Background

• Cap-and-trade systems use market forces to reduce emissions in a cost-effective manner by creating a financial incentive for emission reductions in assigning a cost to polluting. A "cap" is established across industries or economies to limit emissions. The allotted emissions are divided among and traded between polluters. Polluters will attempt to reduce their emissions because becomes profitable when the emissions are restricted.
• An advantage to a cap-and-trade system is that it gives polluters flexibility in achieving emission targets while also cutting total emissions. Other approaches to reducing CO2 emissions may hurt some companies that cannot access greener technologies.
• According to a New York Times Paul Kruman Op-Ed, a system of cap-and-trading system of sulfur dioxide trading was enacted in the 1990s, and it has since reduced acid rain from coal power plants in the United States. Supporters of cap-and-trading carbon dioxide point to this as an example that suggests such a system would be effective, but, according to Krugman, detractors argue that the nature of carbon dioxide makes this system fundamentally flawed. Carbon dioxde created in China, says Krugman, has the same effect as carbon created in the United States, so detractors say that it is pointless to enact any restrictions on carbon emissions in the United States. The Krugman article

Debate

• Critics argue that the market-based approach is flawed because cap-and-trade schemes are skewed to benefit business at the expense of the environment. To ease the transition for businesses, European governments handed out carbon credits instead of requiring businesses to buy credits. They also issued too many carbon credits which eliminated the incentives for firms to cut emissions.

• Some economists argue that cap-and-trade systems produces fewer incentives than a carbon tax for emissions reductions because innovations that reduce costs of cutting carbon also cut the price of carbon credits. This reduces returns for investors. A carbon tax, however, sets a clear price floor for carbon and a minimum return for any innovation.

• The permit prices in cap-and-trade schemes has proven to be alarmingly volatile with the potential to effect the overall health of the economy. The price of tradable sulfur dioxide (SO2) credits has fluctuated by 40% on average since the mid-1990s. Similar fluctuations in the carbon market could have drastic effects on the economy- from inflation to consumer spending to investment.

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Country Comparison

• European Union
  
  • In 2006, Members of the European Union Emission Trading Scheme issued too many carbon allowances, flooding the market and reducing the price of carbon credits. These events discouraged businesses from taking full advantage of carbon markets. An article by The Economist reports that businesses are reluctant to use carbon markets because they are saturated with regulation and they are not designed to reward businesses that attempt elaborate carbon transactions. In addition, firms have not figured out how to capitalize off a system designed to cut pollution (Source: The Economist).

Recent Developments

• The cap-and-trade system first gained prominence in the United States with the 1990 Clean Air Act, which established the first cap-and-trade system to reduce SO2 emissions (the primary cause of acid rain). The success of this system influenced the cap-and-trade CO2 emissions system designed by the European Union.
• In 2003, 9 Northeastern states formed cap-and-trade system to control CO2 emissions that is due to launch in 2009. In this program, each state's carbon budget will be reduced 10% below 2009 levels by 2018.
• Several legislative proposals have been introduced to Congress that would establish a form of national emissions trading system. No national legislation has been passed to date.

Additional Information