favoring taxes. The underlying scientific uncertainty around the exact benefits of carbon abatement and the possible existence of unknown and often unknowable thresholds points toward steeper benefit curves for cumulative emissions, favoring caps. Similarly, proper cap-and-trade design, in particular banking and borrowing of allowances (see section Cap-andTrade Design Principles), will tend to smooth cost curves and again favor caps (Figure 3). Political economy is another important factor. Here, too, the final verdict depends on the particular circumstances. What is the likelihood that the political process will yield a carbon tax that is too low compared to what is necessary? What is the likelihood that the same process will yield a carbon cap that is set too high? One political economy argument clearly favors caps: Regardless of how the regulator chooses to allocate individual allowances among businesses and other stakeholders and how allowance prices develop over time, a cap ensures the environmental integrity of the system. The upper limit stays in place. Industry might find cheap ways to comply with overall emissions limits, driving compliance costs and the resulting carbon price down – yet overall emissions still fall to the level of the
Climate Change and Policy | Carbon Cap and Trade
3
Small potential uncertainty around carbon price
1
Steep abatement benefits due to uncertain thresholds... 2
3
...and flat costs due to cap-and-trade design...
...favor setting carbon caps over prices.
Large potential uncertainty around quantity abated Figure 3 Inherent scientific uncertainties around benefits tend to favor properly designed cap-and-trade systems, depicted by the relative slope of benefit and cost curves in this graph.
cap. With a tax, the lower the price on carbon, the more is being emitted. Every tax credit, every form of tax relief increases overall emissions. In the long run, a cap-and-trade system could have stringent limits and low prices. Under a tax, the price would remain high unless and until politics decreases the tax level. And once it does, emissions may increase again.
Cap-and-Trade Design Principles Successful cap-and-trade systems share several important features. The emissions cap needs to be based on science, decline over time, be predictable and known well in advance, and be strictly monitored and enforced to ensure compliance. The range of compliance options and trading components ought to be as broad and flexible as possible (while remaining as tightly enforced as necessary), enabling carbon allowances to be traded across covered businesses, geographies, sectors, and time. The more flexible the system, the cheaper it will be to comply, which in turn enables more ambitious emissions reduction targets. The fundamental goal of a cap-and-trade system is to limit emissions. For carbon cap and trade, the goal is limiting emissions enough to avoid dangerous global warming as indicated by the best available climate science. Given the global nature of the problem, the ideal carbon cap-and-trade system would therefore establish global emissions reduction goals. The limited progress in the United Nations climate negotiations process has increasingly prompted action at the national level, as well as by multinational regions (notably the European Union – EU) and by subnational jurisdictions such as states, provinces, and cities. In this case, the individual caps ought to not only follow climate science but also notions of fairness of how much each jurisdiction needs to reduce its emissions as part of a wider global effort. Predictability is key. Knowing the path of the overall cap well in advance allows businesses to plan investment decisions, which decreases compliance costs. Coupled with trading allowances across time, it allows smoother allowance price
paths by letting allowance holders bank allowances for the future or borrow them to use sooner. Banking allowances implies greater emissions reductions sooner; borrowing allowances implies more emissions today in exchange for steeper reductions going forward. Other more intricate design features may also be important to the success of a cap-and-trade system. One important decision is around the points of regulation: upstream in the economy at the level of energy and fuel producers or distributors with fewer covered entities, or further downstream at the level of individual emitting facilities with more covered entities and possibly more flexibility. Another is the allocation of allowances: carbon allowances are valuable commodities. Each allows for 1 ton of carbon dioxide emissions and, thus, equals the value polluters are willing to pay in order to emit that ton. How allowances are distributed turns out to have little bearing on the final environmental outcome. The overall cap remains in place regardless of who gets the individual allowances. If allowances are given to polluters, they obtain the right to pollute at low or even negative cost. If allowances are auctioned by the government or given to other stakeholders, polluters pay for each ton emitted, while government or others such as households collect the revenues. The allocation mechanism could follow either of these two cases or some combination of the two. Similarly, governments can decide what to do with the collected revenue from auctioned allowances: refund the money directly to households, reduce taxes, spend it, or pursue more than one. Flexibility is key in controlling costs. Other features may be able to help reduce costs even further. ‘Allowance reserves’ are pools of allowances under the total cap that are not distributed to businesses right away. These allowances can then be offered for sale at strategic times, such as to moderate volatility in allowance prices. Another potential cost-control mechanism is allowing purchases of reductions made outside the cap-and-trade system, often called ‘offsets.’ That could happen either through government funds or by covered businesses themselves. The atmosphere does not notice where on the planet carbon
Climate Change and Policy | Carbon Cap and Trade
emissions are being reduced. In principle, emissions reductions outside the cap have the same environmental effect as if covered businesses reduce their own emissions. An important design decision is what criteria to use in crediting these offsets, as well as potentially how many offsets to allow inside the capand-trade system. The atmosphere certainly does notice if overall emissions go up, so offset programs need to be structured in a way that encourages nations and other jurisdictions to adopt overall caps of their own. One possible mechanism to that effect is to phase out the use of offsets from jurisdictions that have not capped overall emissions by a particular time. Lastly, it is essential that any offsets program include rigorous elements to ensure offset quality and protect against conflicts of interest to make sure that offsets constitute real reductions. Similarly, ‘linkages’ of cap-and-trade systems allow increased flexibility of compliance by enabling businesses covered under one jurisdiction’s cap to trade with businesses or other entities covered by a cap-and-trade system elsewhere. Linking multiple cap-and-trade systems ensures that the widest possible array of people are developing and sharing low-cost ways to reduce emissions. In the end, linkages enable more flexibility while, once again, keeping total reductions the same. As long as some countries cap emissions while others do not, some businesses will face the right incentives to decrease their emissions but not others. That is likely to lead to competitiveness concerns, and a need to combat emissions ‘leakage’: instead of operating in a place that has a cap-and-trade system, one could imagine a company moving abroad and then exporting its products back to the home market to reach the same consumers. In fact, companies are moving across borders but most often for other reasons. In any case, a simple way to reduce leakage is to require importers to hold the same allowances as domestic producers on the basis of their products sold. These border carbon adjustments reduce incentives for businesses to move abroad and, properly designed, may also motivate other countries to put in place cap-and-trade systems of their own.
Lastly, every cap-and-trade system requires proper regulation and oversight. Authorities ought to prevent those trying to corner the market or exhibit other forms of anticompetitive or abusive behavior. This is clearly not unique to cap and trade, and it is similar to regulatory oversight of any market. An essential element of accountability is ensuring that all emitters subject to the cap are held responsible for meeting their emissions reductions obligations, and face stiff penalties for any emissions in excess of the allowances they hold (as well as obligations to make up the difference). A further element for consideration could be a system of ‘buyer liability,’ where it is in the interest of the buyer of allowances to ensure the integrity of those allowances – whether they are from within the system, from other systems via linkage, or in the form of offsets. Buyer liability comes into play because ultimately it is the holder of the allowance who needs to be able to submit it for compliance with the regulator.
Cap-and-Trade Experience An increasing number of countries and regions are implementing and planning carbon cap-and-trade systems: from the EU to Australia and New Zealand to the Northeastern United States and California to cities such as Tokyo. The European Union’s Emissions Trading Scheme (EU ETS) is the world’s largest carbon cap-and-trade system involving individual companies. It was designed as a part of a broader cap-and-trade system established under the Kyoto Protocol at the level of countries. The EU program began full operations in 2008. Even before, during the 3-year initial trial phase, which was marked by an overallocation of allowances that caused the price to plummet once it was revealed, the EU ETS reduced emissions by between 2% and 5% relative to what emissions would have been otherwise. The declining cap during the compliance period all but guarantees further emissions reductions (Figure 4).
11
Carbon emissions (million tonnes)
2700
10 2500 9 2300
8 7
2100 6 1900
5 4
EU real GDP (trillions)
4
1700 3 1500
1990
1995
2000 Counterfactual emissions The cap
2005
2010
2015
2
ETS emissions EU GDP (2000$, trillion)
Figure 4 Emissions decreases within the European Union Emissions Trading Scheme. Source: EU Emissions Data: A. Denny Ellerman, unpublished manuscript, reviewed November 2011. EU GDP data: World Bank.
Climate Change and Policy | Carbon Cap and Trade
The EU ETS has achieved those reductions at lower than projected costs, which has led to significant criticism around its low carbon price not sending a sufficiently strong price signal. Low carbon prices in many ways point to a feature of cap and trade rather than a flaw. Still, they do point to significant emissions reductions potential and suggest that it may be possible to tighten the EU cap sooner than currently mandated by law. The Regional Greenhouse Gas Initiative (RGGI) covers power generators in the Northeastern United States. It has been in operation since 2009 and has provided valuable benefits to the region as well as policy lessons. Its emissions reductions have come at very low cost, most often attributed to an overallocation of allowances in the system, indicating a clear need to lower the actual cap. While RGGI was always meant to be a precursor for a US national system, California’s system scheduled to begin in 2013 is to date the most comprehensive and ambitious US cap-and-trade system. It encompasses greenhouse gases beyond carbon as well as likely linkages with other jurisdictions and is the flagship policy as part of a whole-scale initiative to decarbonize California’s economy akin to the EU’s efforts. Australia for its part is designing a hybrid cap-and-trade and price system, beginning with a carbon price in mid-2012 and transitioning into cap and trade by 2015. New Zealand’s system has been fully operational since 2010 and harbors its own important policy lessons, with a design focused on upstream regulations and comprising forestry emissions under its cap. Moreover, several other countries and regions are looking into implementing cap and trade. China is piloting regional cap-and-trade systems as part of its twelfth 5-year-plan, and other countries, regions, and cities are at various stages of developing a program. All told, the policy community is learning valuable lessons on the design and operation of carbon cap-and-trade systems, and beginning to achieve significant emissions reductions in the process.
Summary Carbon cap and trade is an important policy tool in the attempt to hold polluters accountable for their pollution and limit overall greenhouse gas emissions. Differences with carbon taxes may seem arcane but are important for the final outcome. Caps limit emissions; taxes set the price. Limiting emissions, of course, also sets a price, which is key to
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incorporating a particular cost of pollution that provides incentives for polluters to reduce emissions. The two mechanisms are not mutually exclusive and, in a vacuum, they have the exact same effect. In practice, there are important differences. The final verdict will depend on particular political circumstances. Policy design is at least as important as policy choice. Successful cap-and-trade systems share some key characteristics comprised of policy predictability to enable long-term planning and investments, flexible mechanisms to decrease compliance costs, and appropriate competitiveness provisions. In the end, the most important feature for achieving the environmental goal is a firm, strictly enforced, declining cap on emissions.
See also: Allocation Tools: Environmental and Natural Resource Economics: Decisions Under Risk and Uncertainty; Climate Change and Policy: Carbon Taxes; Clean Development Mechanism; Dealing with the Uncertainty about Climate Change; Double Dividend; Markets/Technology Innovation/Adoption/Diffusion: Policy Incentives for Energy and Environmental Technological Innovation: Lessons from the Empirical Evidence; Technological Change and Climate Change Policy; Technology and Environmental Policy; Policies/Incentives: European Union’s Emissions Trading System; Green Tax Design in the Real (Second-Best) World; Price Instruments; Prices versus Quantities; Quantity Instruments; SO2 Program; Policy Tools: Individual Transferable Quotas in Fisheries; Political Economy: Political Economy of Instrument Choice; Strategic Environmental Policy.
Further Reading Aldy JE, Krupnick AJ, Newell RG, Parry IWH, and Pizer WA (2010) Designing climate mitigation policy. Journal of Economic Literature 48(4): 903–934. Aldy JE and Stavins RN (2012) Using the market to address climate change: Insights from theory and experience. Daedalus 141(2): 45–60. Ellerman AD, Convery FJ, and de Perthuis C (2010) Pricing Carbon: The European Union Emissions Trading Scheme. Cambridge: Cambridge University Press. Keohane NO (2009) Cap and trade, rehabilitated: Using tradable permits to control U.S. greenhouse gases. Review of Environmental Economics and Policy 3(1): 42–62. Nordhaus WD (2007) To tax or not to tax: Alternative approaches to slowing global warming. Review of Environmental Economics and Policy 1: 26–44. Nordhaus WD (2008) A Question of Balance. New Haven, CT: Yale University Press. Wagner G (2011) But Will the Planet Notice? New York: Hill & Wang. Weitzman ML (1974) Prices vs. quantities. Review of Economic Studies 41(4): 477–491.