12.3: Cap and Trade

Many of the policies being undertaken around the world (Chapter 11) use another market-based approach—cap and trade. In this section, we focus on (1) why cap-and-trade policies are considered market based in terms of the tax-like incentives they create for climate action and (2) the main way they differ from a carbon tax.

Cap-and-trade policies tend to be fairly complex, first involving allocation of carbon permits of different vintages (that is, for use during different years). Companies that release greenhouse gases to the atmosphere (and sometimes also financial firms and energy traders) are then allowed to trade these permits with one another. The cap takes effect as companies must periodically “true up” by matching the number of permits they have in their possession with the number of tons of carbon equivalent they have released over a particular period (for example, during one calendar year). There are also rules that govern who can trade permits and when, as well as details to address companies that wish to borrow permits from the future or use permits from other countries or previous years.

The tax-like incentive provided by cap and trade

Return to the hypothetical list (sorted on cost-effectiveness) of all possible actions that lead toward a climate solution. A carbon tax encouraged people to undertake the cheapest, most cost-effective actions on the list because doing the action would be cheaper than paying the tax. In theory, cap and trade can create exactly the same incentive. Because the permits have value, companies should embed the value of carbon permits (that they could have sold if they had shut down their factories or power plants, for example) into their products’ price tags. This works in exactly the same way as the tennis ball manufacturer in the previous section embedded its carbon tax payment into the price of its product.

One potential difference in the practical functioning of the two market-based incentives is that the carbon tax is a direct cost. Companies must actually pay the carbon tax to the government, and so carbon-intensive companies are forced to pass on the tax in the price of the products they sell or take a loss on the sale. Other companies that make carbon-free products, and therefore don’t have to pay the tax, can now offer lower prices than the competition.

Under cap and trade, the value of permits is often an opportunity cost instead of a direct cost: Suppose a company has been allocated most of its carbon permits for free, so if it wanted to, it could keep on selling the same polluting product for the same price and not go bankrupt.* Fortunately, economic logic says that such a company should still raise prices even if it got its permits for free. The reason is that by raising prices, it will sell less of its product and so be able to close down part of its factory. It will then have extra carbon permits it no longer needs and can sell those to someone else. The idea is that by raising the price for its product (and reducing quantity) and by selling surplus permits, it could make even more profit than it would have made if it kept on operating as usual. The concept of opportunity cost is central to the logic of how cap and trade works; it means that cap and trade can produce exactly the same price incentives as a tax, even if the permits are given to the company for free.**

Key difference relative to a carbon tax

One of the most important differences between a carbon tax and a cap-and-trade system is in how the size of the incentive gets set. With a carbon tax, the government gets to choose how big the incentive is. A $30 carbon tax raises the price of carbon-intensive products by a fixed amount ($30 per ton of carbon involved in the product’s production), as shown in the British Columbia example in Table 12.2.1.

Suppose that the government decides the $30 tax is not creating enough action on climate (for example, because of advances in climate science, or when the extent of damages starts to be revealed). Adjustment to a tax policy is straightforward: government can raise the tax from $30 to $40. More emissions reductions will start to occur as carbon-free products become cheaper than carbon-intensive ones, and more of the long list of actions on the cost-effectiveness list will start to make sense, since the tax savings are now $40 rather than $30.

In contrast, under a cap-and-trade system the government chooses the number of carbon permits that will be allocated, and it typically commits to this choice for at least several years into the future. Figuring out how many permits to issue first involves trying to estimate how much carbon all the different companies covered under the program would release in the absence of any policy. Some of the carbon is then subtracted from this “business as usual” estimate, in the hopes that a nice-size incentive (neither too small nor too burdensomely large) will appear. The actual incentive that any particular cap-and-trade program produces in an economy is unknown. It depends on the price at which companies choose to trade permits, which in turn depends on factors like technological change and macroeconomic fluctuations. The final incentive to conserve that is produced by cap and trade can therefore be very large, if the permit price ends up being high, or very small if permits end up trading cheaply.

Key difference relative to a carbon tax: examples

Figure 12.3.1 Market-based carbon incentives in the European Union. Price is in euro. Data from Point Carbon.

Begin with the cap-and-trade system in the European Union, known as the Emissions Trading Scheme (ETS), as an example. The first wave of the ETS allocated permits over the period 2005–2007. Figure 12.3.1 displays the prices of these permits, beginning when they were first traded in 2005 and going through 2007 when the “true up” occurred and the permits were given back to the government in exchange for carbon emissions. What does this mean in terms of incentives and the hypothetical list of actions to mitigate climate change? Toward the end of 2005, permits traded for 22 euro, or about US $27, per ton. This would have worked just like a $27 carbon tax: a company that could take an action to save a ton of carbon for $15, for example, would do it, since it would then be able to sell a carbon permit worth $27 to someone else (making $12 profit in the process). Now consider early 2007: the cap-and-trade price had fallen to about 1.5 euro, or $2. This worked just like a $2 carbon tax: the $15 action was no longer worth it and should be abandoned. In fact, all climate actions costing more than $2 per ton saved would no longer be profitable. By late 2007 the price had fallen to nearly zero, and so the incentive was gone altogether.

Did something change during those years that made climate action less important? Of course not—the climate change problem is global and long-term, and if anything, the urgency to take action was actually increasing rather than decreasing. What this example shows is that permit prices can go up or down for many reasons, even if the true importance of taking action on climate hasn’t changed at all. In this case, the sharp reduction in the incentive most likely came from shifts in industrial composition and mistakes in the government’s forecast of how much carbon would have been released had no cap-and-trade system been in place.

Subsequent phases of the ETS have issued fewer permits and so have generated larger price incentives on average, but the system continues to experience dramatic price swings. When the EU issued a new round of carbon permits for 2008, it greatly reduced the number of permits issued, and the price initially spiked to around 30 euro per ton. This gave European businesses and consumers a very strong incentive for reducing carbon emissions, the same as a carbon tax of 30 euro ($44) per ton. By 2013, however, the price had unexpectedly dropped to about 5 euro per ton, likely as a result of some combination of the great recession, rules on how international cap-and-trade permit markets could link with Europe, and renewable energy policy.* Again, we don’t think the value of taking action actually fell; the decrease in the incentive came instead from the inherent uncertainty of cap and trade.

European carbon incentives remained quite low for about 4 years, through 2017, and then swung sharply back up, with trades in late 2018 again exceeding 20 euro per ton. It turns out to be very hard to predict economic conditions, technology, and permit trading patterns very far into the future.

Now let’s move to California’s experience (discussed in more detail in Chapter 9). The system was set up in a fairly standard way, with one, very important, change: a floor or reserve price was placed on the price of permits. If something happened in permit trading, and price started to fall dramatically, protections would kick in to hold the permit price (and therefore the incentive to take action on carbon) at a floor level. California set the floor at $10 per ton in 2012, with predetermined annual increases thereafter.

Figure 12.3.2 Market-based carbon incentives in California. Data from California Carbon Dashboard and the California Air Resources Board.

Figure 12.3.2 shows the time path of prices for carbon in California’s cap-and-trade market. What can we learn about incentives for Californians to conserve carbon? Early in trading, the carbon price was about $20, and so incentives in the economy were equivalent to a $20 tax. By the beginning of 2014, however, the carbon price had fallen and reached the floor. The protections kicked in, and the price was not allowed to fall below $11.34 (the assigned floor price for 2014). Since then, incentives have risen as the floor rises, periodically rising above the floor when changes in the local economy make demand for permits stronger. The price in 2018 was about $15 per ton (the floor in 2018), and so price incentives in California were about half as strong as they were in British Columbia. This may be less than California lawmakers had hoped for when they set up the cap-and-trade system, but it is still greater than it would have been had the floor not been in place. The use of a rising price floor to combat the uncertainties associated with cap and trade has been a notable success of the program.

Uncertainty in emissions

While cap and trade produces uncertainty in the incentive to conserve (and historically this has sometimes resulted in very small incentives), it is often pointed out that a carbon tax will result in uncertainty in carbon emissions. During a year of weak electricity demand, for example, carbon emissions will go lower than expected, and during a year of strong electricity demand, they will be higher than expected.

Which would we rather have: variation from year to year in the incentive, or variation from year to year in carbon emissions? The economics of cost-effectiveness suggest that variation in incentives from year to year (and place to place, if different economies have separate cap-and-trade programs) can be very expensive. In years when incentives under cap and trade are very low, society will be missing out on lots of very cheap opportunities to save carbon. In years when cap-and-trade permits are selling for high prices, the economy instead undertakes very expensive actions to conserve. Bouncing back and forth between almost no action and then very expensive action adds up to considerable economic losses because we are replacing missed low-cost opportunities to save (in the low-price years) with expensive opportunities to save (in the high-price years).

In contrast, the ups and downs in carbon emissions that appear with a tax-based incentive do relatively little damage. This is because, as discussed in Chapter 1, it is cumulative, global emissions that will have the greatest impact on climate damages into the future. Variation in emissions in any one year or country (either up or down, depending on which way local and global economic conditions are headed) matter relatively little in the context of the overall climate problem.

*The free allocation of permits to polluting companies is often called grandfathering.

**Incentives for entry (that is, starting up a new firm) and exit (going out of business) may be different, however. Notice that profits will be higher with a grandfathered cap-and-trade system than they would be with a carbon tax, and so exit of polluting firms is less likely.