Emissions trading or cap and trade (cap meaning a legal limit on the quantity of a certain type of chemical an economy can emit each year ) [ 1 ] is a market-based approach used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants. [ 2 ] Various countries have adopted emission trading systems as one of the strategies for mitigating climate-change by addressing international greenhouse-gas emission. [ 3 ]

A central authority (usually a governmental body) sets a limit or cap on the amount of a pollutant that may be emitted. The limit or cap is allocated and/or sold by the central authority to firms in the form of emissions permits which represent the right to emit or discharge a specific volume of the specified pollutant. Permits (and possibly also derivatives of permits) can then be traded on secondary markets. [ 4 ] For example, the EU ETS trades primarily in European Union Allowances (EUAs ), the Californian scheme in California Carbon Allowances, the New Zealand scheme in New Zealand Units and the Australian scheme in Australian Units. [ 4 ] Firms are required to hold a number of permits (or allowances or carbon credits ) equivalent to their emissions. The total number of permits cannot exceed the cap, limiting total emissions to that level. Firms that need to increase their volume of emissions must buy permits from those who require fewer permits. [ 2 ]

Some schemes allow the trading of foreign emissions units. Liable entities participating in the EU ETS can use a few different emissions unit types defined under the Kyoto Protocol, although the use of units imported from activities outside the EU remains subject to quantitative and qualitative limits. [ 5 ]

The transfer of permits is referred to as a trade . In effect, the buyer is paying a charge for polluting, while the seller gains a reward for having reduced emissions. Thus, in theory, those who can reduce emissions most cheaply will do so, achieving the pollution reduction at the lowest cost to society. [ 6 ]

There are active trading programs in several air pollutants. For greenhouse gases the largest is the European Union Emission Trading Scheme. whose purpose is to avoid dangerous climate change. [ 7 ] Cap and trade provides the private sector with the flexibility required to reduce emissions while stimulating technological innovation and economic growth. [ 8 ] The United States has an national market to reduce acid rain and several regional markets in nitrogen oxides. [ 9 ] Markets for other pollutants tend to be smaller and more localized. [ citation needed ]

The National Emission trading System includes the European Union, Switzerland, New Zealand, Australia, South Korea and Kazakhstan. The European Union ETS with all 15 member states is the oldest system. Phase 1 of the ETS launched in 2005. [ 5 ] The Swiss ETS was launched [ by whom? ] in 2008 as an alternative option for complying with the national CO2 levy on heating, industrial process, and transport fuels. The ETS became mandatory for large firms on 28 February 2013. [ 10 ] The New Zealand (NZ) ETS was launched in 2008 as a scheme covering only the forestry sector. In July 2010, it was aimed to expand to cover also stationary energy, fishing, industrial processes and the liquid fossil-fuels sectors. [ 11 ] Australia ETS uses the Carbon Price Mechanism (CPM) and was launched in 2012. Under the scheme, 500 companies will pay a tax of A$23 per tonne of carbon, rising by around 5 per cent a year, The first phase are fixed price. From 2015 onward the permits the price will be under a cap-and-trade system. [ 4 ] South Korea’s cabinet approved and adopted rules in November 2012 for a mandatory ETS after legislation received bipartisan support in the country’s unicameral National Assembly [ 4 ] The Republic of Kazakhstan ETS was launched 2013. The scheme covers plants in the manufacturing, energy, mining, metallurgy, chemicals, agriculture and transport industries which emit more than 20 000 tons of CO2 per year. [ 12 ]

The International Emission trading program,the Kyoto Protocol program, provides for trading across nations. This program, under the United Nations Framework Convention on Climate Change, launched phase 1 in 2007. This program invests in low carbon technology to reduce emissions; participants buy permits from one another, or buy carbon offsets from projects in developing countries under the Clean Development Mechanism (CDM). [ 13 ]

Examples of successful cap-and-trade programs include the nationwide Acid Rain Program and the regional NOx Budget Trading Program in the Northeast. Additionally, EPA issued the Clean Air Interstate Rule (CAIR).

SO2 emissions from Acid Rain Program sources have fallen from 17.3 million tons in 1980 to about 7.6 million tons in 2008, a decrease in emissions of 56 percent. Ozone season NOx emissions decreased by 43 percent between 2003 and 2008, even while energy demand remained essentially flat during the same period. CAIR will result in $85 billion to $100 billion in health benefits and nearly $2 billion in visibility benefits per year by 2015 and will substantially reduce premature mortality in the eastern United States. [ citation needed ] A recent EPA analysis shows that implementation of the Acid Rain Program is expected [ by whom? ] to reduce between 20,000 and 50,000 incidences of premature mortality annually due to reductions of ambient PM2.5 concentrations, and between 430 and 2,000 incidences annually due to reductions of ground-level ozone. NOx reductions due to the NOx Budget Trading Program have led to improvements in ozone and PM2.5, saving an estimated 580 to 1,800 lives in 2008. [ 14 ]

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§ Pollution as an externality [ edit ]

By definition, an externality is an activity of one entity that affects the welfare of another entity that is not a party to a market transaction related to that activity. Pollution is the prime example most economists think of when discussing externalities. There are various different ways to address these from a public economics perspective, including emissions fees, command and control regulation and cap-and-trade.

§ Overview [ edit ]

Described in its simplest form, an emissions trading system will consist of a number of participants, each of whom will have a cap, or limit, on their total emissions over a specified period of time. The cap will have been set by reference to the total emissions for a particular participant over a period of time, often referred to as its ‘baseline’, which is used as a reference point for future emissions reductions. Within a classic ‘cap and trade’ scheme, participants take on caps, or targets, requiring them to reduce their emissions and, in return, receive allowances equal to their individual caps. Participants can choose either to meet their cap by reducing their own emissions; to reduce their emissions below their cap and, perhaps, sell the excess allowances; or to let their emissions remain above their cap, and buy allowances from other participants. All that matters is that, when it comes to demonstrating compliance, every single participant holds allowances at least equal in number to its quantity of emissions. The result should then be that the total quantity of emissions will have been reduced to the sum of all the capped levels. [ 15 ]

The overall goal of an emissions trading plan is to minimize the cost of meeting a set emissions target or cap. [ 16 ] The cap is an enforceable limit on emissions that is usually lowered over time—aiming towards a national emissions reduction target. [ 16 ] The government sets an overall cap on emissions and creates allowances, or limited authorizations to emit, up to the level of the cap. Sources are free to buy or sell allowances or “bank” them to use in future years. [ 17 ] In some systems, a proportion of all traded permits must be retired periodically, causing a net reduction in emissions over time. In many cap-and-trade systems, organizations which do not pollute (and therefore have no obligations) may also participate in trading. Thus environmental groups may purchase and retire emission permits and hence drive up the price of the remaining permits according to the law of demand. [ 18 ] Corporations can also prematurely retire allowances by donating them to a nonprofit entity and then be eligible for a tax deduction.

International trade can offer a range of positive and negative incentives to promote international cooperation on climate change (robust evidence, medium agreement). Three issues are key to developing constructive relationships between international trade and climate agreements: how existing trade policies and rules can be modified to be more climate friendly; whether border adjustment measures (BAMs) or other trade measures can be effective in meeting the goals of international climate agreements; whether the UNFCCC, World Trade Organization (WTO), hybrid of the two, or a new institution is the best forum for a trade-and-climate architecture. [ 19 ]

§ Definitions [ edit ]

According to the Environmental Defense Fund, cap and trade is the most environmentally and economically sensible approach to controlling greenhouse gas emissions, the primary driver of global warming. The cap sets a limit on emissions, which is lowered over time to reduce the amount of pollutants released into the atmosphere. The trade creates a market for carbon allowances, helping companies innovate in order to meet, or come in under, their allocated limit. The less they emit, the less they pay, so it is in their economic incentive to pollute less. [ 20 ]

The economics literature provides the following definitions of cap and trade emissions trading schemes.

A cap-and-trade system constrains the aggregate emissions of regulated sources by creating a limited number of tradable emission allowances, [ 21 ] which emission sources must secure and surrender in number equal to their emissions. [ 22 ]

In an emissions trading or cap-and-trade scheme, a limit on access to a resource (the cap) is defined and then allocated among users in the form of permits. Compliance is established by comparing actual emissions with permits surrendered including any permits traded within the cap. [ 23 ]

Under a tradable permit system, an allowable overall level of pollution is established and allocated among firms in the form of permits. Firms that keep their emission levels below their allotted level may sell their surplus permits to other firms or use them to offset excess emissions in other parts of their facilities. [ 24 ]

§ Market-based and least-cost [ edit ]

Economy-wide pricing of carbon is the centre piece of any policy designed to reduce emissions at the lowest possible costs.

Economists have urged the use of market-based instruments such as emissions trading to address environmental problems instead of prescriptive command and control regulation. [ 26 ] Command and control regulation is criticized for being excessively rigid, insensitive to geographical and technological differences, and inefficient. [ 27 ] However, emissions trading requires a cap to effectively reduce emissions, and the cap is a government regulatory mechanism. After a cap has been set by a government political process, individual companies are free to choose how or if they will reduce their emissions. Failure to report emissions and surrender emission permits is often punishable by a further government regulatory mechanism, such as a fine that increases costs of production. Firms will choose the least-cost way to comply with the pollution regulation, which will lead to reductions where the least expensive solutions exist, while allowing emissions that are more expensive to reduce.

Under an emissions trading system, emissions sources must meet a set of emissions target, but will have flexibility with regard to how they meet the target. An individual facility may purchase emissions reduction credits or allowances from other sources, sell credits or allowances, implement cost effective internal emissions reductions, or use a combination of both. This flexibility allows firms to use the most affordable compliance strategy, given their internal marginal abatement costs and the market price of allowances or emissions reductions or credits. In theory, a firm’s individual decisions should then lead to an economically efficient allocation of reductions and lower compliance costs for individual firms and for the programme overall, relative to more traditional command and control mechanisms. [ 28 ] [ 29 ]

§ Emission markets [ edit ]

For emissions trading where greenhouse gases are regulated, one emissions permit or allowance is considered equivalent to one metric ton of carbon dioxide (CO₂ ) emissions. Other names for emissions permits are carbon credits. Kyoto units, assigned amount units. and Certified Emission Reduction units (CER). These permits or units can be sold privately or in the international market at the prevailing market price. These trade and settle internationally and hence allow allowances to be transferred between countries. Each international transfer is validated by the United Nations Framework Convention on Climate Change (UNFCCC). Each transfer of ownership within the European Union is additionally validated by the European Commission .

Emissions trading programmes such as the European Union Emissions Trading System (EU ETS) complement the country-to-country trading provided for in the Kyoto Protocol by permitting private party trading of emissions permits. Under such programmes – which are generally co-ordinated with the national emissions targets provided within the framework of the Kyoto Protocol – a national or international authority allocates emissions permits to individual companies based on established criteria, with a view to meeting national and/or regional Kyoto targets at the lowest overall economic cost. [ 30 ]

Trading exchanges have been established to provide a spot market in permits, as well as futures and options market to help discover a market price and maintain liquidity. Carbon prices are normally quoted in euros per tonne of carbon dioxide or its equivalent (CO₂ e). Other greenhouse gases can also be traded, but are quoted as standard multiples of carbon dioxide with respect to their global warming potential. These features reduce the quota’s financial impact on business, while ensuring that the quotas are met at a national and international level.

Currently there are six exchanges trading in UNFCCC related carbon credits. the Chicago Climate Exchange (until 2010 [ 31 ] ), European Climate Exchange. NASDAQ OMX Commodities Europe. PowerNext. Commodity Exchange Bratislava and the European Energy Exchange. NASDAQ OMX Commodities Europe listed a contract to trade offsets generated by a CDM carbon project called Certified Emission Reductions. Many companies now engage in emissions abatement, offsetting, and sequestration programs to generate credits that can be sold on one of the exchanges. At least one private electronic market has been established in 2008: CantorCO2e. [ 32 ] Carbon credits at Commodity Exchange Bratislava are traded at special platform — Carbon place. [ 33 ]

Trading in emission permits is one of the fastest-growing segments in financial services in the City of London with a market estimated to be worth about €30 billion in 2007. Louis Redshaw, head of environmental markets at Barclays Capital. predicts that Carbon will be the world’s biggest commodity market, and it could become the world’s biggest market overall. [ 34 ]

§ History [ edit ]

The international community began the long process towards building effective international and domestic measures to tackle GHG [ 35 ] (Carbon dioxide, methane, nitrous oxide, hydroflurocarbons, perfluorocarbons and sulphur hexafluoride.) emissions in response to the increasing certainty that global warming is happening and the uncertainty over its likely consequences. That process began in Rio in 1992, when 160 countries agreed the UN Framework Convention on Climate Change (UNFCCC). The UNFCCC is, as its title suggests, simply a framework; the necessary detail was left to be settled by the Conference of Parties (CoP) to the UNFCCC. [ 36 ]

The efficiency of what later was to be called the cap-and-trade approach to air pollution abatement was first demonstrated in a series of micro-economic computer simulation studies between 1967 and 1970 for the National Air Pollution Control Administration (predecessor to the United States Environmental Protection Agency ‘s Office of Air and Radiation) by Ellison Burton and William Sanjour. These studies used mathematical models of several cities and their emission sources in order to compare the cost and effectiveness of various control strategies. [ 37 ] [ 38 ] [ 39 ] [ 40 ] [ 41 ] Each abatement strategy was compared with the least cost solution produced by a computer optimization program to identify the least costly combination of source reductions in order to achieve a given abatement goal. In each case it was found that the least cost solution was dramatically less costly than the same amount of pollution reduction produced by any conventional abatement strategy. [ 42 ] Burton and later Sanjour along with Edward H. Pechan continued improving [ 43 ] and advancing [ 44 ] these computer models at the newly created U.S. Environmental Protection Agency. The agency introduced the concept of computer modeling with least cost abatement strategies (i.e. emissions trading) in its 1972 annual report to Congress on the cost of clean air. [ 45 ] This led to the concept of cap and trade as a means of achieving the least cost solution for a given level of abatement.

The development of emissions trading over the course of its history can be divided into four phases: [ 46 ]

1. Gestation: Theoretical articulation of the instrument (by Coase. [ 47 ] Crocker, [ 48 ] Dales, [ 49 ] Montgomery [ 6 ] etc.) and, independent of the former, tinkering with flexible regulation at the US Environmental Protection Agency.
2. Proof of Principle: First developments towards trading of emission certificates based on the offset-mechanism taken up in Clean Air Act in 1977. A company could get allowance from the Act on greater amount of emission when it paid another company to reduce the same pollutant. [ 50 ]
3. Prototype: Launching of a first cap-and-trade system as part of the US Acid Rain Program in Title IV of the 1990 Clean Air Act. officially announced as a paradigm shift in environmental policy, as prepared by Project 88, a network-building effort to bring together environmental and industrial interests in the US.
4. Regime formation: branching out from the US clean air policy to global climate policy. and from there to the European Union, along with the expectation of an emerging global carbon market and the formation of the carbon industry.

In the United States, the acid rain -related emission trading system was principally conceived by C. Boyden Gray. a G.H.W. Bush administration attorney. Gray worked with the Environmental Defense Fund (EDF), who worked with the EPA to write the bill that became law as part of the Clean Air Act of 1990. The new emissions cap on NO_x and SO₂ gases took effect in 1995, and according to Smithsonian magazine, those acid rain emissions dropped 3 million tons that year. [ 51 ] In 1997, the CoP agreed, in what has been described as a watershed in international environmental treaty making, the Kyoto Protocol where 38 developed countries(Annex 1 countries.) committed themselves to targets and timetables for the reduction of GHGs. [ 52 ] These targets for developed countries are often referred to as Assigned Amounts.

One important economic reality recognised by many of the countries that signed the Kyoto Protocol is that, if countries have to solely rely on their own domestic measures, the resulting inflexible limitations on GHG growth could entail very large costs, perhaps running into many trillions of dollars globally. [ 53 ] As a result, international mechanisms which would allow developed countries flexibility to meet their targets were included in the Kyoto Protocol. The purpose of these mechanisms is to allow the parties to find the most economic ways to achieve their targets. These international mechanisms are outlined under Kyoto Protocol. [ 54 ]

On April 17, 2009, the Environmental Protection Agency (EPA) formally announced that it had found that greenhouse gas (GHG) poses a threat to public health and the environment (EPA 2009a). This announcement was significant because it gives the executive branch the authority to impose carbon regulations on carbon-emitting entities. [ 55 ]

A carbon cap-and-trade system is to be introduced nationwide in China in 2016 [ 56 ] (China’s National Development and Reform Commission proposed that an absolute cap be placed on emission by 2016.) [ 57 ]

§ Public relevance [ edit ]

Ozone is produced naturally in the stratosphere. It blocks UV radiation from reaching the Earth’s surface where it can harm people and eco-systems. Overexposure to UV radiation can cause a range of health effects, including skin damage (skin cancers and premature aging), eye damage (including cataracts), and suppression of the immune system. Researchers believe that overexposure to UV radiation is contributing to an increase in melanoma, the most fatal of all skin cancers. [ 58 ] Reduction of chemical (chlorofluorocarbons (CFCs), hydrochlorofluorcarbons (HCFCs), carbon tetrachloride and methyl chloroform emissions will prevent or decelerate the rate of the ozone layer’s thinning. Improvements have been seen since 1998 over most of the world, and it appears to be recovering because of reduced emissions of ozone-depleting substances. The Antarctic ozone is projected to return to pre- 1980 levels by 2060 to 2075. [ 59 ]

An estimated 30–40% of the carbon dioxide emission in the atmosphere dissolves into oceans. It decreases pH in oceans, rivers and lakes. This also causes decreasing oxygen levels, killing off algae and marine ecosystems. In the oceans, CO₂ concentrations have reached 450 parts-per-million (ppm) and above. Ocean acidification causes disruption of the calcification of marine organisms and the resultant risk of fundamentally altering marine food webs, the following guard rail should be obeyed: the pH of near surface waters should not drop more than 0.2 units below the pre-industrial average value in any larger ocean region. [ 60 ]

Members of the InterAcademy Panel expect emission to decrease to less than 50% of the 1990 level. Reducing the buildup of CO₂ in the atmosphere is the only practicable solution to mitigating ocean acidification. To meet this target United Nations Framework Convention on Climate Change (UNFCCC) would require substantial emission reductions in anthropogenic. [ 61 ]

§ Public opinion [ edit ]

In the United States, most polling shows large support for emissions trading (often referred to as cap-and-trade). This majority support can be seen in polls conducted by Washington Post /ABC News. [ 62 ] Zogby International [ 63 ] and Yale University. [ 64 ] A new Washington Post-ABC poll reveals that majorities of the American people believe in climate change, are concerned about it, are willing to change their lifestyles and pay more to address it, and want the federal government to regulate greenhouse gases. They are, however, ambivalent on cap-and-trade. [ 65 ]

More than three-quarters of respondents, 77.0%, reported they “strongly support” (51.0%) or “somewhat support” (26.0%) the EPA’s decision to regulate carbon emissions. While 68.6% of respondents reported being “very willing” (23.0%) or “somewhat willing” (45.6%), another 26.8% reported being “somewhat unwilling” (8.8%) or “not at all willing” (18.0%) to pay higher prices for “Green” energy sources to support funding for programs that reduce the effect of global warming. [ 65 ]

According to PolitiFact. it is a misconception that emissions trading is unpopular in the United States because of earlier polls from Zogby International and Rasmussen which misleadingly include new taxes in the questions (taxes aren’t part of emissions trading) or high energy cost estimates. [ 66 ]

§ Comparison of cap and trade with other methods of emission reduction [ edit ]

Cap and trade, offsets created through a baseline(The point of comparison, often the historical emissions from a designated past year, against which emission reduction goals are measured. [ 67 ] ) and credit(Credits can be distributed by the government for emission reductions achieved by offset projects or by achieving environmental performance beyond a regulatory standard. [ 67 ] ) approach, and a carbon tax are all market-based approaches that put a price on carbon and other greenhouse gases, and provide an economic incentive to reduce emissions, beginning with the lowest-cost opportunities.

The textbook emissions trading program can be called a cap and trade approach in which an aggregate cap on all sources is established and these sources are then allowed to trade emissions permits amongst themselves to determine which sources actually emit the total pollution load. An alternative approach with important differences is a baseline and credit program. [ 68 ]

In a baseline and credit program polluters that are not under an aggregate cap can create permits or credits, usually called offsets, by reducing their emissions below a baseline level of emissions. Such credits can be purchased by polluters that have a regulatory limit. [ 69 ]

§ Cap and trade versus carbon tax and other methods [ edit ]

§ Cap and trade versus carbon tax [ edit ]

Regulation by cap-and-trade emissions trading can be compared to emissions fees or environmental tax approaches under a number of possible criteria. [ 70 ] Carbon Tax is a surcharge on the carbon content of fossil fuels that aims to discourage their use and thereby reduce carbon dioxide emissions, or a direct tax on CO₂ emissions. [ 71 ]

Many commentators draw a sharp contrast between cap and trade and an alternative way to put a price on pollution: a carbon tax. In fact, cap and trade and carbon taxes are overlapping sets of policy designs. Like cap and trade, carbon taxes can have a range of scopes, points of regulation, and price schedules. And they can be fair or unfair, depending on how the revenue is used. A comprehensive, upstream, auctioned cap-and-trade system is very similar to a comprehensive, upstream carbon tax. The main difference is what’s certain and what’s uncertain. Under a carbon tax, elected officials set the price of carbon, and the market determines the quantity emitted; in auctioned cap and trade, elected officials set the quantity of carbon emitted, and the market sets the price. [ 72 ]

Responsiveness to inflation: In the case of inflation. cap-and-trade is at an advantage over emissions fees because it adjusts to the new prices automatically and no legislative or regulatory action is needed.

Responsiveness to cost changes: It is difficult to tell which is better between cap-and-trade and emissions fees; therefore, it might be a better option to combine the two resulting in the creation of a safety valve price (a price set by the government at which polluters can purchase additional permits beyond the cap).

Responsiveness to recessions: This point is closely related to responsiveness to cost changes, because recessions cause a drop in demand. Under cap and trade, the emissions cost automatically decreases, so a cap-and-trade scheme adds another automatic stabilizer to the economy — in effect, a type of automatic fiscal stimulus. However, if the emissions price drops to a low level, efforts to reduce emissions will also be reduced. Assuming that a government is competently able to stimulate the economy regardless of the cap-and-trade scheme, an excessively low price represents a missed opportunity to cut emissions faster than planned, so adding a price floor (or equivalently, switching to a tax temporarily) might be better — especially when there is great urgency about cutting emissions, as with greenhouse gas emissions. A price floor would also provide a degree of certainty and stability for investment in emissions reductions: recent experiences from the UK have shown that nuclear power operators are reluctant to invest on un-subsidised terms unless there is a guaranteed price floor for carbon (which the EU emissions trading scheme does not presently provide).

Responsiveness to uncertainty: As with cost changes, in a world of uncertainty, it is not clear whether emissions fees or cap-and-trade systems are more efficient—it basically depends on how fast the marginal social benefits of reducing pollution fall with the amount of cleanup (e.g. whether inelastic or elastic marginal social benefit schedule).

Summary: Carbon Tax is a tax on every ton of carbon emitted. Under a cap and trade, each emitter then has a quota on how much the organization is allowed to emit. The magnitude of the tax will therefore depend on how sensitive the supply of emissions is to the price. The permit of cap and trade will depend on the carbon market. Full auctioned equivalent emissions caps can in principle generate the same revenues as the carbon tax. A similar upstream cap and trade system could be implemented. An upstream carbon tax might be the simplest to administer. Setting up a complex cap and trade arrangement that is comprehensive has high institutional needs. [ 73 ]

§ Cap-and-trade versus command-and-control regulation [ edit ]

Command and Control is a system of regulation that prescribes emission limits and compliance methods on a facility-by-facility or source-by-source basis and that has been the traditional approach to reducing air pollution. [ 67 ]

Unlike emissions fees and cap and trade, which are incentive-based regulations, command-and-control regulations take a variety of forms and are much less flexible. An example of this is a performance standard which sets an emissions goal for each polluter that is fixed and, therefore, the burden of reducing pollution cannot be shifted to the firms that can achieve it more cheaply. As a result, performance standards are unlikely to be as cost effective as cap-and-trade emissions trading. [ 70 ] Firms would charge for a higher cost for a product and a proportion of such higher cost will be passed through to the end consumers. [ 74 ]

§ Economics of international emissions trading [ edit ]