Cap and trade: Why you should care, what you need to know


Climate change is rapidly rising as an issue in the public conscience, in Minnesota and across the United States. The number of Americans naming climate change as the world’s biggest environmental problem jumped from 16 percent to 33 percent from 2006 to 2007 (Washington Post/Time/ABC/Stanford University). Closer to home, a 2006 poll for the Minnesota Conservation Federation found that 66 percent of Minnesota sportsmen feel that climate change is an urgent problem requiring urgent action. The question remains, however, how can we address such a complex issue without causing huge economic problems?

Why cap and trade?

An emerging consensus suggests that the answer will be what is referred to as a cap and trade system. Barack Obama, John McCain and Hillary Clinton all propose a cap and trade system as the centerpiece of their environmental agendas. The European Union has had a functioning market for carbon since January, 2005. A group of states in the Northeast have started a regional cap and trade system, and Western and Midwestern states, including Minnesota, are working toward developing their own regional systems. The Chicago Climate Exchange is a private voluntary trading system, which boasts members from heavy industries, such as coal mining, to local and state governments and universities, including the University of Minnesota.

Cap and trade systems are appealing for two main reasons. First, unlike traditional regulatory schemes, they are market-based. Cap and trade systems allow economic forces to dictate where emissions cuts will occur, rather than relying on government mandates. The U.S. has had a cap and trade system to deal with acid rain-causing pollutants since the 1980s, and has achieved deep reductions at far lower costs than had been anticipated. Second, cap and trade is more palatable politically than a direct carbon tax, which would have roughly the same effect.

Musical chairs: How cap and trade systems work

How does a cap and trade system actually reduce pollution? Conceptually, a cap and trade system can be visualized as an enormous game of musical chairs. The chairs represent the ability to emit some pollutant, in this case carbon dioxide. Before a cap is placed, there is an unlimited number of chairs, so anyone can emit as much carbon dioxide as they want, and none of the chairs are reserved.

The government places a cap on the amount of carbon dioxide that can be released. This is like limiting—capping—the number of chairs in the game, with each chair representing the right to emit, say, a ton of carbon dioxide. If a firm wants to burn fossil fuels, it will have to get one of the chairs. Effectively, the game has changed from one where there are unlimited number of seats and general admission, to one with a restricted number of chairs with reserved seating.

At this point, anyone who wants to emit carbon dioxide needs to get a the right to occupy a chair. Imagine Xcel Energy wants to burn coal in a power plant. It needs a certain number of chairs. If it doesn’t have enough, it has to decide what to do. It could choose to operate a natural gas-fired plant that emits less carbon dioxide, or switch away from fossil fuels entirely and use wind power. It could simply decide not to produce power. Or it could try to get an occupant of another chair to get up and trade its seat to Xcel.

If it goes this route, it can make a general offer to all the other players. Say Xcel knows it would cost an extra $15 to switch to natural gas. So it might say it will pay $10 to anyone willing to give up a seat. Imagine there are three other players. Two of them know that it would cost them far more than $10 to reduce their emissions, so they stay seated. The last player realizes it can invest in more energy-efficient equipment that will reduce its emissions by a ton, but will only cost the player $7. If it agrees to Xcel’s offer, it gives up its right to pollute, but installs the more efficient system and comes out ahead by $3. Meanwhile, Xcel pays only $10 instead of the $15 it would have cost to switch to gas.

This process plays out at a much larger scale, and the offers to buy and sell are managed like a stock or bond market. Eventually, every company either has enough seats to cover its emissions, or decides it is cheaper to just reduce its emissions. The key is that emitting carbon dioxide now costs every firm either the price they had to pay to get the chair, or the amount they could have sold the chair for. Over time, the government lowers the cap, reducing the number of “chair” available and leading to long-term reductions in pollution.

Who needs permits? How are permits assigned?

There are two key design issues in a cap and trade system. the first is coverage: how do you decide who needs a permit? For instance, you could design a system that only covers the electricity market. Utilities would have to get permits to produce the electricity, and would probably pass the cost along to consumers. However, there would be no extra cost to driving your car. So far, most cap and trade systems have been targeted at utilities because there are a relatively small number of firms that have to be regulated, and there are already mechanisms in place to collect data. In the future, the systems could be extended to include small manufacturers and even homeowners.

The second issue deals with how those permits are given out. Industries tend to argue that they should be allocated for free. Since permits have value on an open market, this amounts to giving money to the polluters. On the other hand, the government could sell the permits at auction, requiring each firm to buy permits for all its pollution. This method strikes energy-intensive industries such as manufacturing very hard, which can be a tough sell. As a national cap and trade system comes closer to being a reality, keep an eye to see how these issues unfold.

Brian Peterson is pursuing a Master’s of Public Policy degree at the Humphrey Institute of Public Affairs at the University of Minnesota. He is concentrating in Science, Technology and Environmental Policy.