A cap-and-trade system is considered as a useful mechanism to reduce greenhouse gas emissions, the main culprit responsible for climate change, using principles of economics. As the terms suggests, an ever decreasing cap is placed on the amount of greenhouse gas emissions that a specific region, country or economy can emit.
Emitting sectors and companies are given a specific number of permits which set how many emissions they may release. Companies that cut down their emissions can trade those permits and sell them to industries that are having trouble or are simply not cutting their emissions.
By providing the right number of emission permits and where necessary setting a minimum price for selling those permits a market mechanism is created which in principle should force sectors to decrease their emissions.
Practically speaking, if the cap was set at 10,000 tons of carbon, there would be 10,000 one-ton allowances or permits.
Every source of emissions subject to the cap (such as power plants or refineries) would have to hold allowances that equal their emissions. Allowances or permits would be acquired through auction (this would involve biding for the right number of allowances needed for them to operate) or some initial allocation from government or other institute.
The emissions cap and therefore the allowances would decrease as time goes by, meaning that the value of these allowances would increase – this is based on the basic economic principle that price is a function of demand and supply. Because the allowances would be limited and therefore valuable, those subject to the cap would try and decrease their emissions as a way of reducing the number of allowances they have to purchase .
This is certainly a very attractive method which uses free market principles and the powers of demand and supply to the trade to deliver an environmental goal.
Governments have to set up the programme and on the basis of science calculate the number of permits to be issues and from that point onwards the market takes over making sure that emissions decrease without any further government intervention.
But does this really work in practice?
Several jurisdictions have sought to adopt and implement a cap-and-trade system with some successes and some failures being reported over the years. Examples include the global Kyoto Protocol, the EU’s Emissions Trading System and a number of national initiatives such as the American Clean Energy and Security Act (US), South Korea’s national emissions trading scheme or China’s pilot trading programme .
A cap-and-trade system can only really work if there is a political appetite to make this a robust mechanism for reducing emissions. One could argue that the lack of political support for an ambitious mechanism is what led to the failure of the US Clean Energy and Security Act which died in the Senate.
In contrast, the successful adoption and implementation of the US Acid Rain Program, essentially a cap-and-trade emissions scheme for sulphur dioxide emissions, under the Clean Air Act of 1990, led to a 50% reduction of these emissions compared to 1980 levels .
Governments could also easily set up a system that issues too many permits at very low prices, which essentially provides no incentive for companies to invest in measures to reduce carbon emissions.
You would also design a system that simply does not cover key sectors that are responsible for the larger share of emissions, for example, aviation or electricity and heat. This is what partly happened to the EU’s Emissions Trading System (EU ETS): partly due to the economic crisis which reduced emissions more than predicted, there was a considerable surplus of allowances.
This led to a decrease of carbon prices and as a result neutralised any incentive for industry to reduce emissions. The good news is that these issues can be mitigated. The EU has adopted a number of short and long-term measures to ensure that emissions surpluses do not compromise the functions of the EU ETS .
So a cap-and-trade system is not a silver bullet and you cannot have a one-size-fits-all approach. As the example of the EU ETS proves, there is some trial and error involved in terms of the scope of the scheme, the setting of allowances and providing the mechanism with the necessary flexibility to adapt to external circumstances.
As with most things, putting something into practice reveals a set of issues that the theory had not accounted for. But these can be overcome so that a cap-and-trade system can support our transition to a low carbon society.