Learning from Thirty Years of Cap and Trade

A cap-and-trade system is a market-based environmental policy that places a limit on harmful pollutants and establishes a market-based price on emissions. Companies must hold permits to cover their emissions; these permits, often called “allowances,” can be bought or sold at prices determined by supply and demand. The European Union is in the process of extending and strengthening its carbon dioxide (CO2) cap-and-trade system; California has extended and strengthened its own system; and nine New England and Mid-Atlantic US states have extended and strengthened the Regional Greenhouse Gas Initiative (RGGI), a program that sets a cap on CO2 emissions from the electricity sector. In addition, it is expected that before the end of this year, New Jersey will join RGGI, and Oregon will launch its own CO2 cap-and-trade system. And, most important, perhaps, after years of preparation and pilot operations, China is expected to launch the world’s largest CO2 emissions trading system nationwide in 2020.

With such developments in place and on the horizon, this is an important time to think carefully and critically about the history of cap and trade and to identify lessons that can be learned from three decades of prior experiences—both successes and failures.

Historical Context

Thirty years ago, many environmental advocates argued that government allocation of rights to emit pollution legitimized environmental degradation, while others questioned the feasibility of such an approach. At the time, virtually all pollution regulations took a command-and-control approach, in which governments set uniform source-specific requirements, such as specifying the type of pollution-control equipment to be used or setting uniform limits on emissions levels or rates.

Today, economists and students of economics recognize that the total costs of reducing emissions (i.e., abatement costs) under command-and-control approaches can be much higher than those under market-based approaches because emissions reduction costs can vary greatly across sources. Since market-based approaches aim to reduce overall costs by allowing the firms that find it easiest to reduce emissions to reduce more—and for firms that find it more difficult to reduce emissions to reduce less—they can achieve aggregate pollution-control targets at minimum cost.

Overall, we found that cap-and-trade systems, if well designed and appropriately implemented, can achieve their core objective of meeting targeted emissions reductions cost-effectively. This is not something that was taken for granted before cap-and-trade systems were implemented, and it is still not accepted in some quarters. That said, the devil is in the details, and both the design and the economic environment in which systems are implemented are very important. Moreover, as with any policy instrument, there is no guarantee of success. Based on the numerous specific lessons we identified in our analysis, several design and implementation features of cap-and-trade programs appear critical to their performance.

Key Features for System Design and Implementation

First, it is important not to require prior government approval of trades. In contrast to early US experience with emissions offset systems, transactions costs can be low enough to permit considerable efficiency-enhancing trade if prior approval of trades is not required.

Second, it is clear from both theory and experience that a robust market requires a cap that is significantly below business-as-usual emissions.

Third, to avoid unnecessary price volatility, it is important for final rules (including those for allocation of allowances to companies) to be established and accurate data supplied well before companies must start operating under an allowance trading system.

Fourth, high levels of compliance in a system that requires emitters (such as coal-fired electricity generators), rather than fossil fuel producers, to purchase allowances, can be achieved by ensuring there is accurate emissions monitoring combined with significant penalties for noncompliance.

Fifth, provisions allowing companies to save permits for later use, called banking, have proven to be very important for achieving maximum gains from trade, and the absence of these provisions can lead to price spikes and collapses.

Sixth, price collars can lower costs by providing more stable prices that facilitate investment planning. A changing economy can reduce emissions below a cap, rendering it non-binding, or a growing economy can increase emissions and drive allowance prices to excessive levels. Price volatility can be reduced by combining a price floor at which the program administrator will buy allowances with an allowance reserve from which it will sell at a price ceiling. The resulting hybrid system will have less certain emissions reductions, however. Finally, economy-wide systems are feasible, although sectoral programs have been more commonly employed.

Experiences with cap and trade also indicate that political considerations can have important effects on the design of cap-and-trade programs. First, because of the potentially large distributional impacts involved, the allocation of allowances inevitably has been a major political issue. Allowances have been given away for free to help build political support. Under most conditions, if transaction costs are low, the total costs of reducing emissions in a cap-and-trade system are independent of the initial allowance allocation. This means that the allowance allocation decision can be used to build political support and address equity issues without concern about impacts on overall cost-effectiveness.

Of course, giving away allowances for free eliminates the opportunity to generate revenue by selling them at auction, which in turn eliminates the opportunity to use the proceeds to cut taxes that distort economic activity. On the other hand, experience has shown that political pressures exist to use auction revenue not to cut such taxes but to expand environmental programs. Indeed, cap-and-trade allowance auctions can and have generated very significant revenue for governments.

Second, companies’ relocation decisions and other adverse competitiveness impacts from cap-and-trade systems (i.e., leakage) have been a prominent political concern. Virtually any meaningful environmental policy will increase production costs and thus could raise these concerns, but this issue has been particularly prominent in the case of cap-and-trade instruments. In practice, leakage from cap-and-trade systems can range from nonexistent to potentially quite serious. It is most likely to be significant for programs of limited geographic scope—particularly in the power sector because of interconnected electricity markets. Attempts to reduce leakage and competitiveness threats through free allocation of allowances do not address the problem per se, but allowance allocations updated based on levels of production output can do so.

Third, although carbon pricing (through cap and trade or taxes) may be necessary to address climate change, it surely is not sufficient. In some cases, abatement costs can be reduced by using complementary policies that address related market failures. Unfortunately, the “complementary policies” that have emerged from political processes have often addressed emissions under the cap instead—thereby relocating rather than reducing emissions, driving up abatement costs, and suppressing allowance prices.

As we noted at the outset, cap-and-trade systems are now being seriously considered for a wide range of environmental problems around the world. Past experience can offer some guidance as to when this approach is most likely to be successful.

First, the greater the differences in the cost of abating pollution across sources, the greater the likely cost savings from a market-based system—whether cap and trade or tax—relative to conventional regulation. For example, it was clear early on that differences in costs for SO2 abatement among sources was great because of differences in ages of plants and their proximities to sources of low-sulfur coal.

Second, if pollutants are well-mixed in the receiving airshed (or watershed), a market-based system is particularly attractive, because local hot spots are not a concern, and the focus can thus be on cost-effective achievement of total emissions reductions. Most cap-and-trade systems have been based on either the reality or the assumption of the uniform mixing of pollutants. However, even without uniform mixing, well-designed cap-and-trade systems can be effective—as illustrated by the two-zone trading system under RECLAIM—though at the cost of greater complexity.

Third and finally, Martin L. Weitzman’s 1974 seminal analysis of the effects of cost uncertainty showed that the relative efficiency of taxes versus cap-and-trade systems depended critically on whether marginal damages or marginal abatement costs were more responsive to changes in pollution levels. Subsequent literature has identified additional relevant considerations. Perhaps more importantly, theory and experience have shown that there are efficiency advantages of hybrid systems that combine price and quantity instruments in the presence of uncertainty.

Two highly relevant lessons from thirty years of experience with cap-and-trade systems stand out. First, cap and trade has proven itself to be environmentally effective and economically cost-effective relative to traditional command-and-control approaches. Moreover, less flexible systems would not have led to the technological change and innovation that appear to have been induced by market-based instruments.

Second, and equally important, the performance of cap-and-trade systems depends on how well they are designed. In particular, it is important to reduce unnecessary price volatility to avoid excessive costs. Hybrid designs offer an attractive option to do this if some variability of emissions can be tolerated.

All of this suggests that cap and trade merits serious consideration when countries, states, provinces, or regions around the world develop policies to reduce greenhouse gas (GHG) emissions. And, indeed, this has happened. However, as mentioned above, proposals for such policies have often triggered significant opposition.

In the United States, the failure of Congress to pass cap-and-trade climate legislation in 2010 was essentially collateral damage from a much larger political war that decimated the ranks of both moderate Republicans and moderate Democrats. Nevertheless, political support for using cap-and-trade systems to reduce GHG emissions has emerged in many other parts of the world. In fact, in the negotiations leading up to the 2015 UN Climate Conference in Paris, many parties endorsed key roles for carbon markets and broadly agreed on the value of linking those markets.

It is certainly possible that three decades of high receptivity to cap and trade in the United States, Europe, and other parts of the world will turn out to have been only a relatively brief departure from long-term reliance on command-and-control environmental regulation. However, considering the generally positive experience with cap and trade, we are cautiously optimistic that the denigration of cap and trade in US political debates may turn out to be a temporary departure from the long-term trend of increasing reliance on market-based environmental policy instruments. We are hopeful, but only time will tell.