How does cap and trade work?

This post is by Mark MacLeod, director of special projects for the national climate campaign at Environmental Defense.

Cap-and-trade is the structure of most of the global warming bills being considered by Congress.

The “cap” is the cornerstone of the policy. It is an absolute, nationwide limit on global warming pollution. Congress would most likely establish a cap measured as billions of tons of carbon dioxide (or equivalent) released into the atmosphere each year. Over time, the cap would be lowered to cut emissions enough to avoid the worst consequences of global warming. (See our earlier series for more on how much we need to cut.)

The “trade” part is a market that creates powerful incentives for companies to reduce pollution, and provides flexibility in how companies can meet the limits.

Here’s how it works:

  • The government will create “allowances” that add up to the total emissions allowed under the cap.
  • Every year, those subject to the cap must turn in allowances equal to their emissions for that year. These entities include power plants, manufacturers, and others who release large amounts of carbon dioxide. For the nation to meet the cap, entities will have to reduce emissions.
  • If an entity reduces its emissions enough that it has more allowances than it needs, it can profit by selling the extra allowances. This gives them the incentive to reduce below what’s mandated by the cap.
  • If an entity finds it expensive to reduce its emissions, it can buy more allowances from those with extra ones. It can choose the cheapest way to comply with the limits.

The key advantage to a cap-and-trade system is that the more a company reduces its emissions, the more money it can either make or save. Across the whole economy, the most efficient ways to cut pollution will be put into practice most widely. Here’s an example of how cap and trade played out in reducing sulfur pollution, and a detailed report [PDF] on the same example.

One limitation of cap-and-trade is that it should only be used only for certain kinds of pollution. Carbon dioxide travels quickly to the upper atmosphere, so we don’t have to worry about reducing it in specific places close to the ground. This make it a good fit for cap-and-trade. Mercury emissions, in contrast, are frequently deposited near where they are emitted, creating hotspots. It’s also a toxin that threatens people’s health. So mercury is not suited to cap-and-trade.

If you have questions about how cap-and-trade programs work, please post them, and we’ll do our best to answer!

Tomorrow, I’ll build on this post to explain what a “safety valve” is, and why it doesn’t provide any safety.

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  1. me144
    Posted June 4, 2007 at 7:33 pm | Permalink

    I read with great interest your blog on cap and trade. One very important thing bothers me. There is a great temtation to use developing countries as sources of carbon credits,which may distort their ecaonomy to the point of doing them more damage than it does good for the advanced country or for the environment.For example:If a hypothetical country were to focus on growing afuel crop that reduces net carbon dioxide emissions, will this njot distort the agricultural economy of this nation to the point of creatin many negative unintended consequences, including famine. I do not have the expertise to develop this point further, but I think it is worth further injvestigation by someone in your organization.

  2. Posted June 12, 2007 at 4:28 pm | Permalink

    I agree it’s worth investigating, and investigating we are!

    While carbon credits in developing countries can energize the transition to lower-carbon economies, there is a significant risk. The risk, however, is not so much famine as deforestation.

    The increased demand for biofuels could prompt farmers (in both industrialized and developing countries) to clear land for biofuel crops. If farmers growing food crops convert to biofuel crops, other farmers are likely to clear more forest to plant the needed food crops.

    The problem is potentially huge, since forests absorb significant amounts of carbon dioxide.  Already, deforestation – principally in the tropics – accounts for roughly 18 to 20 percent of global greenhouse gas emissions. This amount is comparable to the total fossil fuel emissions of the United States!

    An important first step is to hold biofuel producers accountable for emissions from land use change, but this isn’t enough. What’s urgently needed – in our view, and that of many of our partners in the developing world – is to create real economic incentives for keeping forests standing.

    One innovative approach, called "Compensated Reduction", would use the carbon market to compensate developing countries that reduce national deforestation rates below a historical baseline. Poor people in developing countries would receive direct compensation for protecting forests, instead of only being compensated for cutting forests down.

    The concept is fast attracting worldwide attention. It will be on the agenda at the upcoming climate treaty talks in Bali, Indonesia, and already, some developing countries are hinting they might support it – provided that industrialized countries (including first and foremost the world’s biggest greenhouse gas polluter, the United States) step up to the plate with tough mandatory caps on their own emissions.

    Annie Petsonk
    International Counsel
    Environmental Defense

  3. greenlady
    Posted June 23, 2007 at 7:39 pm | Permalink

    Compensated Reduction–sounds great, but it’s set in the future! Cap and trade sounds great–again, something set for the future. Check out –something that is going on now in Central and South America to help both the people and the tropical forests (one of several such projects) Check out the reforestation project of the –something going on now. (There are other reforestation projects also going on currently.)

    Concerning emissions–well, what can an individual do? Besides buy a bicycle or walk anyplace with a mile or two from their home.(It might even solve the obesity problem from which the US seems to be suffering .) And sign every petition a citizen receives that demands our government set limits on emissions (which they have recently done on automobile manufacturers) and support clean energy research.

    I read recently that China is the biggest buyer of tropical wood, and their indiscriminate wood purchasing practices are leading to poaching from the national forests of Third World countries around the world. The compensation reduction would have to provide greater incentive to the people not to cut their forests than the Chinese are providing to cut their forests. Of course, boycotting wooden items from China might provide the incentive to Chinese manufacturer’s to change their purchasing policies. Just a thought on the subject.

    Love, Peace, and Joy!

  4. Posted January 12, 2010 at 1:31 pm | Permalink

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    i enjoy it !!!

    Good post !!!! very good blog . nice article.i like that.


  5. Posted May 23, 2010 at 8:29 am | Permalink

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