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Cap and Trade 101

Carbon pricing, and specifically the leading strategy of cap and trade, is something we discuss regularly here at Worldchanging. One of our favorite, informed voices on this solution is carbon pricing guru Eric de Place, a senior researcher at the The Sightline Institute, whose writing on the subject we've featured prominently here. From carbon budgets to carbon taxes, Eric's articles and research have been helping us wrap our heads around this issue.

Now Eric and his teammates have gone a step further. Deciding how best to implement this type of fair, efficient and effective carbon policy is a huge and potentially confusing task for everyone from government officials to everyday citizens. So to help inform the debate, the Sightline team has put out Cap and Trade: A Climate Policy Primer.

The policy primer goes over all the basics, such as:

* How does cap and trade work?
* What does a good system look like?
* How do we make sure it's fair for everyone?
* What about offsets?
* Why not use a carbon tax?
* What's the rest of the world doing?

This 37 page PDF, sort of a "cap and trade for dummies," is worth a read whether you just need a refresher or if you are completely new to the topic. And although it's a little too long to publish in its entirety, we'd like to share some of the highlights:

Why do we need cap and trade?

At base, the threat of climate disruption stems from a single fact: We treat the atmosphere as a free dumping ground. No one has to pay to pollute our shared air. The result has been increasing concentrations of climate-warming gases, along with other maladies of our energy system like oil addiction. Jump-starting a transition to a clean-energy economy means, above all else, putting a price on climate-warming emissions: no more free dumping. The way to make polluters pay, while guaranteeing that we’ll meet emissions-reduction goals, is to implement a system called “cap and trade.” Cap and trade commits a region to responsible limits on global warming emissions; gradually ratchets down those limits over time; and harnesses the power of the marketplace to reduce emissions as smoothly, efficiently, and cost-effectively as possible.

Why cap and trade works best:

It’s tested and proven. A cap-and-trade system worked cheaply and efficiently to reduce acid rain pollution in the United States in the 1990s.

It’s cost-effective. A cap provides market incentives to steadily reduce pollution in a cost-effective and efficient manner, encouraging a healthy shift away from the instability and insecurity of fossil fuels.

It’s economically sound. Today, we stand at the top of the pollution staircase. It would be dangerous and risky to jump to the bottom or run down too fast. Instead, cap and trade allows our businesses and families to step down, stair by stair, at a gradual pace that is safe and manageable. We can adjust through fuel efficiency and increased renewable energy resources like solar and wind power. Cap and trade offers us a path to success in the new energy economy: maximum flexibility, clear and feasible goals, and a predictable timeline.

It’s a prudent, long-term investment. The key to our long-term prosperity and a stable economy is a shift away from oil. This shift can work for businesses and consumers alike, allowing us to take charge of rising energy costs, invest in new technologies, and ensure a smooth transition. Right now, we’re sending billions of dollars a year out of local economies to pay for dirty energy.

Most importantly, the cap is a solid guardrail on the path to success. No policy measure can substitute for setting a solid cap on the greenhouse gas emissions that are allowed into the atmosphere; it’s our firm guarantee that we will meet crucial pollution targets.

The basic steps to operating a cap-and-trade system:

1. Tally greenhouse-gas emissions. For example, track fossil fuels at the points where they enter the region’s economy: the pipeline or oil tanker.1 The state of Washington has only about 100 companies in business at such entry points.

2. Set a cap. Decide how much carbon pollution to allow in the program’s first year and require permits for emissions: one permit per ton of carbon dioxide or its equivalent in other heat-trapping gases (known as CO2 equivalent, or CO2e). The number of permits will match the cap to ensure we hit our goals. (A cap does not limit emissions from individual citizens; no paperwork for families or small businesses is required. Instead, it affects wholesalers or suppliers of fossil fuels and similar big “upstream” businesses. Price signals travel downstream
through the economy to other businesses and to consumers.)

3. Distribute permits. Permits can be valid for a single year, or for a multi-year period. One method for distributing them is auctioning; another is to give them away free on the basis of past emissions (“grandfathering”), past energy sales, or some other criterion. Permit holders can buy and sell allowances among themselves. That’s the “trade” part.

4. Enforce the cap. Affected businesses (for example, those that bring fossil fuels into the economy) will file periodic reports verifying that they hold enough permits to cover their emissions. Authorities will audit some reports to deter misrepresentation. They will curb speculation and gaming by overseeing the permit market, much as the Securities and Exchange Commission oversees Wall Street.

5. Ratchet down. Each year, distribute fewer emissions permits, on a predictable, published schedule that takes us to our targets. The gradual nature of this transition maximizes choice and flexibility in a way that narrowly targeted climate policies cannot match.

How to tell whether a cap-and-trade program is well designed
Cap-and-trade programs should embody three core principles:

Effectiveness: Climate policy should cut global-warming pollution gradually enough for businesses and families to adjust but at a pace rapid enough to meet the ambitious targets recommended by science and set by law in many jurisdictions. In short, it should be capable of causing emissions to decline by 15 percent (below 2005 levels) by 2020 and of largely eliminating greenhousegas emissions from fossil fuels in four or five decades.

Efficiency: Climate policy should chart the most cost-effective route. It should be simple, flexible, and market-oriented; it should minimize cheating and gaming. We have neither the time nor the money for a strategy that’s wasteful, poorly conceived, or vulnerable to manipulation.

Fairness: Climate policy should share equitably the economic burdens and benefits of climate stewardship. In fact, climate policy should redress some of the injustice of climate change itself.

Crucial characteristic of a well designed cap and trade system

The principles of effectiveness, efficiency, and fairness described above lead to a particular cap-and-trade system design, which has four crucial characteristics:

1. It is comprehensive in scope.
Comprehensive. Cap and trade should cover all measurable emissions of greenhouse gases to ensure an efficient, economy-wide transition away from carbon-based fuels. In particular, it should cover transportation fuels such as gasoline and diesel.

2. Its point of regulation is upstream.
Upstream. For simplicity’s sake, cap and trade should operate as high as possible in the supply chains for fossil fuels—as close as is convenient to the point at which fossil fuels enter the economy of the state, province, or nation in question. This approach means that far fewer than one-tenth of one percent of businesses will have any direct interaction with the cap-and-trade system. Cap and trade does not create any paperwork for families or small businesses.

3. Its permits are allocated by auction.
Auctioned. Permits to emit greenhouse gases should be sold at quarterly public auctions, not distributed free—“grandfathered”—to historic polluters. Auctioning prevents windfall profits for energy companies, allows the proceeds of the auctions to serve the public interest, and prevents market manipulation and “gaming.” Grandfathering the privilege to pollute would take money from low-income consumers and give it to the predominantly wealthy shareholders of energy companies.

4. It uses auction revenues to provide built-in protections for working families.
Built-in protections. Revenue from auctioning cap-and-trade permits should go, first and foremost, to compensate working families for the burden of expensive energy. Good strategies include full rebating of all auction proceeds on an equal per-person basis (“Cap and Dividend”); rebating certain auction proceeds to lowand moderate-income families (“Cap and Buffer”); investing a share of proceeds in upgrading the energy efficiency of working families’ homes (“Cap and Caulk”); and investing a share of auction proceeds in green-collar-job training programs— giving disadvantaged families a chance to gain from the new opportunities of the
clean-energy economy.

In closing:
Seizing the economic opportunities of a clean-energy future, while avoiding the perils of climate disruption and oil addiction, is arguably the defining challenge for our time. We have exciting chances to slash emissions through low-carbon energy sources such as wind and other renewables and through a revolution in energy efficiency. Similarly, we have an abundance of ways to curb hard-to-track emissions at landfills, industrial facilities, and factory farms. We may be able to soak carbon dioxide out of the atmosphere by restoring forests and grasslands to their historic richness. We may even perfect underground carbon storage. To ease compliance with the cap, we will need a host of other smart policies and innovations: complete, compact neighborhoods that free us from long, tiresome commutes; pay-as-you-drive insurance; bounties on juice-hogging old appliances and gas guzzlers; efficiency standards for buildings, vehicles, and appliances; weatherization brigades to retrofit low-income home; continuous, separate, citywide bikeways and walkways; pervasive for-profit and nonprofit car-sharing; richly networked, flexible, and reliable public transit; loans for efficiency upgrades that are repayable on your
utility bill or property tax; and more.

It’s a bracing challenge, and the clock is ticking. But the most important step— bar none—is the cap. With a firm, legal, comprehensive cap, emissions will decline. Without one, there’s no guarantee. In the absence of a cap (or a self-adjusting carbon tax shift), we could do everything else on the list—including even radically high regulatory standards—and still watch emissions grow.

The key to smart climate policy is putting a price on carbon—ideally through a comprehensive, auctioned, upstream cap-and-trade system with built-in protections for working families. Anything else is second best.

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I don't get the "upstream" thing. Does it mean the fossil fuel importers and refiners, rather than fossil fuel burners, would be the ones to buy permits?

Posted by: Jane on 22 Sep 08

Good question: That's exactly what "upstream" means. Tracking (and capping) carbon upstream is much simpler and more effective because we're looking for hundreds/thousands of sources rather than hundreds of millions of dispersed sources that burn carbon. Also, an oil company is much better equipped to participate in a regulatory and trading program than, say, individual drivers.

Posted by: Eric de Place on 22 Sep 08

But importers aren't necessarily emitters. It doesn't seem fair that they should essentially buy permission to sell their products (as opposed to using them). Also, wouldn't incentives to reduce emissions and be able to sell your permits disappear in such a system?

What about a hybrid system -- cap and trade for utilities and large businesses and a carbon tax on gasoline, heating oil and home natural gas?

Posted by: Jane on 24 Sep 08

Jane, you're right that importers aren't emitters in the case of natural gas and petroleum. But it's the one place where we know precisely how much carbon is coming in to the economy. Essentially, they will purchase allowances and pass along the cost to consumers -- so the effect of including them will be very much like having a carbon tax on those sectors. (You can think of it like a carbon tax that automatically adjusts to get exactly the amount of reductions called for by cap.)

But there are two ways its better than a carbon tax: 1) the price added to carbon-based fuel will be less, because the way the economics works the fuel importers will effectively be financing emissions reductions in other sectors where they're cheaper; and 2) we get certainty about our emissions because we're subjecting all the major sources to a cap.

Posted by: Eric de Place on 24 Sep 08

This is turning into a two-party conversation, but I'll ask one more question. The genius of cap-and-trade is that it almost guarantees reductions faster than the fall of the cap because it allows businesses to benefit from emission reductions in TWO ways.
1. They can buy fewer permits. This leaves them somewhat better off than they would be otherwise, but worse off than they would have been without the system.
2. If their emissions fall faster than planned, or as part of a deliberate strategy, they can sell their permits to other business. Depending on the market price of emission credits, this can potentially leave a business better off than it would have been without the system. At the very least, it creates a profit motive, as opposed to just a loss-avoidance motive.

Since non-emitting importers are not going to trade permits among themselves, upstream regulation kills the second benefit. Thus, it would probably result in a slower reduction of emissions. As for finding out how much carbon is emitted by various enterprises, don't existing sales taxes rely on the same types of records (generally electronic) that would be needed for tracking who emits how much?

Posted by: Jane on 24 Sep 08



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