CAP-AND-TRADE SYSTEM

A tradable permit system is defined as quantity-based environmental policy instrument. The regulatory authority stipulates the allowable total amount of emissions (cap) and the right to emit becomes a tradable commodity. Under a cap-and-trade system, prices are allowed to fluctuate according to market forces. Thus, the price of emissions is established indirectly. Permits could be allocated to firms through auction or free allocation. 

Cap and Trade In an attempt to reduce carbon emissions by industries, some governments and analysts support a "cap and trade" system. First, an overall "cap" is placed, by government regulation, on total carbon emissions for particular companies and/or their industries. The "trade" part of cap and trade allows companies that operate efficiently on a carbon basis, and thereby emit a lower amount of carbon than law allows, to sell or trade the unused... 

The EU ETS is a cap-and-trade system based primarily on the free allocation of a fixed amount of emission allowances to a set of covered installations. Companies can either use these allowances to cover the emissions resulting from the production of these installations or sell them to other companies that need additional allowances (Reinaud, 2005). Hence, for a company using an emission allowance, this represents an opportunity cost, regardless of whether the allowances are allocated for free or purchased at an auction or market. Therefore, in principle and in line with economic theory, a company is expected to add the costs of C02 emission allowances to its other marginal (variable) costs when making (short-term) production or trading decisions, even if the allowances are granted for free (Burtraw et al., 2002, 2005 Reinaud, 2003). 

Article 11(3) of the Emissions Trading Directive required Member States to take into account the need to provide access to allowances for new entrants, but it provided no specific guidance and did not direct free allocation. Nevertheless, all twenty-five Member States set up reserves to provide free allowances to new entrants and most require closed facilities to forfeit post-closure allowances. This feature is the more remarkable in that it is not found in other cap-and-trade systems (in the US) where with few exceptions new entrants must purchase whatever allowances they may need and the owners of closed facilities are able to keep the allowances distributed to those facilities. 

Whether this perception of the abatement potential for CO2 is correct is not the issue. There is much to suggest that it is not. If there is one lesson from the US experience with cap-and-trade systems, it is that unexpected forms of abatement appear when a price is imposed on emissions. Moreover, it is commonly asserted in Europe that further gains in energy efficiency can be achieved a relatively low cost, in which case equal reductions in CO2 emissions logically follow at low prices. While it is too early to know the degree of abatement that has occurred in Europe in response to CO2 prices, the question is whether the perception of limited abatement potential was accepted sufficiently to be politically important in determining allocation choices. That appears to have been the case. 

A more effective approach to clean air policy, and one example of a sensible program being implemented by the federal government, is the Clean Air Interstate Rule or CAIR, intended to reduce emissions of particulate matter and NO in the eastern United States. EPA finalized the CAIR rules on March 10, 2005 in response to a finding of non-attainment of National Ambient Air Quality Standards (NAAQS) for fine particulate matter and ozone formation. CAIR requires reductions in SOj and NOj emissions from coal-fired power plants the emissions limits spelled out in the CAIR plan affect electric utilities in 28 eastern states and the District of Columbia. Emissions reductions are to be achieved through a market-based cap-and-trade system similar to other air pollution programs EPA has put into practice over the last few decades. 

More surprisingly, a source has one additional option under the cap-and-trade system it can elect to discharge more than it is required so long as it buys at least equivalent emissions reductions from one or more of the other sources of that pollutant. All that matters is that the total amount of emissions reductions that take place from all sources are equal to the initial cap established by EPA (or another regulatory authority). Those sources that will elect to make significant emissions reductions under this system are precisely those that can do so inexpensively likewise, those that elect to buy emissions reductions from other sources rather than cut back themselves will be those that find it very expensive to reduce. (This is the analogue to Adam Smith s famous invisible hand that steers producers and consumers to the most efficient allocation of resources.) Moreover, all sources have a continuing incentive to reduce their pollution—the more a source s emissions fall short of its limitation, the more emissions permits it will have to sell to other sources. 

Why have cap-and-trade policies flourished in comparison to pollution taxes in the United States Perhaps most obviously, a system in which discharge permits are issued, but made saleable, looks rather like the regulatory system currently in place in the United States, with the added twist of marketability. Another reason has to do with the uncertainty each system creates. Specifically, under a cap-and-trade system, the total amount of pollution is firmly fixed-that is the purpose of the cap. What is uncertain are exactly where the emissions will occur (this depends upon who trades with whom), and how much an emissions permit (the right to emit one ton in a given year, say) will cost —the latter is determined in a competitive market. 

The choice between cap-and-trade systems and pollution taxes rests at least in part on the pollutant in question. For pollutants like sulfur dioxide, CFCs, or carbon dioxide that mix equally in the atmosphere and that pose few or no local health effects, cap-and-trade works well because we are unconcerned about where emissions take place. On the other hand, if we are concerned that limiting emissions might impose too big a burden on the economy, the pollution tax approach is best because sources know that they will never have to pay more for a ton of pollution discharged than the tax. Effluent charges also raise revenue—not a trivial issue in many places, including developing countries. 

To link or not to link benefits and disadvantages of linking cap-and-trade systems CHRISTIAN FLACHSLAND, ROBERT MARSCHINSKI,... 

In order to avoid high CO prices or price spikes, cap-and-trade schemes may implement cost-containment measures, including offset provisions, borrowing provisions or price caps. If these provisions are present in one of the linked systems, they will be made available to participants in the other system regardless of whether the other system has the same provisions (Stavins and Jaffe, 2007). The unlimited import of low-cost credits from other sectors and regions will reduce the CO price and total abatement costs in a cap-and-trade system. However, if policy-makers... 

ICAP is composed of countries and regions that have implemented or are actively pursuing the implementation of mandatory cap-and-trade systems (ICAP, 2007). The partnership provides a forum to share experience and knowledge. Sharing and evaluating best practice will help ICAP members in determining the extent to which their respective programmes can be supported by, and/or benefit from, the ICAP process. 

See Flachsland et al. (2009b) for an extensive treatment of the generic implications and trade-offs when linking cap-and-trade systems. 

Flachsland, G., Marschinski, R., Edenhofer, O., 2009b, To link or not to link benefits and disadvantages of linking cap-and-trade systems. Climate Policy 9(4) Special Issue Linking GHG Trading Systems, 358-372. 

The basic rationale for linking cap-and-trade systems is that significant efficiency gains can be realized when permit prices (implicitly marginal abatement costs) across schemes are equalized... 

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