
The Big Picture
"A cap-and-trade system is a market-based mechanism that uses market principles to achieve emissions reduction. A core component of a greenhouse gas cap-and-trade program is that an emitter must turn in one “allowance” for every metric ton of carbon dioxide equivalent (CO2e) that they emit." (Source for this, and all other quoted passages in this section, Western Climate Initiative)
"The government(s) running the cap-and-trade program sets an absolute limit, or cap, on the amount of greenhouse gas emissions. Then, through a method called 'allocation,' each emitter is issued a set number of allowances." The total number of allowances issued represents the total emissions set by the cap. For example, if the cap were set at 1,000 tons of CO2e, then a total of 1,000 allowances would be issued. These allowances are tradeable; that is, emitters can buy and sell them to one another.
To comply with the cap and trade law, an emitter must submit one "allowance" for each metric ton of CO2e they emit. If an emitter's emissions are higher than the number of allowances it holds, the emitter must either buy allowances from another emitter or reduce its own emissions. "In this way, individual emitters do not have a limit on emissions, but the system as a whole has restricted supply of allowances to cover emissions."
The decision an emitter makes to acquire sufficient allowances or to reduce emissions depends largely upon cost. "The price of allowances efficiently informs consumption and investment decisions. For some participants, implementing new, low-emitting technologies may be relatively inexpensive. Those participants will buy fewer allowances or sell surplus allowances to participants that face higher emission control costs. A participant will choose to buy more allowances when the cost of an allowance is lower than the cost of reducing its emissions. By giving participants a financial incentive to control emissions and the flexibility to determine how and when emissions will be reduced, the capped level of emissions is achieved in a manner that minimizes the cost of emissions reductions."
Useful Terminology
(Source for full section: Western Climate Initiative)
Allocation: Process by which emissions allowances are initially distributed. For example, if the cap were set at 100 metric tons, then a total of 100 allowances would be made available to the market (allocated) in some fashion, either through free distribution or by an auction. When allowances are allocated based on on historical emission levels, it is called grandfathering.
Banking: Entities are allowed to hold more allowances than they need to cover their emissions in one compliance period and use these allowances in future compliance periods to cover emissions.
Carbon credits: When reductions are made by an offset project [see below], the sponsor of the project receives credits that can be sold and traded within a cap-and-trade program and function similar to an emissions allowance.
Compliance period: The time frame for which entities must submit sufficient allowances equivalent to their emissions during that period. This submission is called a true-up. Reporting periods may be shorter than compliance periods. For example, the reporting period may be annual, but the compliance period may be three years.
Offsets: Alternative compliance mechanism where emission reductions are made by sources not included in the cap-and-trade program. An offset must result in an emission reduction outside of the cap. These reductions must be additional, meaning over and above those that would otherwise have occurred in the absence of the project. They must also be permanent, the definition of which is subject to the rules that govern specific categories of offset projects.
Details and Programs
Viewing Assignment
Watch this outrageously fast-talking video, Cap and Trade Explained in Under Four Minutes. It's fast and fun, but on the money. It will help you put the pieces together. When the ecogeek uses the term "credit" in the video, he means what is more commonly called "allowances."Reading Assignments
- From the Environmental Protection Agency, read "Cap and Trade: Essentials"
- Read Cap and Trade Curbed Acid Rain: 7 Reasons Why It Can Do The Same For Climate Change (Forbes magazine)
- Visit the Regional Greenhouse Gas Initiative (RGGI). Read "Welcome" page and "Program Design"