Cap-and-Trade (Part I)

(1/12/2009) - I’ve now written several articles that mention my affinity for a carbon cap-and-trade program.  In this article, I will outline what I mean when I say cap-and-trade.  In Part 2, I will talk about the cap-and-dividend plan, why I favor cap-and-trade over the carbon tax, and some reasons why we must recognize the limits of any cap-and-trade system in the efforts to prevent catastrophic global warming. 

If anyone but John McCain has been the Republican nominee, we would have heard a lot more about cap-and-trade programs.  Instead, we all we got from two presidential candidates was banal agreement on the topic as they chose to debate more contentious issues such as health care reform and the war in Iraq. 

Despite the lack of arguments, passing a cap-and-trade program is a key component of President-Elect Obama’s energy and environment platform, and he has stated many times that this is one of his three (or, after the financial meltdown, four) policy areas he will focus on.  So what is a cap-and-trade program, anyways?

Cap-and-Trade Defined

A cap-and-trade system is one in which a government regulates the release of pollution into the public environment (atmosphere, oceans, rivers, or what have you).  The government determines how much pollution is appropriate (hopefully based on good science) and distributes permits to those companies who want to pollute.  These permits are tradable.  Companies that emit less than authorized may sell their permits to companies that need to pollute more in order to do business. 

This is the essence of cap-and-trade.  However, there are many variables that can drastically change how the cap-and-trade system operates in reality.  Lets look at some of the issues that make, for example, a carbon cap-and-trade system good or bad.

Setting the Proper Cap

The first sticking point with cap-and-trade is how the government in question chooses to determine the level at which it sets the carbon cap.  Ideally, an overall emissions goal can be determined by a consensus of climate scientists.  Obama’s plan, which calls for an 80% reduction in greenhouse gas emissions by 2050, is based on a rough consensus from about three years ago.  Since then, some scientists have said that cuts need to be implemented quicker.  

Lets suppose for now, for the sake of argument that scientists agree that Obama's goal is a good one.  In 2006, the U.S. released 7,075.6 teragrams – a teragram is 10^6 metric tons – of carbon dioxide equivalent greenhouse gases.  Lets suppose the cap-and-trade system goes into effect at the beginning of 2010, which is probably the earliest we can expect it to hit full swing anyways.  Do you simply reduce emissions by 2% every year?  Or do we ease into the regime, perhaps letting emissions rise for a few more years, then clamping down harder and harder?  Maybe we should shoot for the moon and reduce emissions by 4% a year and get‘er done?  Policy experts and scientists can advise on this issue, but when it comes down to it, the shape our fight against global warming will take will eventually rest on political decisions.

How to Distribute Permits

Second, the government needs to decide how to distribute the emission permits.  In the E.U., which as had a cap-and-trade program since 2005, member countries give away pollution permits.  If the permit recipient doesn’t “use” all of their emissions (i.e., they are allowed to emit 2000 tons of CO2, but only end up emitting 1500), they can sell the unneeded permits to organizations that don’t have enough.  In many cases, this amounts to a government giveaway as officials misestimate (assuming there's no corruption) the amount of CO2 emissions companies will require. 

In Obama’s plan, 100% of carbon permits will be auctioned off.  The price of carbon is therefore determined by two factors – the level of the carbon cap, and how much carbon industry believes it needs.  If a company underestimates how much carbon it will release, or finds economical ways to reduce emissions, it can buy or sell permits on the market. 

I favor a 100% auction and am wary of any cap-and-trade system that doesn’t auction off its permits.  This is the direction most opinion seems to be heading in as well.  Wikipedia reports that the E.U. is proposing to change their system so 60% of permits will be auctioned.  We will have to wait and see if these changes, which would go into effect in 2013, are passed. 

In the beginning of 2009, ten northeast and mid-Atlantic states launched the Regional Greenhouse Gas Initiative (RGGI), the “first mandatory cap-and-trade program in the United States to reduce greenhouse gas emissions.”  The initiative is limited in scope – it only caps emissions made by power plants larger than 25 MW.  It has also set the bar lower than the E.U.  While the E.U. aims to cap emissions at 80% of 1990 levels by 2020, RGGI is aiming at a more modest cap of 90% of the average emissions for the period between 2000 and 2004. 

The RGGI is, to my knowledge, the only cap and trade system in the world that auctions off all of its permits.  The first permits were auctioned in September 2008 and sold for about $3.07 a ton.  A second auction in January 2009 resulted in sales of $3.38 per ton.  These low prices reflect the nature of the first phase of RGGI’s plan, which is to stabilize emission levels.  Beginning in 2015, RGGI will begin to reduce the cap by 2.5% a year.  As a first in the nation system, I think taking it slowly is the right way to go about it.  In the long run, RGGI is more of a guinea pig than a permanent solution.  Any lessons that can be gleamed from it will be useful for implementing a national plan.  At the same time, if RGGI moved to quickly, there would be a greater risk of a public backlash, which might hurt cap-and-trade programs in the future. 

(This article continues here)

(Photo Credit: Freefotouk)