Cap and Trade

Cap-and-trade is a market-based policy approach to emissions reductions. Under cap-and-trade, policymakers determine a “cap,” the maximum amount of permissible emissions for the total covered area, a sector, region, or country.  In a cap-and-trade system, the cap is set lower than the status quo and decreases over time.  A central authority issues emission permits to each member of the group covered.  The initial allocation of allowances under cap-and-trade systems may be accomplished through an auction, allowing the market to begin its work almost immediately, through grandfathering, or distribution of allowances based on historic or recent emissions, or, most likely, some combination of the two.  These allowances permit a company to emit up to a particular volume of emissions over a specified period of time.  A carbon market, the “trade” side of cap-and-trade, ensures that permits will be allocated efficiently by allowing emitters above their quota to purchase allowances from those who have successfully reduced their greenhouse gas (GHG) emissions or that pollute less.  Non-participants in the cap-and-trade system may also purchase allowances in order to retire them and to increase the price of polluting.  Emitters must either pay for permits or find ways to internally reduce emissions – ideally, cap-and-trade will create incentives for innovative means of reducing emissions as the cost of carbon rises. This scheme adds the previously hidden price of carbon to the costs of doing business, forcing emitters to rethink their business models.  Thus, cap-and-trade combines governmental regulatory power and market mechanisms to reduce emissions.

The largest GHG cap-and-trade system is the European Union Emission Trading Scheme , which was created under the Kyoto Protocol .  Several regional cap-and-trade programs for GHG emissions have been established.  The Western Climate Initiative , formed in 2007 by Western states and Canadian provinces, aims to reduce emissions by 15 percent of 2005 levels by 2020.  The first phase of this international cap-and-trade program is planned for implementation in 2012.  As part of the Regional Greenhouse Gas Initiative , launched in January 2009, nine northeastern states have committed to a cap-and-trade system for power generation to reduce emissions to ten percent below their 2009 allowances by 2018.  Japan, Australia and New Zealand have planned regulatory carbon cap-and-trade programs to be implemented within the next few years.

The United States established an early example of a cap-and-trade type emission reduction system under the Acid Rain Program of the Clean Air Act (1990), which supports a national acid rain reduction market and regional nitrous oxide cap-and-trade models.  The Chicago Climate Exchange is a voluntary but legally binding cap-and-trade emissions reduction system wherein companies that join must commit to reducing their GHG emissions by 6 percent by 2010.  The tabled Lieberman-Warner bill , presented in October 2007, introduced a plan for a regulatory cap-and-trade system for the U.S.  In November 2008, President Obama promised to "implement an economy-wide cap-and-trade program to reduce greenhouse gas emissions 80 percent by 2050." On June 26, 2009, the House of Representatives approved the American Clean Energy and Security Act (also known as the Waxman-Markey Bill ), which would establish a variant of a regulatory cap-and-trade program.  In addition to setting an 80 percent GHG reduction target by 2050, the ACES bill sets a 17 percent GHG reduction target by 2020.

Cap-and-trade is generally viewed as an acceptable and politically palatable compromise between environmentalists, business interests, and policymakers as well as an effective response to the problem of climate change.