Cap and Trade Policy Memo

Kelly Wilder










11/18/08
Cap-and-Trade CO2 Emissions Control
Are pollution auctions an effective mechanism for reducing negative externalities?

Carbon dioxide is the most important anthropogenic greenhouse gas. Its atmospheric
concentration has grown by a third since before the industrial revolution, contributing to
global warming of over one degree Fahrenheit over the past century. The growth in CO2
emissions is due primarily to increases in fossil fuel use. When fossil fuels – mainly
petroleum, natural gas and coal – are burned to produce energy, the carbon contained in them
is emitted almost entirely as CO2.

The effects of increases in CO2 emissions and subsequent climate change are already
apparent. Without a departure from business as usual, it is likely that we will see further,
drastic environmental, social and economic effects in the near future. Because an average
CO2 molecule remains in the atmosphere for hundreds of years, it is essential that we begin
to lower CO2 emissions immediately if we hope to avoid some of the more dire effects of
climate change.

Recommendations: Cap-and-Trade

Policy options for reducing CO2 emissions include a tax, cap and trade, and command-and-
control. This brief will examine each of the methods and conclude that both a tax and cap-
and-trade are preferable to a command-and-control approach. Of these, cap-and-trade is the
best option because it reduces compliance costs to firms. We recommend a national cap-and-
trade program with strong enforcement of limits and auctioned, bankable permits.

Cap-and-trade systems put a limit on the amount of emissions all firms in the market are
allowed to emit. This total level of emissions is broken down into allowances. In the model
that we recommend, a governing body would auction these permits to polluting firms. Firms
would be required to lower emissions – by investing in more efficient technology or using
less carbon-intensive fuel – or buy extra allowances from firms that have lowered their own
emissions below the limit. In this way, emissions are reduced in the most cost effective way.

Background: CO2 and Emissions-Control Precedents

Atmospheric greenhouse gas concentrations have risen markedly in the past two centuries
due to human activities. Changes in atmospheric levels of greenhouse gases change the
energy balance of the earth’s climate system. It is unequivocal that our climate system is
experiencing a warming trend. Temperatures over the last 50 years have risen an average of
0.65 degrees Celsius, almost twice the rise over the last century of 0.74 degrees Celsius.
Climate system effects attributed to the rise in anthropogenic greenhouse gas emissions
include warming oceans, melting glaciers and ice caps, and rising sea levels. In turn, these
effects have serious ecological, social and economic implications.

---

Carbon dioxide is the most important anthropogenic greenhouse gas in terms of its radiative
effect on global climate. Carbon dioxide has increased in concentration from a pre-industrial
level of about 280 ppm to almost 400 ppm in 2005, far above the 650,000-year average of
180 to 300 ppm. This increase has been due primarily to fossil fuel use and land use change
since the industrial revolution.

There are precedents for a CO2 cap-and-trade program. Title IV of the Clean Air Act of 1990
implemented a cap-and-trade for SO2 emissions – a major driver of acid rain. Using a
tradable allowance system capitalizes on the power of the marketplace to reduce emissions in
the most cost-effect manner. The General Accounting Office projects that the tradable
allowance system could save as much as $3 billion per year – over 50 percent – compared
with a traditional command-and-control approach. As a result of the Acid Rain Program, SO2
emissions have been reduced by almost 40 percent below required levels.

The European Union Greenhouse Gas Emission Trading Scheme (EU ETS) was established
in 1995 as a cap-and-trade system for trading in greenhouse gas emissions. The EU has
pledged to reduce emissions to 30 percent below 1990 levels by 2020 – at a cost of only 0.1
percent of GDP. A first phase focuses on point-source emissions from large emitters in the
power and heat generation industry and in selected energy-intensive industrial sectors. A
second phase may include aviation emissions. Under the EU ETS, the vast majority of
allowances are being given away for free.

Analysis: Command-and-Control, Cap-and-Trade or Tax?

The choice between command-and-control and fee-based emissions reduction schemes is
based on the level of knowledge in the market, as well as the marginal costs of various firms’
abatement efforts. In the case of greenhouse gas emissions, the costs of abatement are high:
drastically lower output or utilize high-tech solutions. Fee-bases schemes are preferable for
other reasons as well:
• Fees achieve the same reductions as standards at lower costs.
• Fees give an incentive to install new equipment that will lower emissions even
further.
• Fees can generate government revenue that can be used to achieve related goals.

A cap-and-trade system is economically preferable to a tax. It is simpler and more
transparent; a tax would have to be tailored to each firm in order to be equitable. Simplicity
and transparency are important in the formation of a new market, especially for something as
nebulous as environmental commodities. The literature also suggests that auctioning of
permits reduce rent-seeking behavior among firms – the practice of investing resources in
affecting the outcome of an administrative process. In the electric sector, auctioning tends to
reduce the difference between price and marginal cost for electricity generation compared
with free allocation. Another advantage of both auctionable cap-and-trade and emissions
taxes is that “revenue recycling” would reduce the cost of climate policy on households and
firms. Overall, auctioning will create a revenue stream that could be used to invest in
research and development of new technologies and in the necessary adaptation of both the
private and public sector to climate change.

---

There is evidence that auctioning of allowances will place the burden of abatement more
heavily on consumers, as in the electric sector where utilities can pass on higher costs to their
consumers. However, these costs would be born most heavily by consumers in highly coal-
dependent states, and these consumers would still face lower energy costs than in other parts
of the country.



A disadvantage to the free allocation of allowances in the electric sector is related to the fact
that some utilities are competitive and some are highly regulated. In the case of free
allocation, producers in competitive markets would raise prices while those in regulated
markets would not. This asymmetry, related not to the level of emissions but to the state of
regulation, is a stumbling block for advocates of free allocation.



It could be argued that failure to pass on costs of abatement to customers is in fact inefficient.
Without an increase in energy prices, electricity customers have little incentive to reduce
consumption – an important step if the goal is to reduce overall emissions.

Conclusion: Cap, Auction and Trade

---

This report recommends a cap-and-trade system to lower CO2 emissions. The system should
incorporate auctioned, bankable pollution permits. It should also have strong enforcement
ability – the largest and top-grossing firms could otherwise find it economical to pay penalty
fees instead of reducing emissions.



Sources:

http://ipcc-wg1.ucar.edu/wg1/Report/AR4WG1_Print_SPM.pdf
http://www.epa.gov/climatechange/emissions/co2_human.html
http://www.epa.gov/airmarkets/progsregs/arp/basic.html
http://ec.europa.eu/environment/climat/pdf/bali/eu_action.pdf
http://www.rff.org/focus_areas/features/Documents/CT-Burtraw-Testimony-08-01-23.pdf

---

Additional Information:




Source: http://www.epa.gov/climatechange/emissions/usinventoryreport.html

---

Source: http://ec.europa.eu/environment/climat/pdf/bali/eu_action.pdf

---

Results of a Tax:
•
The efficient abatement level is achieved: e*
•
The abatement cost to the polluting firms, C + G + K, is minimized
•
Government revenue = B + C + F + G + J + K
Results of Cap-and-Trade:
•
The efficient abatement level is achieved: e*
•
The abatement cost to the polluting firms, C + G + K, is minimized

---