Cap and trade systems and command and control regulation both involve the limiting of emissions in polluting sectors of the economy. However, cap-and-trade provides economic incentives for private sector actors to engage in mitigation, thereby making it the most efficient method of achieving an environmental target. Cap-and-trade is already the policy instrument of choice in many U.S States, the EU and Australia, and has proven to be effective in the U.S Acid Rain Program.

The principal advantages of emissions trading are:

Cap-and-trade achieves the objective.

Where it is clear that there is an urgent need to achieve a given amount of reduction of emissions or pollution by a given time, as appears to be the case now with global greenhouse gases, setting a cap with appropriate sanctions for breach is the most direct and effective approach.  And allowing trading within that cap and deadline is the most effective way of minimizing the cost.  Determining physical actions that companies must take, with no flexibility, is not guaranteed to achieve the necessary reduction.  Nor is setting a price, since the appropriate price is not known in advance.

Cap-and-trade discovers prices

The world has only just started to realize the importance of achieving reductions in greenhouse gases.  Many technologies in many sectors can help achieve these reductions.  Even though indicative cost curves and comparisons are widespread, it is a commonplace that when the power of the market is turned onto an area where previously there has been little incentive to reduce costs and prices, remarkable reductions can be achieved, as improvements driven by competition leapfrog each other.  It is unsafe and potentially expensive to assume the costs of the technologies are known, and a price or a choice of specific technologies can be made by the regulator.  Only a cap and trade system gives full rein to the market to discover prices.

Cap-and-Trade incentivizes investment in low-cost emissions abatement

Allocating allowance permits for emissions and then trading between firms enables abatement to occur where the marginal cost is lowest. This is because firms are seeking to reduce emissions in the most cost-effective way possible, motivating them to devise economically efficient investments in new technology or production methods, or to search out external suppliers who can reduce emissions cheaper than they can.  Efficiency is therefore the driver of investment decisions under an emissions trading system, with firms all motivated by the need to reduce emissions with the lowest cost impact possible.

Conversely, in a command and control system there is only one way emissions are limited, and that is through pure regulation. Pure regulation does not foster the necessary inputs of the competitive marketplace to discover the relative marginal abatement costs between covered entities. In other words, there is no motivation for companies to seek the lowest cost solutions, or even to factor costs, but instead to comply with directives from government authorities, regardless of cost. This inefficiency impacts productivity and vitality in those businesses confronting these  regulations, and dampens growth in the national economy.

Cap-and-trade does not impose solutions, but encourages economically efficient investment decisions by  companies

Innovation is necessary for mitigating serious climate change. The emissions-reducing technologies available now require further improvements to increase their efficiency and effectiveness, and new technological concepts need to be devised.  A marketplace for the emissions reductions provides the incentives to improve and  uncover these technologies. A cap-and-trade system also adds the prospect of an immediate reward for the companies who are best at using technology to reduce their emissions.  It therefore aligns incentives for investors and stakeholders to reduce their emissions through technological innovations, intended to outperform competitors.

The use of inflexible command and control-type regulatory tools fails to deploy these incentives, and thus hampers technological progress. Enforcing compliance with no mechanism for fomenting competition amongst businesses results in stagnant and stale ideas. Governments and regulators cannot foresee the technologies and innovations that will clear the path for future emissions reductions, but under the regulatory approach they impose technology restrictions on companies by defining what they must do to comply, rather than letting them choose how to meet compliance targets.

Cap-and trade optimises improvements and investments in capital stock

Emissions trading allows for necessary investments in carbon reduction to come about at the most cost-effective time within the overall compliance target set for the economy, as firms can make a series of make-or-buy decisions according to their own cost curves and the price signals from the market.  Companies can avoid assets being stranded by the decisions of the regulator, and can also accelerate investment if they see that earlier production of emissions reductions could be beneficial or profitable.

Command and control, however, often has the unintended effect of prolonging capital investments in new plants and equipment. For example, a power plant facing new restrictions on plant design will stretch out the life of its current, dirtier, plant in order to delay costly compliance. The motivation is to extend the life of existing assets, delaying the inevitable costs of replacing until absolutely necessary. The net effect of this is to actually drive up pollution and drive down investment, by making new investment unattractive to industries that are subject to these regulations.   Yet where regulations are imposed from a certain date on all plant, assets with a continuing productive  life can be closed down.

Cap-and-trade has proven effective

Cap-and-trade has proven its effectiveness in the US through the acid rain program, where it quickly and effectively reduced pollution levels at a far lower cost than expected. The European Union Emissions Trading System has shown that cap-and-trade can be extended to carbon and can be done so in an agreed-upon manner across many countries, and in doing so creates a price on carbon that drives emissions reductions.  Reductions in pollution that industry feared would be excessively costly were achieved at a fraction of the original estimates.

On the whole the use of direct regulation as a policy instrument to achieve emissions reductions that could be spread geographically and through a time period without damage to the policy objective is a blunt tool.  It can increase the costs of emissions reductions, and it can have negative economic implications for businesses and society as a whole. Where a market can operate effectively, and where there is a premium on keeping costs to a minimum, a cap and trade route should be chosen.

There are, however, some instances in which cap-and-trade is unable to operate effectively, and therefore regulations can be the most useful tool. One widespread example  is private road transportation, where vehicle emissions standards can be used to affect changes in the production of motor vehicles often more effectively and with lower transaction costs than bringing those directly responsible for the emissions together in a market.   It is hard to capture and verify the actual emissions of automobiles during their use, and regulating from the pre-production stages can produce better overall results.   In other cases a mixture of cap and trade, direct regulation, tax and incentivisation by subsidy will produce the optimum outcome.  Cap and trade is not a panacea, but there are good economic arguments for always considering it first, even if supply-chain characteristics and market failures mean that a special mix of other policies has to be created as well.

But in direct comparisons with command and control, where that is appropriate, there is a clear winner.   By not providing a profit incentive for companies to invest in further emissions reductions, command and control sets a rigid and staid framework for industries to base their strategies for low carbon growth upon. Harnessing market forces allows for reductions to come more efficiently, and bringing about innovations necessary to achieve sustainable economic and environmental conditions.

The EU's Emissions Trading System

The European Union cap and trade system is the most developed in the world and will become progressively tighter and more comprehensive as the decade progresses.

The EU’s emission trading scheme (ETS) - kicked off in 2005 and, following an initial pilot phase, now in its second phase - is the most ambitious of its kind in the world. It covers about 12.000 installations in 30 countries(1) and 41% of the EU’s CO2 emissions. The ETS sector includes the power and heat generation sector, combustion plants, oil refineries, coke ovens, iron and steel plants and factories making a.o. cement, glass, lime, bricks, ceramics.

The pilot phase has succeeded in attaching a price to carbon and changing the culture of corporations in a very short time. The impact of carbon is on the board room agenda and built into company strategies. Secondly, a reliable monitoring, reporting and verification system, which is the backbone of any functioning ETS, is now in place. Thirdly, management systems have been set up and operational experience has been gained. Fourthly, the EU ETS has been instrumental in spurring the development of CDM projects.

Phase 1 was a test phase and not conceived to result in major emission cuts. Yet, around 200 million tonnes of CO2 or 3% of total verified emissions were abated due to the ETS at very low transaction costs (2).  These achievements are all the more remarkable if one considers that the scheme was set up very rapidly, with little information available regarding actual GHG emissions. As a result, markets realized belatedly that phase 1 suffered from over-allocation. It was this which led to the price volatility and low first period price. As a response, inter-phase banking of allowances was introduced from 2008, when phase 2 started, and allocation plans were tightened.

In a revision of the EU ETS Directive(3) in December 2008, several features of the scheme were considerably strengthened:  

• Phase 3 has a prolonged compliance cycle, spanning from 2013 to 2020, and will incorporate a centralized EU-wide allocation of allowances with a yearly linear decrease of the emissions cap of 1.74% per year, even beyond 2020.
• Auctioning will progressively replace free allocation. Free allocation of emission allowances has been a key element for acceptance of the EU ETS in the pilot phase but comes at an efficiency loss. Apart from a few transitional exemptions, the whole power sector will have to auction emission allowances. The European Commission expects that at least 50% of all allowances, corresponding to 1 bn tCO2, will be auctioned in 2013, and this proportion will rise each year. 
• Industrial installations will receive allowances on the basis of product-specific EU-wide benchmarks but must purchase at least 20% of allowances in 2013 rising to 70% in 2020 and 100% in 2027. Operators at risk of carbon leakage (4) will receive allowances for free up to their benchmark. The benchmark is based on the average 10% most efficient installations in a given sector. Benchmark values are finalized and in the process of being approved by the European Parliament and Council. 
• The EU ETS will cover new industries (e.g. aluminium and part of the chemical industry) and two new gases (nitrous oxide and perfluorocarbons). The capture, transport and geological storage of all greenhouse gas emissions will also be covered. Small installations can be excluded if their emissions are subject to equivalent measures. The ETS will cover the aviation sector already from 2012 onwards and might be further extended, e.g. to maritime emissions by end-2011. 
• International offset credits will continue to be eligible for compliance under the EU ETS in phase 3. Also, they might not account for more than 50% of reduction efforts between 2008 and 2020 (around 1.6bn tCO2) and certain projects will be restricted on qualitative grounds (5).  The use of credits from Least Developed Countries (LDCs) or from countries with bilateral agreements would not be restricted. New sectors and new entrants will have a guaranteed minimum access to international offset credits of 4.5% of their verified emissions during the period 2013-2020. For the aviation sector, the minimum access will be 1.5%.

The European Commission is currently assessing the need for additional rules to prevent market abuse. The EU ETS has indeed been plagued by fraud cases in the area of value-added tax and registry phishing. However, interference with the market price through market manipulation or insider dealing has so far not been detected. One of the reasons for this could be the good degree of a liquidity that the system has achieved through allowing intermediaries and financial firms to participate in the trading of emission allowances from the very outset.

As the market volume is doubling each year, the Commission might nevertheless propose stricter rules on market participants. This could involve more reporting obligations, greater monitoring, clearing obligations for the OTC market, etc. However such rules do bring with it economic costs and administrative burdens which would mean giving up some of the cost-efficiency gains of an emissions trading system.

Pressure is also increasing on the EU to raise its emission reduction ambitions as companies will bank a large amount of surplus emission allowances into phase III. The Commission has made a study that moving to a higher target is economically feasible but companies warn of consequences for their international competitiveness if other major economies do not move along. In case other developed countries committed themselves to comparable emission reduction targets, the EU would revise some of those rules, in particular with respect to free allocation/carbon leakage, and consider the adoption of a higher reduction target. This could also involve a loosening of limits for the use of international emission credits.

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1 European Union’s 27 Member States, Iceland, Liechtenstein and Norway.
2 Ellerman A. Denny et. al. (2010) Pricing Carbon: the EU Emissions Trading Scheme, Cambridge University
3 Directive 2009/29/EC
4 According to the carbon leakage list, reviewed every 5 years from 2009, over 70% of EU ETS installations are exposed to carbon leakage, or the risk of shifting production abroad.
5 The EU will ban the use of credits from industrial gas projects (HFC23) from 1 May 2013. Further restrictions could follow under art. 11a(9) of the ETS Directive but nothing concrete is being proposed or discussed at this point in time. 

A cap and trade system is the best means to establish a quantifiable, legally enforceable limit on emissions which will ensure that essential climate change targets are met at the lowest possible cost. Such a program, when combined with offsets, will accelerate global emissions reductions. In addition, cap and trade provides the private sector with the flexibility required to reduce emissions while stimulating technological innovation and economic growth. Cap-and-trade is already the policy instrument of choice in many US States, the EU, New Zealand and Australia, and has proven to be effective in the US Acid Rain Program.

Advantages of emissions trading are:

Cap-and-trade is designed to deliver an environmental outcome, in that the cap must be met.

This certainty is critical for the environment. While a carbon tax ensures an increase in energy prices, it does not ensure that emissions will be reduced to the necessary level. It may take some years for policy makers to establish the level of tax necessary to deliver a given emissions reduction pathway. The climate problem needs very urgent attention: it is widely accepted that global emissions have to begin to decline by 2020 in order to avoid the worst impacts of climate change.

The true price of carbon is not yet known, and cannot be identified to create a tax rate. Markets are critical for price discovery, and in the case of cap-and-trade can determine how efficiently and effectively emissions reduction targets will be achieved.

Cap-and-trade will deliver its environmental objective at lowest cost to the economy.

By combining trading with a price for emitting CO2, cap-and-trade seeks out the most efficient reduction projects within the market, delivering a lowest cost outcome. Emissions trading has been applied to the problem of sulfur emissions from power stations in the US, where the overall cost of meeting environmental targets has been much lower than anticipated. Achievement of the required SO2 emission reductions in the Acid Rain Program (when the program is fully implemented in 2010) are now projected to cost $1 to $2 billion per year, just one quarter of original EPA estimates._⁽¹)

Dependent on the varying situation of any particular economy, the price for emissions self-stabilizes when using a market-based approach. This can be witnessed in regards to the recent price fluctuation in the European Union carbon markets, where signs of economic down turn reflected, quite properly, by a softened price for emissions.

Cap-and-trade can form the bulwark for a global agreement to reduce emissions.

Climate change is a global problem requiring a global solution. Cap-and-trade provides a means of establishing rigorous, measurable, and enforceable targets across the globe. National trading systems can be linked with other such systems, delivering over time a global carbon market. Developing countries can be linked through project based crediting. The bigger and broader the market, the wider the range of projects, leading to a lower overall cost.

A trading system offers both compliance and policy flexibility that is important for business.

Compliance flexibility is delivered through the ability to “make or buy”, i.e. to implement a project and make reductions (including selling allowances), or to buy allowances from the market. A tax is unable to replicate the incentive for companies to reduce emissions that a trading system brings. Cap-and-trade delivers a profit-incentive to companies which discover stronger and more effective ways of reducing emissions. Perhaps because of the lack of positive incentive, energy tax elasticities are not high, and their impact on behaviors and consumption is low.

Policy flexibility comes through the mechanism for distribution of allowances. For example, in Phase III of the EU ETS some allowances will be distributed for free to deal with competitiveness concerns. Despite this, the incentive to reduce emissions remains in that the allowances have a value. Replicating this approach in a tax-based system—through tax credits or exemptions—would add the complexity that tax-proponents claim to avoid.

Emissions trading is remarkably simple, although, like the tax code, it can be made more complex to meet a variety of
different ends. To compare the two systems;

• Both require a bureaucracy to oversee compliance.

Cap-and-trade has proven effectiveness.

Cap-and-trade has proven its effectiveness in the US through the acid rain program, where it quickly and effectively reduced pollution levels at a far lower cost than expected.The European Union Emissions Trading System has shown that cap-and-trade can be extended to carbon and can be done so in a agreed-upon manner across many countries, and in doing so creates a price on carbon that drives emissions reductions. In contrast, legislating a carbon tax has proven to be unattainable in the past. The EU tried and failed to implement a carbon tax in the early 1990s. The political stigma of “another tax” significantly stacks the argument in favor of a trading approach.

(1) http://www.epa.gov/airmarkets/cap-trade/docs/ctresults.pdf

The Basic Design Elements of Cap and Trade Systems

A cap and trade system is a means by which reductions in greenhouse gas (GHG) emissions can be implemented. It involves creating a market where GHG emission allowances can be bought and sold by entities , better facilitating the reduction of GHGs in a way that prevents inflexible limitations on economic activity. When designing a cap and trade system there are several important elements that must be considered and employed properly in order for the system to fulfil its task of reducing emissions. These elements include realistic yet challenging target setting, fair allocation of carbon emissions allowances, reliable access to offsets, and suitable measurement and monitoring of the reduction program. In addition to such elements, there are many technical issues such as registry operations and legal matters that must be handled correctly for the smooth operation of a cap and trade system.

Target Setting

Target setting is part of what creates the “cap” in a cap and trade system, and is fundamental to its function. A successful cap and trade system must set targets for emissions reductions if its designers wish the system to reduce emissions and discover a value for carbon over a defined period. Voluntary, unilateral, emissions reductions will always be less effective than targeted reductions in a cap and trade system. Well-designed cap and trade systems encourage greater emission reduction measures by offering a means to incentivize emissions reductions beyond the targeted individual cap through profitable trading.  Targets for a cap and trade system can be set by a governmental or inter-governmental body , but sometimes the target setting entity can be a group of private sector constituents cooperating of their own volition or in anticipation of government regulation.

Targets for emissions reduction are usually set in relation to the total of GHG emissions by the “covered” entity in a base year, and relative to other factors such as the compliance dates of the cap and trade system, and the final date for target achievement. Target setting  results in a numerical emission reduction objective for covered entities, usually with the objective of limiting emissions throughout the reduction program to a percentage of a base year’s emission level within a period of time. An ideal target would reduce emissions as much as possible, while still allowing participating emitters to remain competitive in their respective markets.  The target should be reasonable and achievable, but beyond “business as usual” practices.  Some difficulty in achieving the target is vital to encouraging innovative thinking on how to further reduce emissions within the confines of the cap.

Allocation

Allocation is the process by which the regulating entity, usually a government body or agency, distributes to individual covered entities the total GHG emission allowances consistent with the overall target. Allowances in a trading system will have a commercial value.  However they can be distributed free to some or all covered entities or auctioned to highest bidders within a competitive bidding process. Each emission unit usually represents one ton of GHG allowed to be emitted within the period concerned.

If an emitter cannot reduce their GHG emissions below the number of allowances they obtain, than they must buy enough permits to “cover” their business practices, incurring a cost.  On the other hand, if an emitter is able to reduce its total emissions below number of permits that it possesses, then it may sell its excess allowances for a price, providing an incentive for increased performance.

Offsets

Offsets are an optional part of a cap and trade system, but can provide an inexpensive alternative to creating additional supply in the market, i.e. issuing more emissions allowances, while still allowing for the achievement of the set target in terms of total national or global emissions reductions, rather than in the emissions of the group of covered entities. All emissions reduction policies aim at reducing global totals, since it is global greenhouse gas concentrations that cause climate change. Typical international offsets are projects, including the implementation of clean energy solutions, improving energy efficiency and reforestation of land previously deforested.

Emission reduction achieved through such projects can be evaluated and converted into units of equivalent compliance value to emission allowances. For an emission reduction to be considered an offset it must not be subject to a cap and trade emissions market.  All economic theory and modelling shows that emissions can be produced more cheaply the wider the market, and offsets are a means of widening the market in advance of, or in default of, a universal global cap.

Data Collection and Monitoring

Establishing, operating, and evaluating a cap and trade system requires a vast amount of data collection and analysis.  To manage all the data, an emissions registry must be created whose primary task is to operate a database for collecting, verifying, and tracking emissions data from emitters. It is important for the registry to collect emissions data from each emitter in the cap and trade system, since the individual’s emissions data will be vital for tracking allowances and progress towards reaching the target emissions level. An indirect function of a registry is to build public confidence in the cap and trade system. It will allow individuals and the emitters themselves to evaluate progress of the system as a whole and verify that it treats each emitter justly.

In order for the data gathered and collected in the registry to be considered accurate, a process of GHG accounting takes place in cap and trade systems. Independent  third parties are often given responsibility for verifying that data collected by the registry is accurate. This verification covers both the emitter’s overall emissions levels and the validity of offsets.

Market Oversight

Controls over the registry and GHG accounting processes by which data is verified are both important components in providing appropriate market oversight to the entire cap and trade system. Effective oversight of both the environmental impact of emissions and the market is absolutely vital to achieve the trust necessary for markets to be effective. Emissions reporting has to be reviewed to assure that reductions are taking place. Precise initial measurements of GHG emissions in a base year are necessary to establish the overall goal for each covered entity, where simple purchase by auction is not favoured. Emission levels must be checked regularly, and emission trading should be monitored. If there are rewards for “early action”  by an entity before the cap and trade system was implemented, the impact of these actions must also be measured rigorously.