Market-Based Strategies

At-a-glance

  • Market-based approaches, like a carbon tax or cap-and-trade program, help reduce emissions at the lowest possible cost.
  • Eleven U.S. states and more than 50 other jurisdictions around the world use market-based approaches to reduce greenhouse gas emissions.
  • The U.S. has more than 30 years of experience using market-based approaches to phase out leaded gasoline and to reduce acid rain and smog.

Market-based strategies help fight climate change by putting an explicit price on carbon emissions and spurring businesses to find cost-effective ways to reduce those emissions.

The costs of climate impacts – such as higher sea levels and more frequent and severe heat waves, droughts, wildfires, and downpours – are not reflected in the price of goods and services that emit greenhouse gases. Putting a price on those emissions gives businesses an incentive to reduce them. By giving them flexibility to choose the most economical way to reduce emissions, rather than mandating one approach, pricing also encourages businesses to innovate.

Two of the best-known market-based strategies – cap and trade and a carbon tax –are being used around the United States and the world to reduce emissions.

The costs of climate impacts are not reflected in the price of goods and services that emit greenhouse gases. Putting a price on those emissions gives businesses an incentive to reduce them.

Carbon Pricing in Action

Market-based approaches to pollution were pioneered in the United States. A cap-and-trade program for sulfur dioxide, the cause of acid rain, was created in 1990 by a bipartisan Congress and launched by Republican President George H.W. Bush. Emissions were cut about twice as fast as predicted and at a fraction of the cost of traditional regulation.

Market-based policies to curb greenhouse gas emissions are being used in 11 states accounting for more than a quarter of the U.S. population and a third of U.S. GDP:

Boulder, Colo., was the first U.S. city to enact a carbon tax, and others are exploring the option.

Carbon pricing programs also are in place or in the works elsewhere around the world. European countries have operated a cap-and-trade program since 2005. Alberta, Canada, has had a carbon price since 2007, and now all Canadian provinces are implementing or developing carbon pricing plans. Several Chinese cities and provinces have had carbon caps since 2013, and government is working toward a national program. About half of the nations that signed the Paris Agreement plan to use market-based approaches to help achieve their emissions pledges.

State of World Carbon Pricing

Cap and Trade

Under a cap-and-trade approach, the government sets an upper limit on emissions (the cap). Emission allowances that equal the cap are distributed (either freely or through auction) to regulated sources.

Businesses can trade allowances among themselves, so a company that can cheaply reduce emissions may do so, and then sell its allowances to a company that finds it more cost-effective to buy allowances. This allows the market to find the cheapest ways to reduce emissions overall. The price is determined by the amount of allowances (supply), emissions (demand), and the cost of reducing emissions (abatement costs). Thus, the government establishes the environmental goal (the cap), but the market sets the price.

Carbon Tax

Under a carbon tax, the government sets a price that emitters must pay for each ton of greenhouse gas emissions they emit. Businesses will take steps to reduce their emissions to avoid paying the tax. The market will determine the emissions because businesses will undertake only those reduction activities that are cheaper than the tax.

Environmental Justice

Thoughtfully designed carbon pricing policies can drive down emissions while also tending to other social responsibilities. Revenue from cap-and-trade programs or carbon taxes can be used for a variety of purposes, including expanding clean energy and energy efficiency opportunities in low-income communities and reducing taxes on personal income or business.

More than $1 billion in program revenues from RGGI have been invested in energy efficiency, renewable energy and other efforts that are expected to lower energy bills. California’s program designates a significant portion of the revenue to help disadvantaged communities.

Companion regulations can ensure that other types of pollutants directly affecting the local community are reduced.

Reducing greenhouse gas emissions at the lowest cost allows more to be done, faster. That especially benefits those who can least afford to cope with the impacts of climate change, and keeps costs down for all consumers.

Cap and Trade vs. Carbon Tax

In theory, the choice between a cap-and-trade program and a carbon tax is the choice between environmental certainty (the cap) and price certainty (the tax). But in practice, these lines are blurred. The cap-and-trade programs operating in the Regional Greenhouse Gas Initiative (RGGI) and California both have provisions to limit how low or high the price of allowances can go. Taxes, too, can be designed to automatically adjust if emissions don’t drop to desired levels. These policies can also be used in conjunction, as in the U.K. and other countries.

Offsets

Both cap and trade and carbon taxes can include the use of carbon offsets. An offset represents a reduction, avoidance, destruction, or sequestration of carbon dioxide or other greenhouse gas emissions that: 1) are from a source not covered by an emissions reduction requirement; 2) can be measured and quantified; and 3) can be converted into a credit if it meets established eligibility criteria.

The effects of climate change are felt globally. The benefit of reduced emissions is also felt globally, regardless of where the reductions occur. Many offset projects can reduce emissions more cheaply than the industrial sources typically covered by climate policies. When offsets are allowed, they can provide the same environmental benefit at a lower cost.

Other approaches

Other market-based strategies price greenhouse gases indirectly. In the U.S. many states have Renewable Portfolio Standards (RPS) that require electricity providers to get some of the electricity from renewable sources. These states issue tradeable Renewable Energy Credits (RECs) to track the renewable power, and then the market sets a price for RECs as a function of the supply and demand for renewable power. This indirectly prices greenhouse gas emissions because the renewable power sources don’t emit greenhouse gases.