As discussed in our brief on Decarbonization (linked in Further Reading), reducing greenhouse gas emissions is a key strategy for reducing global temperature increases. There are many ways to achieve this goal with new technologies, such as requiring Americans to use electric vehicles instead of those powered by gasoline. Cap and trade offers another strategy, one that leaves it up to individual decision-makers to decide when and how they will reduce greenhouse gasses. Is cap and trade a good alternative or complement to government regulations?
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.
Further Reading
Ramseur, L. J. (2021). A Brief Comparison of Two Climate Change Mitigation Approaches: cap and trade and Carbon Tax (or Fee). Congressional Research Service. https://tinyurl.com/y3zkjfp9, accessed 4/11/24.
Bayer, P., & Aklin, M. (2020). The European Union emissions trading system reduced CO2 emissions despite low prices. Proceedings of the National Academy of Sciences, 117(16), 8804-8812. https://tinyurl.com/537ffez9, accessed 4/11/24.
Policy vs Politics Policy Brief: Decarbonization, https://policyvspolitics.org/decarbonization/
Sources
What is Cap and Trade?
Aldy, J. E., & Stavins, R. N. (2012). The Promise and Problems of Pricing Carbon: Theory and Experience. The Journal of Environment & Development, 21(2), 152-180. https://tinyurl.com/yrhcc7zb, accessed 4/11/24.
Ramseur, L. J. (2021). A Brief Comparison of Two Climate Change Mitigation Approaches: cap and trade and Carbon Tax (or Fee). Congressional Research Service. https://tinyurl.com/y3zkjfp9, accessed 4/11/24.
What problem is Cap and Trade designed to solve?
Aldy, J. E., & Stavins, R. N. (2012). The Promise and Problems of Pricing Carbon: Theory and Experience. The Journal of Environment & Development, 21(2), 152-180. https://tinyurl.com/yrhcc7zb, accessed 4/11/24.
Blackman, A., Li, Z., & Liu, A. A. (2018). Efficacy of Command-and-Control and Market-Based Environmental Regulation in Developing Countries. Annual Review of Resource Economics, 10, 381-404. https://tinyurl.com/4ebsb7z9, accessed 4/11/24.
Does Cap and Trade happen today?
Bayer, P., & Aklin, M. (2020). The European Union emissions trading system reduced CO2 emissions despite low prices. Proceedings of the National Academy of Sciences, 117(16), 8804-8812. https://tinyurl.com/537ffez9, accessed 4/11/24.
Hernandez-Cortez, D., & Meng, K. C. (2022). Do Environmental Markets Cause Environmental Injustice? Evidence from California’s Carbon Market. National Bureau of Economic Research Working Paper Series, 27205. https://tinyurl.com/7zuphh9p, accessed 4/11/24.
Schmalensee, R., & Stavins, R. N. (2017). Lessons learned from three decades of experience with cap and trade. Review of Environmental Economics and Policy, 11(1). https://tinyurl.com/3vuc8xtu, accessed 4/11/24.
Why don’t more governments use Cap and Trade?
Green, J. F. (2021). Beyond Carbon Pricing: Tax Reform is Climate Policy. Global Policy, 12(3), 372-379. https://tinyurl.com/8ppp98c5, accessed 4/11/24.
Nordhaus, T., & Shellenberger, M. (2009). The Flawed Logic of the cap and trade Debate. Yale Environment 360 Web Publication. https://tinyurl.com/mruhvau8, accessed 4/11/24.
Schmalensee, R., & Stavins, R. N. (2017). Lessons learned from three decades of experience with cap and trade. Review of Environmental Economics and Policy, 11(1). https://tinyurl.com/3vuc8xtu, accessed 4/11/24.
Tvinnereim, E., & Mehling, M. (2018). Carbon pricing and deep decarbonization. Energy Policy, 121, 185-189. https://tinyurl.com/am2atc8w, accessed 4/11/24.
Contributors
Julia Acevedo (Intern) is a Political Science and Public Policy double major at Susquehanna University and is expected to graduate in May 2024 and pursue a Masters degree in Public Health.
Nina Dragasevic (Intern) is a Political Science student at Binghamton University concentrating in international affairs. Her expected graduation is May 2024, and she will be finishing her degree on an internship at the John W. Kluge Center in Washington, D.C..
Dr. Robert Holahan (Subject Matter Expert) is Associate Professor of Political Science and Faculty-in-Residence of the Dickinson Research Team (DiRT) at Binghamton University (SUNY). He holds a Ph.D in Political Science in 2013 from Indiana University-Bloomington, where his advisor was Elinor Ostrom.
Dr. Nathaniel Birkhead (Content Lead) received his Ph.D in Political Science from Indiana University. He is Associate Professor of Political Science and Department Chair at Kansas State University. His research focuses on American politics, especially Congress and state legislatures.
Dr. William Bianco (Research Director) received his Ph.D in Political Science from the University of Rochester. He is Professor of Political Science and Director of the Indiana Political Analytics Workshop at Indiana University. His current research is on representation, political identities, and the politics of scientific research.
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Published 6/4/24