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Quick Facts on Cap-and-Trade Policies to Reduce Carbon Emissions

Barack Obama and John McCain have both endorsed the idea of a "cap and trade" system for reducing greenhouse gas emissions. Such a program, which is intended to steadily reduce total CO2 emissions over future decades, would require consumers to pay significantly more for carbon-based fuels, such as oil, coal, and natural gas. Other policy experts favor a related proposal--an explicit carbon tax--to achieve the same goal.

  1. What is cap-and-trade?
  2. What has Senator McCain proposed?
  3. What has Senator Obama proposed?
  4. Does it matter whether permits are given away or auctioned off?
  5. Does it matter whether permits are tradable?
  6. Does it matter whether permits are bankable?
  7. Does it matter whether permits go to upstream producers or downstream users?
  8. How does a cap-and-trade program differ from a carbon tax?

1. What is cap-and-trade?

A cap-and-trade approach to reducing carbon emissions first sets an overall limit on those emissions and then allocates permits that allow holders to emit that quantity in the aggregate. Firms may trade (buy and sell) permits as they choose. The government may give permit allocations to firms or auction permits to the highest bidders. Permits may cover a specific time period or have unlimited duration. The quantity of permits issued may rise or fall over time to phase in a policy or to meet changing needs. Many plans call for large initial annual allocations and reductions over time to ease firms’ transition to lower annual levels of carbon emissions.

2. What has Senator McCain proposed?

The McCain plan would impose a cap and trade system on electric power, transportation fuels, commercial business, and industrial business but would exempt small businesses. Firms would either reduce their emission of greenhouse gases or purchase “offsets” to cover emissions. Targets for greenhouse gas emissions would decline over time as follows:

2012: Return Emissions To 2005 Levels (18 Percent Above 1990 Levels)
2020: Return Emissions To 1990 Levels (15 Percent Below 2005 Levels)
2030: 22 Percent Below 1990 Levels (34 Percent Below 2005 Levels)
2050: 60 Percent Below 1990 Levels (66 Percent Below 2005 Levels)
Permits would be auctioned “eventually” with proceeds going toward the development of advanced technologies to reduce greenhouse gases.

3. What has Senator Obama proposed?

The Obama plan would impose a market-based cap-and-trade system designed to reduce carbon emissions to a level 80 percent below 1990 levels by 2050. All firms would have to purchase at auction enough pollution credits to cover all of their pollution. Revenue from auctioning allowances would go to develop clean energy, improve energy efficiency, and to offset some of the costs of compliance and the added burden on low-income families.

4. Does it matter whether permits are given away or auctioned off?

Giving permits to firms provides large windfall gains for the recipients, who will be able to pass on higher prices to consumers whether they pay for the permits or not. Auctioning permits generates substantial revenues, which the government can then use to offset some or all of the adverse impact of higher energy prices and employment shifts on firms, workers, and households by cutting taxes or providing transition assistance to workers (such as coal miners) who would be displaced by a shift to a less carbon-intensive economy. Some of the revenue could also be used to fund research to develop alternative energy sources.

5. Does it matter whether permits are tradable?

Trading of permits is essential to the goal of reducing carbon emissions in the least costly way. Firms that can reduce their use of carbon-based fuels at a cost below the going price for permits will sell their permits, spend some of the proceeds reducing fuel use, and pocket the difference. Firms whose cost of reducing fuel use exceeds the permit price will purchase permits and continue to generate carbon emissions. The combination means that the policy reduces the use of carbon-based fuels in the least expensive way.

Trading permits also provides flexibility in terms of firms’ decision making. Without trading, firms must decide how many permits to buy at what price by accurately projecting their output level, the amount of fuel use associated with that output, and their costs of reducing fuel use below that amount. Any change in those variables would lead to a shortage or surplus of permits purchased at too high or too low a price. Firms could adjust to changes in those variables only if they could buy additional permits or sell excess ones.

6. Does it matter whether permits are bankable?

Allowing firms to bank permits lets them shift carbon emissions across time rather than requiring that firms use permits in the time period for which they were issued. That makes sense for greenhouse gases like carbon dioxide that build up over time and are long-lived. It doesn’t matter too much when greenhouse gases are emitted since it is their total quantity that matters, not the amount released in any time period. In contrast, for short-lived pollutants that dissipate over time, it matters when emissions occur because the damages they produce are higher during and immediately following periods when emissions are high.

7. Does it matter whether permits go to upstream producers or downstream users?

To minimize administrative costs, most proposals would allocate permits to upstream firms (oil refineries, gasoline importers, coal-burning utilities) instead of to final users (drivers, trucking firms, airlines, household and business electric power consumers). Because there are fewer firms involved, upstream enforcement lowers transaction costs. Policies with downstream enforcement often limit the policy’s coverage to limit transaction costs (e.g., the EU carbon trading policy only applies to four industries that are heavy users of fossil fuels), but that makes the policy less efficient because it leaves some emissions unregulated. Ultimately, however, it is final users who pay higher prices for goods that use carbon in production and distribution.

8. How does a cap-and-trade program differ from a carbon tax?

The two policies work on different sides of the market, one directly affecting quantity and the other directly affecting prices. Because the market links prices and quantities, the two approaches can have identical outcomes.

A cap-and-trade program directly limits the quantity of carbon-emitting fuels burned, leading to higher energy prices as consumers bid for scarce output. In contrast, a carbon tax raises the price of carbon-emitting fuels, inducing firms and consumers to reduce their quantity. With complete information about how firms or consumers would react, either policy could achieve the same result.

Because we often lack that information, however, both approaches run the risk of reducing carbon emissions too much or too little and neither is more likely to miss on one side rather than the other. The choice between the two boils down to which is more likely to come closer to the target (which depends on technical issues involving the benefits and costs of reducing pollution) and which can be more readily adjusted if it misses its goal (which is essentially a political question).