There are two general approaches to environmental regulation: command-and-control regulation and market-based instruments.

Command-and-control regulation is the most common approach to address environmental problems around the world.  It works by setting standards and directly regulating the activities of firms and individuals.  The Clean Air Act in the United States is an example of a successful command-and-control environmental policy. In the case of climate change, standards could be applied to energy using devices (cars, appliances, homes), the carbon content of fuels, and the mix of energy sources used to generate electricity.

Market-based instruments change price signals so that polluters face direct cost incentives to reduce emissions.  The two primary instruments under consideration to manage carbon are taxes and tradable permits. In an emissions tax system, a tax is imposed per unit of pollutant.  In the case of climate change, a tax would be placed on the carbon content of fossil fuels. Coal would be taxed the most; natural gas the least (See Principle 2). In a cap-and-trade scheme, polluters receive permits to emit, and can then buy and sell these permits among one another.  In theory, overall costs are minimized when market-based instruments are used because they induce firms to choose control levels at which their marginal abatement costs are equal.

Potential benefits of cap-and-trade

In theory, a cap-and-trade approach offers a lot of attractive potential benefits:

• It sets a total limit on carbon emissions, which ultimately is what affects climate. The government caps the level of carbon dioxide emissions by issuing a limited number of allowances Polluting firms must surrender an allowance for each unit of CO2 they emit.
• Emission allowances are tradable, so overall emissions targets can be met while giving firms flexibility in deciding how to do it.
• Carbon emission reductions can increase gradually and predictably, giving energy producers and energy consumers time to adjust.
• The point of regulation can be upstream, meaning that energy producers rather than energy consumers participate in the system. This eases the burden of monitoring and enforcement since there are far fewer producers than consumers.
• Regional cap-and-trade systems could be harmonized with national systems; ditto for national and international systems.
• A cap-and-trade offers the potential of compensating for the inevitably unequal burdens imposed by climate policy at the national and international level. For example, some of the initial allowances could be given away to firms and nations disproportionately burdened by the policy.  Similarly, revenues from the auction of permits could be returned to those parties that bear the brunt of higher energy prices
• In the United States, a cap-in-trade system prevents politicians from committing political suicide by proposing a new, large tax.
• The cap-and-trade approach to reducing carbon emissions is rapidly being adopted around the world.

Cap-and trade systems

In January 2005 the European Union Greenhouse Gas Emission Trading System (EU ETS) commenced operation. The EU-ETS is designed to achieve the EU's overall environmental target of a 20% reduction in greenhouse gases and a 20% share of renewable energy in the EU's total energy consumption by 2020. The ETS covers more than 11,500 installations in the energy and industrial sectors that are collectively responsible for about.  It is estimated that the sources to which the trading scheme applies will account for about 45% of CO₂ emissions in 2010, and 30% of total greenhouse gas emissions in that year.

The early returns on the success of the EU ETS are positive, but not without problems and criticisms. The price of carbon in 2005 and 2006 moved erratically, and the free initial allocation of permits to some polluters created windfall profits.  However, most analysts point to the path breaking success of the program. A transparent and widely accepted price for tradable CO₂ emission allowances emerged by January 1, 2005, a functioning market for allowances has developed quickly without any prodding by governments, the cap-and-trade infrastructure of market institutions, registries, monitoring, reporting and verification is in place, and a significant segment of European industry is incorporating the price of CO₂ emissions into their daily production decisions.

The Obama Administration’s FY 2010 Budget Proposal contains proposes the imposition of a cap-and-trade system to reduce greenhouse gas emissions approximately 14 percent below 2005 levels by 2020, and approximately 83 percent below 2005 levels by 2050.

A cap-and-trade system will have significant impacts on price and types of fuels used for a simple reason: pollution permits or allowances will be scarce, and thus will have a price attached to them. As the emissions cap become more stringent over time, the price of allowances will rise. The cost of allowances will ripple through the economy, affecting energy prices, the mix of fuels, consumer expenditures, and the structure of technology.  The details of the structure of the cap and trade policy will greatly influence the plan’s economic implications, but here some likely outcomes:

• As a cap progressively tightens with time, the cost of reducing emissions becomes more expensive and as a result, the cost of a CHG allowance increases.
• The cost of GHG allowances is passed through to consumers, raising the price of fossil fuels charged and providing an incentive to lower energy use and shift away from fossil fuels, particularly in the electric power sector.
• Poor households will assume a larger share of the burden caused by higher energy prices because they spend a greater fraction of their income on fuels and electricity compared to wealthy households.
• In electricity generation, coal will lose significant market share to some combination of natural gas, nuclear, and low-carbon renewables such as wind and solar.
• Estimates of the macroeconomic impacts of a cap-and-trade system (GDP growth, employment, investment) are highly variable due to different assumptions about how the rising the cost of a CHG allowance ripples through the economy.  In the U.S., for example, estimates of the reduction in GDP by 2050 relative to a case with no cap-and-trade range from less than 1% to as much as 15%.

Sources

• Convery, Frank J. Origins and Development of the EU ETS, Environmental and Resource Economics, Published online: 17 March 2009, DOI 10.1007/s10640-009-9275-7.
• Ellerman, A. Denny and Paul L. Joskow, The European Union's Emissions Trading System in Perspective, Pew Center on Global Climate Change, May 2008.
• Energy Information Administration, U.S. Dept of Energy, Energy Market and Economic Impacts of a Proposal to Reduce Greenhouse Gas Intensity with a Cap and Trade System, Report #SR-OIAF/2007-01, January 2007.
• Montgomery, W. David, Robert A. Baron, Paul Bernstein, Anne E. Smith and Sugandha Tuladhar, Impacts of the Climate Provision in the Obama Administration’s FY2010 Budget Proposal, CRA International, Washington D.C., April 2009.
• Paltsev, Sergey, John M. Reilly, Henry D. Jacoby, and Jennifer F. Morris, The Cost of Climate Policy in the United States, MIT Joint Program on the Science and Policy of Global Change, Report No. 173 April 2009.
• Shammin, Md Rumi , and Clark W. Bullard, Impact of cap-and-trade policies for reducing greenhouse gas emissions on U.S. households, Ecological Economics, In Press, Corrected Proof, Available online 4 May 2009, ISSN 0921-8009, DOI: 10.1016/j.ecolecon.2009.03.024.
• Stavins, Robert, A U.S. Cap-and-Trade System to Address Global Climate Change, Hamilton Project Discussion Paper 2007-12 (October, 2007), Brookings Institution.