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.
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.
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.
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 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.