Cap and Trade

What is Cap and Trade?

A cap and trade system creates a marketplace for trading the right to emit greenhouse gasses. Under this system, there would be a national cap on emissions. Firms that produce greenhouse gasses would be given emission credits, which is the right to release a set amount of greenhouse gasses, such as 1000 tons of CO2. Firms could use these allowances to operate normally or install equipment that reduces their emissions and sell some of their credits to other firms. Credits could also be purchased by pro-environment groups and retired out of the marketplace. Doing so would reduce the total amount of greenhouse gas emissions.   

What Problem is Cap and Trade Designed to Solve?

Cap and trade has emerged as a popular policy alternative to the more strict “command and control” policy – for example, where the government requires all firms to reduce their emissions by a set amount or mandates that firms install new technology to reduce emissions.  

While regulations of this kind can effectively reduce emissions, they can be inefficient and reduce innovation. For example, when the government sets emissions standards, firms are not motivated to install technologies that might further reduce emissions. Similarly, government technology mandates reduce the incentive to develop alternate technologies that might be cheaper or work better.  

Under a cap and trade system, the government’s role is limited to setting a cap on emissions. Firms then make their own decisions about how to implement this limit. Advocates of cap and trade argue that leaving it up to firms to make these decisions increases the chances that the best possible solutions will be adopted and strengthens incentives to develop new technologies that reduce emissions even more.  

Does Cap and Trade Happen Today?

There are a few cap and trade programs at various levels of government worldwide. California implemented a cap and trade program in 2013 and found that greenhouse gas emissions were reduced annually by about 9% from 2012 to 2017. However, as we noted in our brief on decarbonization, emissions declined across the United States during this time, though by a smaller amount.

The Regional Greenhouse Gas Initiative (RGGI) focuses on electrical power generation among Northeastern states. However, the emissions cap is nonbinding and has produced only limited reductions in CO2 emissions. In recent years, states such as Virginia have withdrawn from the initiative.  

The European Union’s Emissions Trading System (established in 2003) is the only multi-country emissions trading system. The system’s emissions cap has evolved from being set by member states—who had incentives to make the cap high—to a more restrictive centrally determined cap. As the cap became more restrictive, emissions dropped, saving 1 billion tons of CO2 (about 4% of total EU emissions).

Why don’t more governments use Cap and Trade?

For cap and trade to effectively limit carbon emissions, it requires a cap on overall emissions that is progressively ratcheted down and a high enough price on carbon to encourage innovation and adoption of low-carbon technology. The RGGI cap and trade system had a nonbinding cap, meaning there was no penalty for the over-production of carbon. Similarly, the price of carbon in the European Union’s Emissions Trading System is quite low. Thus, despite its theoretical potential, cap and trade systems have had only limited effects because of how they were implemented.

Simply put, even if politicians are willing to enter into a cap and trade system, the system is not effective unless they commit to restrictive caps – even caps that are so low that businesses do not receive enough credits to cover their current emissions, and are therefore forced to develop or buy new technology to cut emissions or purchase credits on the open market. In this way, cap and trade systems give enormous power to governments, as they can set emissions caps at whatever level they wish.

The fact that cap and trade systems increase rather than reduce the government’s regulatory power is one reason why many businesses oppose cap and trade. From their perspective, a cap and trade system can increase energy costs, forcing them to raise prices or even lose business to firms in other countries that do not operate under a cap and trade system. Even if caps are initially set high, a company might worry that future governments would reduce them to reduce greenhouse gas emissions.