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What is Cap-and-Trade?

Under a cap-and-trade plan to reduce greenhouse gas emissions, a limit is set on the amount of greenhouse gases (GHG) – carbon dioxide and five others – that can be emitted by regulated entities – e.g. the power plants that produce electricity, chemical refineries, and other carbon emitting industries.  This is the cap.

Regulated entities purchase, or are given, allowances equal to the amount of GHG they will be emitting over a given period of time.  For example, a power plant could be given x number of allowances for the x metric tons of CO2 they will be emitting through their operations.  Entities that purchase more allowances than they need may sell additional allowances to entities that are unable to keep their emission level under the cap. This is the trade.

A cap may be set slightly higher than the existing level of GHG emissions across the participating sector.  This limit is then gradually lowered, making allowances more expensive over time and reducing emissions – the ultimate goal. Cap-and-trade enables emitters to choose whether to reduce their emissions at the source, or, if this is prohibitively expensive, to purchase allowances from other emitters that have been able to reduce their own emissions.

Carbon dioxide is the most prevalent greenhouse gas produced by human activity, followed by methane, then ozone.  Because greenhouse gases are carbon based, plans that monetize GHG emissions are considered to be “putting a price on carbon.”

Elements of Cap-and-Trade

In theory, designing a cap-and-trade plan involves addressing several potentially thorny issues, including:

  • Setting the cap

Initially setting the cap too low – say, below current emission levels – makes industry compliance technically impossible.  This is a real danger in the absence of comprehensive emissions inventories, though political reality probably works against the setting of reduction targets that are too stringent.  Without adequate protections, a low cap could also cause consumer energy prices to rise steeply as power producers pass along the cost of meeting a rapid reduction schedule.

Setting the cap too high creates a “non-binding cap” that actually encourages an increase in emissions.  If the cap is higher than industry demand, the value of allowances will be negligible, negating the whole principle behind the trading system.

  • Incorporating offsets

In lieu of on-site emissions reductions, regulated entities under cap-and-trade can contribute to projects that reduce greenhouse gas emissions at another source, or reduce emissions globally.  For example, a power utility could pay for the capturing of methane at a landfill or pay for a tropical reforestation project creating a “carbon sink” that absorbs atmospheric CO2.  The utility would then receive emissions allowances equal to the “offset” GHG emissions

Offsets are controversial.  First, they have to be stringently monitored and quantified to ensure equivalency between the offset and an emissions allowance.  Secondly, while an offset may help reduce emissions levels globally, it does not address the impacts of emissions locally.  For example, if the utility pays for tree planting in a distant country instead of reducing emissions at its power plant, surrounding communities affected by particulate pollution and poor air quality see no benefit.

  • Preventing leakage

The goal of a cap-and-trade plan is undercut if power production shifts from regulated to unregulated sources as the cap lowers and allowances become more expensive.  For example, a cap-and-trade initiative that only covers certain states could simply push electricity production into bordering unregulated states.

Related is the concern that a nationwide cap-and-trade plan in the United States could push heavy industry to relocate to other countries that do not put a price on GHG emissions. American jobs would be lost and global emissions would not be reduced.  The major strategy to avoid leakage, at any scale, would be to make sure that an equivalent price is put on emissions across all regions and countries.

  • Allocating allowances

Allowances can either be gifted to entities depending on their existing levels of emissions, or auctioned off to the highest bidder.  In the auction scenario, the price of an emissions allowance is set by industry demand.  Essentially, this is why cap-and-trade is considered a “market-based” policy.

Some cap-and-trade plans combine both gifting and auctioning.  A portion of the allowances are granted to the regulated industry – or “grandfathered” – and the rest are auctioned.  This was the case with the 2008 Lieberman-Warner Climate Security Act that died in the U.S. Senate.

Most green economy advocates favor auctioning 100% of emissions allowances.  This is the case with the Obama plan outlined in the 2009 Federal budget.

  • Spending revenue:

If allowances are auctioned, cap-and-trade creates a large pool of money.  This revenue can be used directly to help industry comply with emissions reductions – e.g. installing new technologies or switching fuels at emissions sources – or invested in public uses.

Green economy advocates, including the Apollo Alliance, favor a “cap-and-invest” strategy. “Cap-and-Invest” means that auction funds are dedicated to energy efficiency, renewable energy, and green technology programs – in other words, toward easing the transition away from fossil fuel dependency and minimizing the potential impact on consumers of rising energy prices as industry passes along the costs of emissions allowances.

An alternate model, called “cap-and-dividend”, returns all, or the greater part, of auction revenue to the people in the form of a direct payment or tax break. Obama’s plan would dedicate a portion, but not the majority, of auction funds to renewable energy and energy efficiency programs.  The greater part would go towards payroll tax breaks, specifically framed as a means of offsetting increased energy costs.

An Alternative to Cap-and-Trade: Carbon Taxation

The major alternative to cap-and-trade is a carbon tax.  A carbon tax sets a price on the burning of fossil fuels and emitters must pay for every ton of their carbon pollution.  In other words, they cannot buy and trade allowances, or offset their source pollution.  A carbon tax would be set and adjusted by government, rather than being directly determined by market demand.  Each sector of the economy may pay a different tax rate based on the carbon intensity of their operations.

Many environmental justice advocates support carbon taxation over cap-and-trade.  To the Environmental Justice Leadership Forum on Climate Change, cap-and-trade creates a “stock market that commodifies pollution and continues to trade our health and environment for profit.” In particular, environmental justice advocates object to the modest reduction targets that often accompany a cap-and-trade, and the problem of offsets.  Based on their experience, they believe that companies will pay for offsets or purchase extra allowances rather than cleaning up their operations in the low-income areas and communities of color that often host polluting industries.

In January 2009, WE ACT for Environmental Justice, a major environmental justice organization in New York City, hosted a major summit on climate change policy, “Advancing Climate Justice: Transforming the Economy, Public Health and Our Environment.”Hundreds of environmental and economic justice advocates gathered to discuss climate solutions that “restore our credibility nationally and globally on the issue of climate change while preserving the livelihood, health and safety of all Americans.” Many conference participants spoke out against cap-and-trade and in favor of carbon taxation. The full Principles of Climate Justice released at the conference can be seen here.

Some economists also support a carbon tax because it is more straightforward and transparent than cap-and-trade – the tax is set legislatively and then levied equally on all industries based on the carbon content of their emissions.  These economists have also noted how a carbon tax can be revenue neutral if tax revenues are used to reduce the overall tax burden.

Carbon taxation supporters are the textbook definition of strange bedfellows: Some right-wing pundits and representatives from the most fossil-fuel intensive industries, including the CEO of ExxonMobil, have taken up the carbon tax banner.  It is unclear whether they are actually supportive of a carbon tax, or are trying to delay national action by prolonging the debate around greenhouse gas emission reduction strategies.

Carbon taxes have been instituted in several countries and even municipalities.  Boulder, Colorado adopted a small carbon tax in 2006. At the moment, however, political momentum is behind cap-and-trade as a basis for national policy.

Existing Cap-and-Trade Initiatives

The cap-and-trade approach has been tried before.  Beginning in the 1990s, the U.S. Environmental Protection Agency oversaw a successful cap-and-trade program to reduce sulfur dioxide emissions causing acid rain. Europe, however, is currently farthest along in implementing a cap-and-trade program.

  • European Union Emission Trading Scheme (ETS)

Beginning in 2005, the European Union countries launched a cap-and-trade initiative to meet their Kyoto Protocol commitment of reducing GHG emissions 8% below 1990 levels by 2012.  The European Union Emission Trading Scheme (ETS) covers most electricity generation and some heavy industry in European Union countries, representing 45% of Europe’s CO2 emissions. The ETS defined the first three years as a trial period and mistakes were made, demonstrating some of the potential pitfalls of cap-and-trade implementation.

Due to industry pressure, the ETS initially gave away 90% of emissions allowances to industry.  Utilities passed along the cost of the allowances to consumers through higher energy prices, even though they were not paying for them. The New York State Department of Environmental Conservation estimates that, “in the [United Kingdom] alone, free allowances amounted to a $1 billion grant to the power industry.” *

Because there was no reliable inventory of existing emissions at the time, the European plan also gave away too many emissions allowances, creating essentially a non-binding cap.   The over allocation caused wild fluctuations in the price of emissions allowances, undermining their value and the “trade” side of the equation. There was also concern that the plan’s Clean Development Mechanism – the offset program component – was becoming a bonanza for unregulated offset projects in China.

Europe learned from the initial missteps.  Armed with better emissions inventories, they have tightened the cap, auctioned a greater proportion of the allowances, and strengthened CDM regulation as the ETS heads into the second implementation period, during which the cap will begin to lower.

  • Regional Greenhouse Gas Initiative (RGGI)

In the U.S., the Western Climate Initiative, a cap-and-trade plan involving seven Western States and four Canadian provinces, will soon go into effect.  In the Northeast, the Regional Greenhouse Gas Initiative is already underway. A partnership of Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, and Vermont, RGGI (or “Reggie”) is the first mandatory plan in the U.S. to reduce carbon dioxide emissions from the electricity generation sector.  RGGI aims to reduce these emissions ten percent by 2018.  The details of its implementation provide a good idea of how the various aspects of a U.S. cap-and-trade plan could work in practice.  Indeed, experts believe that RGGI will be a model for a potential national cap-and-trade plan.

RGGI is a cap-and-invest plan.  It uses a cap-and-trade mechanism to reduce emissions and invests money from the auction of emissions allowances in the green economy.

It works like this:  As of January 1, 2009, RGGI sets a regional, annual emissions cap of 188 million tons of CO2 for 225 fossil-fueled electric power plants across the ten states.  That’s 9 percent above the actual level of emissions in 2007.  Beginning in 2015, the cap is reduced by 2.5 percent each year until 2018.

One hundred percent of RGGI allowances will be distributed by auction to electricity generators.  One hundred percent of auction revenues will also be reinvested in public programs that complement RGGI goals, like consumer energy efficiency programs.

Offsets can account for 3.3 percent of a power plant’s reductions.  This proportion may increase if the price of the emissions allowances hits certain thresholds.  To address the potential for leakage, a RGGI working group has outlined a slate of potential remedies.  These include monitoring programs, statewide energy use reductions to slake demand, and political advocacy for a national cap-and-trade program that would eliminate any room for leakage.

New York State’s proceeds from participating in its first RGGI allowance auction in December were approximately $42 million.  When this total is combined with upcoming auctions, revenues could total more than $217 million for New York in 2009 alone.  This revenue stream will increase to a river once the cap begins to lower in 2015.

New York’s RGGI auction revenue is controlled by the New York State Energy Research & Development Authority (NYSERDA), the public benefit corporation that runs the state’s energy efficiency, renewable energy, and green technology programs. In January 2009, the NYSERDA board, its official decision-making body, decided on how to divide up the first $42 million.  Under the Early Action Plan, they committed $15.3 million to residential heating efficiency programs, $5.5 million to commercial and industrial efficiency, and $2.1 million for workforce development.  Of the residential efficiency allocation, $ 7.6 million will be dedicated to helping low-income renters and homeowners.

More Information


Point Carbon,

Regional Greenhouse Gas Initiative (RGGI),

“The European Union Emissions Trading System in Perspective,”

“Learning from Europe: Designing Cap-and-Trade Programs that Work,”

“Group Says European Cap-and-Trade System Reduced Emissions,”

Carbon Taxation

Carbon Tax Center,

“Making the Case for a National Carbon Tax,”

The Politics of Cap-and-Trade and Obama’s Budget

“Prospects for Climate/Energy Action,”

“Drilling Down on the Budget: Setting Green Goals,”

“Budget?  I barely know it!”

“Faint Signal: What is Obama’s Proposed Price on Carbon?”

“Nine Climate Questions for President Obama,”