Cap-and-trade could soon make a comeback — especially after the Obama administration unveils new rules next week to cut carbon-dioxide emissions from US power plants.
It's been a few years since cap-and-trade was relevant to national climate policy debates. Back in 2010, Democrats in Congress tried to pass a bill that would set a nationwide limit on carbon-dioxide emissions and let companies buy and sell permits to pollute. That bill failed, and further discussion quickly ceased.
But the policy itself has survived at the state level. California just enacted its own cap-and-trade system for carbon dioxide as part of a statewide plan to reduce global-warming pollution. In the Northeast US, meanwhile, power plants in nine different states participate in a cap-and-trade program known as the Regional Greenhouse Gas Initiative (RGGI).
Now there's a chance cap-and-trade could expand even further. On Monday, June 2, President Obama will announce new rules to curtail emissions from the nation's existing fossil-fuel power plants. States will have several options to cut emissions from their power plants — including, possibly, joining existing cap-and-trade systems or creating new ones.
So it's time for a quick refresher on what cap-and-trade does and why it may soon be making a comeback:
How cap-and-trade works
Under a cap-and-trade system, the government hands out a limited number of permits for emitting carbon-dioxide each year — effectively creating a "cap" on overall pollution.
Companies that are covered by the program can then buy and sell those permits among themselves (this is the "trade" part).
Since the overall supply of permits is limited, some companies will decide that it's cheaper to cut back on their carbon emissions rather than buy permits. Perhaps they invest in more efficient technology, or cut energy waste, or switch to renewable power. Whatever's cheaper than buying up permits.
The cap then gets lowered over time — meaning there are fewer and fewer permits available each year. Permits keep getting more expensive, so more companies opt to reduce their emissions instead of buying the allowances:
A rough illustration of cap-and-trade:
It's possible to modify this program in all sorts of ways, but that's the basic idea. Essentially, companies have to pay a price for emitting carbon-dioxide — the price of the permits. That price varies according to supply and demand. (This is a bit different from a carbon tax, where the government fixes the price that companies have to pay to emit carbon-dioxide.)
The main appeal of cap-and-trade is that it's more flexible than flat pollution rules. The government doesn't say: "Each individual company must reduce its emissions by 20 percent." It says: "Overall emissions must go down by 20 percent — discuss among yourselves how best to do so." Companies that find it cheaper to make cuts can make cuts. Those that find it harder to do so can buy up permits instead.
The main downside of cap-and-trade is that it's considerably more complicated — raising the possibility that companies could game the rules. For instance, some systems allow companies to purchase "offsets" — say, investing in forestry projects to "pay" for pollution. But there's a fair bit of skepticism about these offset programs, depending on how they're structured.
You can read much more detail about cap-and-trade in this excellent piece by Justin Gillis at The New York Times.
Cap-and-trade already exists in the United States
There are already a couple of cap-and-trade programs for carbon-dioxide emissions at the state level:
1) RGGI in the Northeast. Ever since 2005, nine states stretching from Maine to Maryland have been experimenting with their own cap-and-trade program for electric power plants. The cap is fairly modest — and covers only a sliver of US emissions. But it's a demonstration of the basic concept.
The results have been encouraging so far: Carbon-dioxide emissions from the power plants in the nine participating states fell 40 percent between 2005 and 2012.
Now, there are caveats in that: some of that drop may have been due to lower energy demand thanks to the recession — plus the fact that power plants are switching from coal to somewhat cleaner natural gas.
There's also the financial aspect. The nine participating states have raised a fair bit of money from auctioning off pollution permits — more than $1.6 billion since 2009.* States have used much of that money to promote energy-efficiency and clean energy programs. (Plus a few other purposes: New Jersey used $75 million of that money to shore up its budget deficit before withdrawing from the program in 2011.)
In recent years, however, RGGI permits have become plentiful and cheap — because pollution was falling faster than the cap required. On the bright side, that means electricity bills haven't really risen sharply because of the program. On the downside, that means the program gave electric utilities little incentive to curtail their emissions.
So, last year, the RGGI states decided to tighten the cap by reducing the number of permits available. The price to emit a ton of carbon rose from $2.80 to around $4 at the last auction. And the revised plan will now require power plants to cut their emissions 2.5 percent each year between 2015 and 2020.
2) California's cap-and-trade program: In 2013, California launched its own cap-and-trade program, as part of a statewide program to reduce carbon-dioxide emissions 80 percent by 2050.
You can read the gritty details here, but the initial phases of California's cap-and-trade will mainly apply to power plants, large industrial plants, and fuel distributors — about 360 businesses in all. The policy will require those companies to reduce emissions 16 percent between now and 2020.
California's program has a few twists here. First, companies can buy "offsets" if they don't have enough pollution permits. Essentially, they're allowed to invest in clean-energy projects or plant trees elsewhere to "pay" for their emissions. In theory, this could reduce the price of cutting emissions by adding flexibility, but there are lots of criticisms about whether these offset projects would have occurred anyway.
Second, California's program will be linked up with Quebec — meaning that companies in California can buy permits from companies in Quebec and vice versa. This makes the market a bit bigger, which, again, can add flexibility.
3) The acid-rain program. This isn't a climate program, but it's worth mentioning. Lots of power plants in the United States have experience with cap-and-trade in a different context — the acid rain program that Congress enacted in 1990 to reduce sulfur-dioxide emissions in the Northeast.
This was done through emissions trading, and the end result was encouraging: companies cut their emissions 98 percent at a far lower cost than anticipated. But critics often point out that cutting sulfur-dioxide emissions was fairly simple (power plants installed scrubbers or switched to low-sulfur coal). Cutting carbon-dioxide emissions and weaning ourselves off fossil fuels is considerably more difficult.
How Obama's rules could expand cap-and-trade
On Monday, the Environmental Protection Agency will propose a "performance standard" requiring a certain level of emissions cuts from power plants around the country. Each state will then have to come up with a plan to implement those standards.
We still don't know the full details, but it looks like the EPA will set overall emissions limits for each state — and give states plenty of flexibility in how to keep their power plants under that limit.
So, for instance, coal power plants could adopt more efficient technology. Or maybe electric utilities could switch from coal to slightly cleaner natural gas. Or perhaps they could boost their supply of wind or solar or nuclear power. Or promote energy efficiency in homes.
But according to Coral Davenport of The New York Times, states could also come up with plans to link up their power plants to existing cap-and-trade systems. They won't have to do this — they can devise their own plans to reduce carbon emissions. But many may choose to do so if it's the cheaper option.
Indeed, a few electric utility officials told Davenport that cap-and-trade might be a preferable option here: "By trading on carbon credits, we'll be able to achieve significantly more cuts at a lower cost," said the CEO of of FirstEnergy, which has power plants in Ohio, West Virginia, Pennsylvania, Maryland and New Jersey.
What's more, this could make existing state cap-and-trade programs more effective. If more and more power plants are covered by a cap-and-trade system, there are more opportunities for trading and the markets become more efficient. At least that's the theory.
Still, there are a lot of details we still don't know yet — like how the EPA's rules will interact with existing cap-and-trade systems, or how different states might be allowed to work together to reduce their emissions. What's more, it'll take a long time for this to all shake out. The power-plant rule won't be finalized until June 2015 — and states won't submit implementation plans until 2016.
Still, there's a real possibility that cap-and-trade for carbon emissions could grow rather than fade away in the years ahead — long after Congress killed the policy in 2010.
* Correction: My numbers for how much money RGGI has raised through auction were out of date. The correct number is $1.6 billion so far.
Further reading:
- This piece by Justin Gillis is one of the best introductions to carbon trading around.
- Here's a good discussion of the merits of cap-and-trade versus a carbon tax.
- Back in 2013, the World Bank found that carbon pricing schemes were gaining momentum around the world — more than 40 national governments and 20 sub-national governments have either put in place carbon-pricing schemes or are planning one.