Concerns about global warming are fostering creative strategies for reducing our emissions of heat-trapping gases such as carbon dioxide (CO2). The most well-known approach, the Kyoto Protocol, came into force this past February, though without U.S. participation. As an alternative, several American policy makers have put forth emission reduction policies including the federal Climate Stewardship Act and the Regional Greenhouse Gas Initiative, an effort undertaken by the governors of nine northeastern states to reduce carbon emissions from power plants. A common feature among these climate strategies is a “cap-and-trade” system for reducing emissions.
These systems draw on the power of the marketplace to reduce emissions in a cost-effective and flexible manner. In practice, cap-and-trade systems create a financial incentive for emission reductions by assigning a cost to polluting. First, an environmental regulator establishes a “cap” that limits emissions from a designated group of polluters, such as power plants, to a level lower than their current emissions. The emissions allowed under the new cap are then divided up into individual permits—usually equal to one ton of pollution—that represent the right to emit that amount.
 Because the emissions cap restricts the amount of pollution allowed, permits that give a company the right to pollute take on financial value. Companies are free to buy and sell permits in order to continue operating in the most profitable manner available to them. So, those that are able to reduce emissions at a low cost can sell their extra permits to companies facing high costs (which will generally prefer to buy permits rather than make costly reductions themselves).
A key advantage of a cap-and-trade system compared with other emission reduction strategies is that it gives companies flexibility in the manner in which they may achieve their emission targets. Another advantage is that it sets a clear limit on emissions. Traditional approaches often focus on emission rates or require the best available technology, but do not always require that specific environmental goals be met. For example, an emissions tax penalizes polluters but does not guarantee the degree to which the environment will benefit, because some companies might find it easier to pay the tax instead of reducing emissions.
A Small-Scale Example
In a real-world cap-and-trade system, permits would be traded between many polluters and at varying prices. Let us consider a simplified example involving only two power plants: Plant A emits 600 tons of CO2 each year, and Plant B emits 400 tons, for a combined annual total of 1,000 tons. An environmental agency then establishes a CO2 emissions cap of 700 tons per year (a 30 percent reduction).
Under a traditional approach, both plants could be ordered to reduce their emissions by 30 percent, which would force Plant A to reduce its annual emissions to 420 tons (a reduction of 180 tons) and Plant B to reduce its emissions to 280 tons (a reduction of 120 tons). The cost for each plant to make emission reductions depends on factors such as plant efficiency and the type of fuel used (e.g., coal, natural gas); in this example, it would cost Plant A an average of $50 per ton and Plant B an average of $25 per ton to meet these reductions, for a total cost of $12,000.
Under a cap-and-trade system, each plant seeks out the lowest-cost way to reduce emissions. Initially, Plant B is able to reduce its emissions at a lower cost than Plant A, so it can sell permits to Plant A. However, the more Plant B reduces its emissions, the more expensive it becomes to make further cuts. Eventually, both plants reach a point where their cost to reduce an additional ton of pollution is equal.
The end result of the cap-and-trade system is that the two plants are able to reach the emission reduction goal set under the cap, but at a lower cost. In our example, we calculate a total cost of $9,000—a savings of 25 percent compared with the traditional approach.
Encouraging American Innovation
In the United States, cap-and-trade systems first gained prominence when amendments to the 1990 Clean Air Act established the first cap-and-trade system to reduce emissions of sulfur dioxide (SO2), the primary cause of acid rain. This system has proven to be such an environmental and economic success—reducing SO2 emissions at a fraction of the expected costs—that the European Union borrowed directly from it to design its cap-and-trade system for CO2 emissions, which went into effect earlier this year.
In general, cap-and-trade systems work best when the emissions have a negative impact on broad geographic areas or, in the case of heat-trapping emissions, globally. These systems are also successful when the cost of reducing emissions among polluters varies, and when emissions can be consistently and accurately measured.
Heat-trapping emissions such as CO2 are an ideal candidate for regulation under a cap-and-trade system because they mix equally throughout the atmosphere and therefore have a global impact regardless of their geographic source. Furthermore, there are many sources for these emissions, they face different reduction costs, and measuring these emissions is relatively simple.
There are cases in which other emission reduction approaches are preferable to cap-and-trade. For example, less flexible regulations are more appropriate when the negative impact of pollution is direct and localized (as with asthma) rather than indirect and global (as with climate change). Cap-and-trade systems are also not very beneficial if the polluters have identical costs for reducing emissions, or if policy makers prefer to be more certain about how much the program will cost rather than how much the environment will benefit.
Cap-and-trade systems do, however, exert constant pressure on polluters to reduce emissions while allowing flexibility in the process. This encourages companies to meet (or exceed) their emission targets in the most innovative and cost-effective way possible. By promoting innovation, cap-and-trade systems can help slow the pace of global warming while spurring the development of new technologies and industries that will contribute to the long-term growth of the U.S. economy.
Jason Mathers is outreach coordinator and Michelle Manion is a senior analyst in the Global Environment Program.
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