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What Cap and Trade Programs Are Really About

by Hugh Gorman

Mr. Gorman is Associate Professor of Environmental Policy and History at Michigan Technological University and the author of Redefining Efficiency: Pollution Concerns, Regulatory Mechanisms , and Technological Change in the U.S. Petroleum Industry. He currently writing a history of human interactions with the nitrogen cycle.

Is a “cap and trade” system for managing U.S. emissions of carbon dioxide likely to be as successful as the sulfur dioxide “cap and trade” program established by the Clean Air Act of 1990? Most people familiar with the sulfur program agree that it has been a success. Yet plans to use the same kind of policy tool for managing emissions of carbon dioxide have generated substantial opposition. This opposition is, to a large extent, due to important differences in the design and objectives of the two programs. These differences also provide insight into what cap and trade programs are really about: integrating ecological and geophysical limits into a market economy.

Conceptually, a “cap and trade” program for managing emissions of any kind is straightforward. First, a governing body places a limit or cap on the total amount of material allowed to be released in a region. Then, enough tradable emission credits are issued to match the cap, with each emission credit serving as a permit to release a ton (or some other convenient unit) of material. Once the system is in place, anybody responsible for emissions of that material must secure enough emission credits to allow for its release. For example, in the sulfur dioxide emissions trading program, a power plant that emits 40,000 tons of sulfur dioxide into the atmosphere must secure 40,000 tons worth of emission credits.

The beauty of the system, regardless of the material being emitted, is that it provides the flexibility companies need to make the technological and business choices that are the most efficient for them. Regulators do not have to get involved at the so-called “command and control” level of detail. Power companies, for example, have several options to choose from when managing sulfur emissions. They can: burn inexpensive high-sulfur coal and secure enough credits to cover a large volume of emissions; burn expensive low-sulfur coal and secure fewer emission credits; install equipment for removing sulfur from stack gases; or use some combination of all three. Choosing the right strategy is primarily an economic decision that firms have the flexibility to make on their own. In the process, they can buy and sell emission credits. Regulators simply need to verify that companies secure enough emission credits to match their actual emissions. If that happens, the total sulfur emissions from all power plants will never exceed the cap. Furthermore, if regulators determine that further reductions in emissions are required, they do not have to engage in an elaborate reorganization of permits. They simply have to remove some credits from circulation.

The flexibility that comes with a “cap and trade” program will remain in place with the proposed carbon program. However, the design of the proposed carbon program differs from the sulfur program in an important way. That difference has to do with who owns the credits being traded, and the implications are far-reaching.

In the case of the sulfur program, Congress decided to make the transition to lower sulfur emissions as painless as possible. Therefore, the U.S. Environmental Protection Agency first gave power companies enough emission credits to cover their average sulfur emissions. As a result, power plants initially could continue operating much as they always had. Over the years, though, regulators gradually reduced each company’s allocation of credits until the desired cap was reached. The bulk of each company’s allocation of credits, however, remained in place. Companies only had to respond to the cut in their allocation of credits. Furthermore, a company that significantly reduced its emissions, perhaps by switching to low sulfur coal or by installing a scrubber, could sell its unneeded credits to another company. In effect, critics noted, the federal government had given away a valuable resource, the right to emit sulfur into the air, for free.

In the case of the proposed carbon “cap and trade” program, emitters of carbon will have to purchase credits for all the material they release into the atmosphere. In effect, the federal government no longer plans to give away emission credits for free. The practical effect, of course, is that the cost of burning fossil fuels will rise as companies pass on their costs to consumers. Ideally, these costs will encourage greater investment in cleaner forms of energy, in energy conservation, and in the technology to sequester carbon. In the meantime, however, the federal government will gain a new source of revenue: the revenue gained from selling permission to emit carbon into the air. The price of this permission will depend, of course, on the demand for the available credits. Depending on one’s point of view, one can frame that source of revenue as a royalty on the exploitation of a valuable resource (the right to emit stuff into the air) or as a flexible tax (the value of which will be determined by the market for emission credits).

Which approach is better? If the goal is solely to achieve a reduction in emissions with as little other change in the status quo as possible, the approach used in the sulfur program is preferable. The strategy used in the sulfur program, of granting ownership based on past emissions, is not without precedent. The approach has a long history in western water law. Water is a finite quantity, so the cap is often set by nature rather than by a political body, but the effect is the same. In the same way that some people gained the right to withdraw water from a river or lake based on their past use, power companies under the sulfur program gained the right to emit sulfur based on their past emissions. If one views the right to emit gases into the air as a resource such as water, there is little difference between the two cases.

On the other hand, if the goal is to not only achieve reductions but also to move toward an economy in which environmental costs are better accounted for, the proposed carbon program is preferable. Indeed, such a program would represent an important step toward what some scholars refer to as a system of ecological economics.

Other important differences between the two “cap and trade” programs involve differences in scale and scope. The sulfur program involves a relatively small number of participants (the operators of large power plants in the United States) who operate within a single industry (the electric power industry) and have a limited number of options (switching to low-sulfur coal, installing scrubbers, or purchasing more credits). A successful carbon program not only would have to include the electric power industry but also the refined products industry and the natural gas industry. Furthermore, it would also have to be linked to larger system of carbon accounting that would reward options such as the use of biofuels. In addition, in the long term, that system of accounting will have to be integrated into a global system of accounting.

The question, then, is not simply whether the carbon “cap and trade” program is likely to be as successful as the sulfur “cap and trade” program. It is more a question of how best to construct an economic system that accounts for the fact that we live on a physical planet comprised of ecological and geophysical systems that can be affected by our actions. To the extent that people accept the need for limits on sulfur and carbon emissions, the most important questions have already been answered. The question now is how best to integrate those limits into a market economy. The sulfur “cap and trade” program represented an important step in this direction; a well designed carbon “cap and trade” program has the potential for being an even larger step in the same direction.