Market Mechanisms: Understanding the Options
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The most recent study on climate change by the U.S. National Academy of Sciences concluded that, “Climate change is occurring, is caused largely by human activities, and poses significant risks for—and in many cases is already affecting—a broad range of human and natural systems.1 (See Climate Change 101: Science and Impacts.) The combustion of fossil fuels has contributed to the expansion of the global economy since the start of the Industrial Revolution. It has also substantially increased the concentration of carbon dioxide, the primary greenhouse gas in the atmosphere. The cumulative impact of these emissions poses significant economic risks. Policies to reduce emissions are required if we are to avoid the most costly damages of a rapidly changing climate. This brief describes how market-based policies can achieve climate goals more cheaply and efficiently than alternative policy structures—all while driving innovation to develop more cost effective, clean energy solutions that will serve as the foundation for strong economic growth throughout the 21st century.

Economic Externalities - Pollution

All environmental pollution, including emissions of greenhouse gases (GHGs), imposes costs on people who did not create the pollution. This is an example of an economic externality – a consequence or side effect of an action that is not experienced by the individual or entity from which it originates, and that is not reflected in prices. The damages and associated costs to society that GHGs cause through climate change (e.g., increased extreme weather events, rising sea levels, and loss of biodiversity) are not paid for by the entities that emit those gases, so those costs are not reflected in the market prices of goods and services. Because polluters do not have to account for the costs associated with the damages that greenhouse gases create, society produces and consumes too many pollution-creating products (like fossil fuels) resulting in additional GHG emissions being put into the atmosphere.

Market-based policies aim to correct this form of market failure (an instance where economic resources are allocated inefficiently). They do this by constructing systems that cause the “external” costs associated with pollution to be incorporated in the polluting entity’s decision-making. When firms explicitly see and must pay for the societal cost of pollution, they are able to determine how best to meet an environmental objective. Moreover, when prices of products reflect their full environmental costs, consumers also are better able to make informed purchasing decisions.

Market-based versus Command and Control Regulations

Market-based environmental policies are a potentially attractive alternative to traditional command-and-control regulatory programs. Command-and-control policies are widely and typically require polluters to take specific actions to reduce emissions by installing a particular technology or meeting a specific emissions standard. Command-and-control regulations have been criticized as not providing the flexibility to take into consideration that different plants face different compliance options and associated costs – some can do more for less, while others face higher costs. Moreover, traditional regulations do not provide an incentive for firms to innovate, to go beyond the reductions required by the standard.

Market-based options provide greater flexibility for firms and seem particularly appropriate in the context of policies to reduce GHG emissions. For traditional air pollutants, it matters that emissions at any particular point or region do not exceed health-related thresholds. For those types of pollutants, command-and-control regulation is often the appropriate preferred policy response. Because GHGs are not harmful on a localized basis – they are globally mixed in the atmosphere and do damage on a global scale – market-based policies that provide greater compliance flexibility are feasible and can achieve environmental objectives at lower overall costs.

Examples of Market-Based Policy Options for GHGs

Market-based policies work by creating a structure in which a price associated with pollution emerges. Under this structure, each regulated business chooses independently how to most cost effectively achieve the required pollution abatement. Notably, some companies can reduce pollution more cheaply than others (because of the age of their equipment or the technology they are using), allowing them to reduce their pollution more, to compensate for those facing higher costs doing less. Taken together, the overall environmental objective will be achieved at the lowest possible total costs. The key criterion in determining if a policy is ‘market-based’ is that it provides a financial incentive designed to elicit a specific behavior from those responsible for the pollution. Some policy options are applicable as economy-wide solutions where greater efficiencies can be achieved, while others are more generally targeted to a particular market segment or sector. (Appendix Aat the end of this brief provides a quick reference for the market-based options described here.)

Each of the policy options described below has the flexibility to be structured in a variety of ways to meet particular political contexts or sets of economic challenges. Further, none of the policies, alone, is a panacea for solving the global climate crisis – for example, complementary policies aimed at research and development and programs to adapt to climate change may also be required. Moreover, different policy approaches may be required depending on the specific market failure that needs to be addressed (e.g., capturing externalities, split incentives between building developer and occupant).To the extent the introduction of these policies proceeds in a piecemeal fashion it is important to remember that market-based policies are more efficient the more businesses and sectors they cover. With more options for reductions it is more likely that some will be less expensive to achieve – thus reducing overall costs for a given level of emissions reduction. For this reason, designing more limited market-based policies (e.g., to a sector or state) so they can later be interconnected with other market-based emission can help reduce the costs of meeting an environmental objective.

Taxes and Subsidies

The most basic form of a market-based policy is a tax that sets a price on each unit of pollution. By introducing a tax on pollution, the entity that is producing the pollution incurs an additional cost based on the amount of pollution emitted. Because of this, the entity has an incentive to reduce the quantity of pollution produced by changing its processes or adopting new technology. In this way, the tax provides a continuous incentive for innovation; the more emissions can be reduced, the less tax a company would pay. Ideally, the cost of the tax would be set equal to the cost to society that the pollution creates (ascertaining this cost, however, is not always easy – see the box below on Uncertainty). Taxes to reduce GHGs can come in two broad forms: an emissions tax, which taxes firms directly based on the GHG emissions they produce, and a tax on goods or services that are generally GHG-intensive (an example would be a carbon tax on gasoline).

Subsidy programs that provide government assistance (or tax credits) for specific types of low-emitting activities or technology applications function in a similar way to taxes, in that they provide a specific financial mechanism to motivate a particular environmentally beneficial outcome (they are, in fact, negative taxes). Subsidy programs are by their nature a “cost” to taxpayers in general but they are often more popular than new taxes, being seen as a carrot rather than a stick. The current “production tax credit” is an example of a program that uses tax breaks to incentivize the deployment of renewable energy technologies which indirectly reduces GHG emissions.

Box 1: Uncertainty

Assessing the cost to society from pollution is often difficult. While some damages caused by pollution are relatively easy to estimate in monetary terms, others are much more challenging to quantify. For example, if pollution causes a reduction in the fish population for a commercial fishery, we can estimate the damages based on the lost value of the fish at market prices. If, however, wetlands are destroyed or a species becomes extinct, it is not clear how society should assign a specific economic value to that loss. Other complications make it difficult to put a precise dollar figure on the costs imposed by a unit of pollution: they involve questions of how damages that apply to future generations should be valued in today's decisions, and how to quantify consequences when there is a range of possible outcomes or the potential exists for a low-probability, high-impact event.

Cap and Trade

An alternative market-based mechanism is a cap-and-trade program. This approach is “quantity-based.” Instead of setting a price on each unit of pollution, the regulatory authority determines a total quantity of pollution (a “cap”) that will be allowed. Companies buy and sell emission allowances (tradable certificates that allow a certain amount of emissions) based on their needs. The limited number of these allowances creates scarcity. The requirement that regulated businesses hold enough allowances to cover their emissions ensures the cap is met and creates demand for the allowances (for more detail on the design of a cap-and-trade program, see Climate Change 101: Cap and Trade). If it is less costly for a company to reduce emissions than to buy allowances, the company will reduce its own emissions. Similarly, if a company can reduce emissions below its requirements, so it has excess allowances, those allowances can then be banked for future use or sold in an open market to a firm that finds it more difficult (costly) to reduce emissions.

Because there is a scarcity of allowances and businesses can trade them, the allowances are valuable and lead to a price on GHGs. This price on GHG emissions provides a continuous incentive to reduce emissions and innovate since firms can save money if they reduce their emissions and avoid buying allowances. In contrast to a tax, some firms may actually be able to raise revenue by selling their excess allowances. This is particularly true if firms are allocated some number of allowances for free (allowances are grandfathered to existing emitters). Since the allowances are valuable, how they are distributed has implications. If they are given away for free, this is a financial benefit to the recipients. If they are auctioned, the resulting revenue can be channeled to specific groups or uses (see the box below on Uses of Revenue). As discussed below, cap and trade has been successfully used to reduce ozone-depleting substances under the Montreal Protocol, acid rain under the Clean Air Act, and GHGs under programs in Europe and in some states in the northeast United States.

Flexible Emissions Standard

A “flexible emissions standard” builds on the rate-based standards typically used for traditional air pollutants. For example, in the power sector, standards could be based on tons of carbon dioxide (CO2) per megawatt hour (MWh) of electricity produced. With a flexible emissions standard, firms would be able to meet a technology-based standard either by reducing their own emissions or by trading credits for emission reductions from other firms.

The program to remove lead from gasoline in the 1980’s, for example, used a rate-based flexible emission standard to achieve reductions at much lower cost than originally anticipated (see below). Companies that are able to reduce emissions below their targets for less money could generate tradable credits to be sold to firms that have relatively higher control costs. Since firms are participating in a market for tradable reduction credits, the resulting price for those credits sets an equal cost for emission reduction across all of the regulated entities. If the firm has higher reduction costs internally, it can opt instead to buy credits at the lower market price. Instead, if it has lower costs, it has the option to reduce more emissions and profit from selling them at the market price.

Clean or Renewable Electricity Standards

Clean or renewable electricity standards are types of electricity porftolio standards typically targeted to spurring commercialization of less polluting clean or renewable energy technologies (often with specific provisions to favor one or more particular technologies) in the electric power sector. These standards can be designed so that each utility within a particular territory must obtain a certain percentage of its delivered electricity from a defined set of clean or renewable sources. Often this is combined with a mechanism that reduces overall compliance costs by allowing a utility that can exceed the standard to create tradable credits that can be banked for future use of sold to other utilities for their compliance. Thirty-one states and the District of Columbia already have their own clean or renewable electricity standards in place (see Climate Change 101: State Action). Several legislative proposals have been put forward in Congress over the past few years to create a national standard for clean or renewable energy.

CAFE Standards

Corporate Average Fuel Economy (CAFE) standards are used for regulating the fuel economy (i.e., miles per gallon of gasoline) of new light-duty vehicles, which include passenger cars and light trucks such as pickups. This standard is calculated using the harmonic mean of the fuel economy of vehicles produced for sale in a year using a set of fuel economy targets that is based upon each vehicle’s footprint. The automaker must meet or exceed this standard (including using optional credit transfers) or the firm must pay a fine based on the number of vehicles sold and the magnitude of the difference between the standard and the achieved sales-weighted average. Like a rate-based flexible emissions standard, CAFE standards are designed so that companies that exceed their fuel economy requirements can sell credits associated with that additional fuel economy to firms that do not meet the standard in a given year.


Feebates are a regulatory program creating a schedule of fees and rebates (hence “feebates”) to the purchase price of a good based on an aspect of the good that policy hopes to influence. Feebates are most often discussed in the context of changing the relative prices of automobiles based on their fuel economy, but could be applied to a wide range of consumer durables (like refrigerators, washer-dryers, televisions, etc.). Not dissimilar to a gas-guzzler tax, a feebate goes a step further and uses the revenue collected from such a tax to create a subsidy for fuel-efficient purchases. Because it both collects fees as well as distributes rebates (subsidies), the system can be designed to be revenue-neutral to the government (or could be structured to generate revenues or direct expenditures depending on the relative magnitudes of the fees and rebates).

Box 2: Uses of Revenues from Taxes or Allowance Auctions

Either a GHG tax or a cap-and-trade system that auctions emission allowances, has the potential to raise revenues for the government. For a tax, the potential revenue raised would be equal to the tax rate times the total quantity of GHG emissions produced in a given year. Under a cap-and-trade program, the revenue generated would depend on the share of allowances offered for sale and the allowance prices at auction.

There are many possible ways that these revenues could be used. A large body of research suggests that one option, using these revenues to reduce existing distortionary taxes on labor and capital investments, would lower the economy-wide costs of the program. Sweden and British Columbia provide two examples of GHG taxes being used specifically to offset taxes on, respectively, labor and individuals/businesses.

However, there may be reasons to use carbon revenue for other purposes. In addition to economic efficiency, policymakers have to concern questions of equity (avoiding burdensome impacts on particular households and businesses). In addition, there are valuable programs that may require funding (e.g., clean energy R&D, adaptation). Several states in the Regional Greenhouse Gas Initiative (where 100 percent of allowances are auctioned) dedicate much of the revenue to renewable and energy efficiency investments.

In past federal cap-and-trade programs for other pollutants, allowances have generally been allocated for free to regulated businesses. In recent climate proposals, allocation of allowances has gone to a combination of public utilities that would be required to use the allowances for the benefit of their consumers, businesses that could face international competitive impacts, funding for low-carbon technology research and development, and programs to ease the transition to a low carbon economy.

One concern is that allowances or credits that are allocated to regulated businesses under certain circumstances could result in windfall profits. For example, in its first phases, the European Union's cap-and-trade program gave emission allowances to power generators for free, but in competitive electricity markets electricity prices nonetheless increased to reflect the carbon price created by the cap-and-trade program. This led to concern over "windfall profits" for power producers who were viewed as essentially charging customers for emission allowances that they had received for free. Informed by the European experience, U.S. state and regional GHG cap-and-trade programs and federal cap-and-trade proposals generally avoid freely allocating emission allowances to power producers in competitive electricity markets and instead direct the value of those allowances to benefit electricity customers.

A Brief History of The Use of Market Mechanisms

Market-based policies to improve the environment are not new; they have been used extensively to protect human health as well as sensitive habitats. These market policies have been used in environmental contexts as diverse as tradable development rights, water effluent, wetland protection and even biodiversity. The U.S. has been a leading proponent of market-based policies globally and both political parties have historically embraced these types of policies in a range of contexts. The examples below highlight some of the market-based policies that have been used in the United States and abroad for reducing different types of air pollution.

Phasing Out Leaded Gasoline

EPA started a program for reducing the amount of lead in gasoline in the mid-1970s. Airborne lead, a byproduct of the combustion of leaded gasoline, is known to cause significant health problems. Lead also reduces the function of catalytic converters which were by then required on new vehicles in order to help reduce other forms of air emissions. The initial program required that each refinery individually meet the gasoline lead concentration requirements (though eventually companies were allowed to average across operations company-wide, rather than just refinery-wide).

In the early 1980’s, however, it became clear that reducing the content of lead in gasoline even further was required to protect public health. In 1982, under the Reagan Administration, EPA started an enhanced program that operated as a rate-based, flexible emissions standard. It required refiners to meet the lead content requirement based on the quantity of gasoline produced, and allowed firms to trade credits generated by outperforming the standard. If a firm, for example, produced 100 gallons of gasoline, it would be given rights (in 1982) for 110 grams of lead (100 gallons times 1.1 grams per gallon). If the lead content of the gasoline produced by the firm was less, the difference was tradable in the form of credits to another firm that exceeded its rate-based target.

Firms were also allowed to “bank” credits from one compliance period for use in the next. Estimates from EPA suggested that savings to refiners as a result of the banking provision for the program were on the order of $228 million (in 1985 $), and other analysts have suggested that the savings were even higher. EPA estimated that the total cost to refiners to comply with the program would be $2.6 billion, while the benefits to society in the form of reduced health impacts from airborne lead would be $36 billion.2

Limiting Ozone-Depleting Substances

Under Title VI of the 1990 Clean Air Act (CAA) Amendments, EPA established regulations for the reduction of ozone-depleting substances in order to meet the requirements of the 1987 Montreal Protocol to protect the stratospheric ozone layer. The regulations called for a cap-and-trade program in which each of the producers (and importers, as defined by the CAA) were allocated production allowances according to their historical (1986) market shares. Trading of allowances was allowed, and was done on the basis of ozone-depleting potential – that is, the relative amount of harm each chemical inflicts on the ozone layer (in this case, denominated in terms of the ozone-depleting potential of CFC-11).

EPA has estimated that in 1992 the trading provisions enabled cost savings of $250 million “and perhaps twice as much by 1996.” Also important were savings in administrative costs – EPA was able to run the program with just four staffers, compared to the 33 that were estimated to be needed under a traditional standards-based, command-and-control regulatory approach. Record keeping for industry would have cost around $300 million under a command-and-control approach but cost only $2.4 million under the trading program.3

Acid Rain

The 1990 CAA Amendments (Title IV) also initiated a program aimed at reducing sulfur dioxide (SO2) emissions, the major industrial pollutant responsible for the formation of acid rain. This program instituted a cap-and-trade program that is widely credited with reducing emissions at much lower costs than command-and-control. The program was designed to increase the stringency of emissions reductions in two phases. Phase I, started in 1995, targeted large sources in the eastern half of the U.S. (where the acid rain problem was most acute) and was followed by Phase II, in 2000, which covered nearly all power plants.

The acid rain program allocated most emission allowances based on historical fuel use and environmental performance benchmarks to the regulated power companies, but retained a small portion of the allowances for an open auction in which all were free to participate. Allowances were both tradable and bankable – so at any given moment the market for allowances included the current year’s emission allowances as well as all unused emission allowances from previous years.

The acid rain program has widely been held up as a model for the success of market-based environmental policy, and for cap and trade in particular. Prior to the start of the program, credible estimates for the costs of compliance for the sulfur dioxide trading program ranged from $2.7 to $8.7 billion dollars annually by the year 2000. As a result of the flexibilities provided by the market mechanisms associated with the policy, the actual annual compliance costs (averaged from 2000-2007) were only $1.9 billion.4.


A regional example of an environmental market-based policy at work is the Regional Clean Air Incentives Market (or RECLAIM) in southern California. The RECLAIM market is designed to reduce emissions of nitrogen oxides and sulfur dioxide in the region in a cost-effective manner. The program splits the affected region in southern California into two zones, coastal and inland. The trading program allows trading of emission allowances within each of the zones, but restricts inter-zone trading by disallowing trades from the inland region to the upwind coastal region (in an effort to enhance the protection of the downwind region – trading from the coastal region to the inland region is allowed). The program does not allow banking of current allowances for future years, which has reduced its cost-saving potential but has enhanced the protection to human health by minimizing highly localized pollution concentrations.

Regional Greenhouse Gas Initiative (RGGI)

The Regional Greenhouse Gas Initiative (RGGI) is a program originally covering ten New England and Mid-Atlantic states who agreed to cap-and-trade carbon dioxide emissions from power plants.5 The RGGI program sets a cap on power plant emissions to stabilize annual emissions at 188 million tons of CO2 for the years 2009-2014, and then reduces the cap by 2.5 percent per year from 2015-2018 to result in a 10 percent total emissions reduction. Power generators have a variety of options to comply with RGGI; they can reduce their emissions through efficiency measures, switching fuels, using new control technologies, or they can purchase allowances at auction or from other firms. Additionally, generators can use emission “offsets” to meet their emission reduction obligations. Offsets under the RGGI program are defined as emission reductions from sources other than power plants. For example, a permissible source of offsets for the RGGI program could be the capture of methane emissions (a potent GHG) from landfills or agricultural sources. The RGGI program currently allows generators to meet up to 3.3 percent of their emissions obligations through the use of offsets.

European Union Emissions Trading System (EU ETS) for Carbon Dioxide

The largest market-based policy directly addressing the climate issue to date is the European Union’s Emissions Trading System (EU ETS). Designed to be consistent with the emission reductions targets included in the Kyoto Protocol, the EU ETS creates a market of tradable emissions allowances for CO2 emissions among the EU member states. The program was, in fact, modeled largely on the successful U.S. acid rain SO2 trading program, and includes many of the same elements.

The program requires that each member state limit and distribute emissions in a manner that is consistent with the nation meeting its international reduction commitment. Once allocated however, the emission allowances are tradable among the participating member states in a common market. Firms can also use emission reduction credits from the Clean Development Mechanism (CDM)6 for compliance with the program. While some CDM credits have been the subject of controversy, they are widely supported by industry as a tool to control program costs and provide market liquidity. The EU ETS is currently in its second phase (its Kyoto Protocol Compliance period) and Phase III will run from 2013-2020. Banking of excess allowances and credits from phase two into phase three will be allowed.


Choosing Between Price-Based and Quantity-Based Market Policies

In general, the fundamental trade-off between price-based (e.g., taxes) approaches and quantity-based (e.g., cap and trade) approaches is either greater compliance cost certainty or greater environmental certainty. A policy that sets an explicit price on a unit of pollution (like a tax) results in a program that offers a high degree of price certainty for the businesses that are regulated. However, while the compliance cost associated with the pollution is more certain, the resulting level of pollution reduction overall is less certain, because each company will respond differently to the price set by the tax. For example, a tax of $1 per gallon of gas could cause Company A to reduce its gasoline consumption by 20 percent but only cause Company B to reduce its consumption by one percent. The level of the reduction is difficult to know in advance and the level of the tax may need to be adjusted over time to achieve a specific emission reduction goal.

In contrast, a quantity-based market policy provides certainty about the environmental outcome because only a limited number of pollution allowances are distributed or auctioned. In this case, while the environmental outcome is certain, the cost to firms for emitting pollution is uncertain (particularly at the outset of the program) and will be determined by the market price for allowances. Real-world market-based policy proposals, however, are not so “black and white” and can be designed with policy components that create more certainty for both price and quantity. For example, recent cap-and-trade policy proposals have included price floors and price ceilings in order to give more compliance cost certainty (for more details see Climate Change 101: Cap and Trade).

A typical concern about implementing any new environmental policy relates to the short-term market disruptions that often accompany an adjustment to a new regulatory environment. These concerns tend to be amplified during periods when the economic environment is already distressed (as is the case at the time of this publication). An inherent advantage of emission trading systems in this respect is its self-adjusting nature in response to economic conditions. Reduced economic growth tends to lower the use of fossil fuels, which lowers the demand for allowances and thus under a cap-and-trade system the market price of allowances would be reduced. This has certainly been the recent history in both the RGGI and EU ETS where demand for allowances and market prices have decreased with reduced economic growth. In times of economic expansion, the opposite is true – under cap-and-trade, allowance prices rise when economic growth is strong. In this sense, cap-and-trade can be seen as providing a self-adjusting price, higher when the economy is doing well and lower when the economy is in a downturn.


Impetus to Act

Often the debate surrounding whether policy should be pursued to mitigate climate change focuses on the costs associated with such actions. It is certainly true that regulations designed to curtail emissions of greenhouse gases will entail costs. But it is also true that failure to regulate GHGs will also result in costs – the costs of climate damage from inaction. (See Climate Change 101: Science and Impacts and Climate Change 101: Adaptation). Market-based climate policies are designed to minimize compliance costs while also avoiding the worst consequences that a dramatically changing climate could create.

There is no single policy that can achieve a comprehensive solution to mitigating climate change – a variety of policies will undoubtedly be required to address the challenges specific to different sectors of the economy. Market-based policies provide the most economically efficient path for doing so. The more flexibility that regulated businesses have, the more opportunities they will find to innovate and to reduce the costs associated with protecting the environment. A significant advantage of market mechanisms, whether they be price-based (e.g., tax) or quantity-based (e.g., cap and trade), is that they provide a continuous incentive to reduce emissions – the more a company can reduce, the larger its financial gain. Under traditional command-and-control regulation, there is no incentive to go beyond the regulatory standard. In a market-based policy, the financial incentive drives the private sector to continuously innovate and seek new emission-reducing technologies that regulators might not anticipate under command-and-control. In a market system, such emission-reducing innovation can set the stage for deeper emission cuts over time. This is particularly important because addressing such a challenging environmental problem as climate change will require new technology to achieve the substantial emission cuts that are necessary over the coming decades.


Appendix A: Policy Summary Table

Innovation Compliance Cost Certainty Environmental Certainty Linkability Expansion Revenue Recycling
Technology Mandate - Command-and-Control Limited - incentive exists to achieve mandated technology at lower costs Yes Yes N/A N/A No revenue raised by policy
Performance Standard (rate based, non-tradeable) Limited - once the standard can be met, there is little incentive to continue to improve performance beyond reducing costs No - difficult for policymakers to understand cost structures that will lead to compliance Some - a performance standard will require that each unit have a certain emissions profile but total emissions will depend on overall use characteristics Difficult to link beyond a specific sector Some - policymakers can create standards specific for each sector to expand their reach No
Performance Standard (rate-based, tradeable Yes - firms have incentive to innovate to reduce emissions and avoid buying allowances (or to have more excess allowances to sell) No - difficult for policymakers to foresee trading prices based on sector-wide marginal compliance costs Some - a rate-based standard determines the emission-intensity of output; but total emissions will vary with output Yes - resulting “carbon price” could theoretically be linked to other trading programs No - difficult to expand beyond initial sector No
Renewable or Clean Energy Portfolio Standard (potentially tradable Limited - once standard is met there is no ongoing incentive to invest in renewables. Does not incentivize efficiency innovations Minimal - can be difficult to know costs of meeting a renewable quota Some - an RPS/CES behaves similarly to a performance standard. Total emissions will vary with overall output since an RPS/CES typically requires some fraction of power to be renewable Yes - programs can be designed to trade production quotas, or buy renewable power, from other regions Minimal - an RPS could link with a renewable fuels standard, but these renewable fuel mandates are probably limited to electricity generation and transportation fuels No
Cap-and-Trade Yes - firms have incentive to innovate to reduce emissions and avoid buying allowances (or to have more excess allowances to sell) No - difficult for policymakers to foresee the price of allowances in a tradable open market (can be mitigated with price bands) Yes - a “cap” on emissions means that the total level of emissions is known (certainty reduced with price bands) Yes - new regions can be included or merged into a trading program (may be complicated by price bands) Yes - can be expanded to other sectors or regions Depends on if allowances are allocated for free or if they are auctioned to raise public revenues
Cabon Tax (on emissions or product) Yes - firms have incentive to innovate to reduce emissions and tax payments. May lead to substitution toward other goods and could lead to process efficiencies or new techniques with low carbon products Yes - the marginal cost of a unit of pollution is defined by the tax rate No - with a fixed tax rate, actual emissions will vary depending on the cost of reducing emissions as determined by such factors as economic growth, technological progress, and changes in energy supply Potentially harmonized with the tax rates of other governments, but may be politically contentious. Cannot be linked to trading programs to reduce compliance costs Potentially can be expanded to include additional sectors or regions as needed. Yes
Production Tax Credit Limited - induces innovation for production of favored technologies. Does not incentivize new technologies or processes, does not price carbon Yes - provides financial incentive to producers. Costs to businesses taking advantage of the credit are negative No - actual deployment of technologies will depend on other market conditions in addition to the magnitude of the tax credit No No No - reduces tax receipts
Feebates (revenue neutral) Yes - efficiency is priced into the good so consumer-demand will continuously shift for more efficient products Yes - there is no compliance cost to manufacturers, only changing consumer demand patterns based on altered final retail prices No - many other market factors will influence ultimate uptake of efficient goods No No Depends on “zero-point” of feebate. Typically designed to be revenue-neutral

Appendix B: Glossary of Market Mechanisms Concepts

Allocation– Under an emissions trading scheme, one approach is for emission allowances to be given away for free. Sometimes referred to as ‘grandfathering’ allowances allocated in this manner can be based on past emissions or output in a base year, or on emission performance benchmarks, or on an ‘updating’ approach based on more recent emissions or output. The alternative is to auction permits in an initial market offering. Policymakers have discretion when allocating emission allowances and this can be a useful political tool to ease the transition to an emissions trading program, or to compensate affected parties.


Banking– The carry-over of allowances from one emissions trading period to the next, i.e., saving emissions allowances for use at a later date. In order for an entity to “bank” allowances, they must have an excess of allowances from an earlier period as the result of over-compliance with an emission reduction standard.


Borrowing– The conceptual opposite of “banking”; using an emissions allowance prior to the date of its issue. Often regulators design borrowing programs to include the assessment of a fee or penalty to discourage over-use of this type of provision. Borrowing leads to under-compliance in the early period and over-compliance in the later period.


Carbon Tax – A surcharge placed on the carbon content of oil, coal, and gas that discourages the use of fossil fuels and aims to reduce carbon dioxide emissions.


Cost-Effective (Cost-Effectiveness) – minimizing the costs of achieving some given objective. A ‘cost-effective’ environmental policy achieves its environmental goals at the lowest possible overall costs. Improving a policy’s ‘cost-effectiveness’ moves in that direction – it achieves an environmental objective at a lower average unit cost.


Discounting – The process that reduces future costs and benefits to a present value reflect the time value of money and preference for consumption now rather than later. A ‘discount rate’ makes an explicit assumption about the relative value of a good or service in the future compared to the present.


Emissions Cap – A mandated restraint in a scheduled timeframe that puts a “ceiling” on the total amount of emissions that can be released into the atmosphere, and a key component in a ‘cap-and-trade’ program. This can be measured as gross emissions or as net emissions (emissions minus gases that are sequestered).


Emissions Tax – A tax applied to the quantity of emissions produced.


Emissions Trading – A market mechanism that allows emitters (countries, companies or facilities) to buy emissions from or sell emissions to other emitters. Emissions trading is expected to bring down the costs of meeting emission targets by allowing those who can achieve reductions less expensively to sell excess reductions (e.g. reductions in excess of those required under some regulation) to those for whom achieving reductions is more costly.


Externality – A consequence or side effect of an economic activity that impacts individuals not directly related to the activity, and that is not reflected in prices. Environmental pollution is an example of a negative externality because pollution imposes a cost on people who are not necessarily a party to the activity that produces the pollution. It is a form of market failure.


Linkability – The ability of a policy mechanism to be coordinated with other similar policies. An emissions trading program (like cap and trade) has linkability because such a program can be designed so that its participants can trade emissions allowances with participants in other programs, essentially creating a common market.


Market Failure – When a market does not allocate resources efficiently. A negative externality caused by pollution is an example.


Offsets A voluntary emission reduction project done outside of a mandatory requirement where the resulting emission reductions can be quantified and ownership transferred. Some trading programs allow the resulting ownership credit of the offset to displace a similar level of emission reduction within a trading program.


Price Ceiling (Safety Valve) – A price ceiling is a policy option for an emissions trading program in which the regulatory authority makes a standing offer to sell additional allowances into the system at a specified price. That price serves as the upper bound that the market price for tradable emissions allowances will reach. This is used to ensure that compliance costs do not exceed policy-makers’ design assumptions.


Price Floor – The conceptual opposite of the ‘price ceiling’. In an emissions trading program the price floor is a price at which the regulatory authority is willing to buy (or withhold from auction – also called a ‘reserve price’) allowances from the system. The price floor serves to place a lower bound that the market price for tradable emissions allowance will reach. Price floors are used to guarantee the value of emissions allowances, which is important for encouraging investment in emission-reducing technology.


Revenue Recycling – The re-use of the government revenues generated as a result of a market-based policy (either from tax receipts or from the proceeds of an allowance auction).


Subsidy – A government payment to encourage a particular economic action; the opposite of a tax.


1   National Academy of Sciences, Advancing the Science of Climate Change (Washington, DC: National Academies Press, 2010).

2   Robert Hahn, “Economic Prescriptions for Environmental Problems: How the Patient Followed the Doctor’s Orders,” The Journal of Economic Perspectives 3 (1989, no. 2:95-114.

3   “Savings from Using Economic Incentives for Environmental Pollution Control,” U.S. Environmental Protection Agency, last modified March 19, 2012, http://yosemite1.epa.gov/EE/epa/eed.nsf/webpages/SavingsFromEconomicIncentivesTOC.html.

4   Larry Parker, and Brent D. Yacobucci, Climate change costs and benefits of the cap-and-trade provisions of H.R. 2454, R40809 (Washington, DC: Congressional Research Service, Library of Congress, 2009).

5   Since the initial agreement, one state has dropped out of the cap-and-trade program. On May 26, 2011 New Jersey Governor Chris Christie announced that his state would be leaving RGGI’s cap-and-trade program. The New Jersey legislature passed a bill in August 2011 that would have kept the state in the program, but it was overridden by Governor Christie’s veto.

6   The Clean Development Mechanism was created under Article 12 of the Kyoto Protocol. The mechanism allows for the approval of emission-reduction (or emission removal) projects in developing countries that can earn certified emission reduction (CER) credits. These saleable credits can be used by industrialized countries to meet a part of their emission reduction targets under the Kyoto Protocol