Current and Proposed Cap-and-Trade Programs in the United States and Europe

Appendix
A

Current and Proposed Cap-and-Trade Programs in the United States and Europe

The concept of distributing tradable pollution rights—what this paper refers to as emission allowances—first appeared in the academic literature in 1968.¹ Trading programs can be attractive alternatives to more traditional approaches that mandate specific pollution limits for all sources. A primary advantage of trading programs is that they can lower the costs of achieving a given environmental goal by giving participants some flexibility about where and how reductions are made.

Trading programs have been used for various purposes in the United States, such as to decrease the amount of lead in gasoline, to reduce discharges into rivers and reservoirs, and to lower emissions of two air pollutants—sulfur dioxide (SO₂) and nitrous oxide (NO_x). The trading programs for SO₂ and NO_x provide the most relevant comparison for a trading program for carbon dioxide (CO₂) emissions. Trading programs to reduce such emissions have been proposed in the United States and are in effect in Europe.

U.S. Programs for Sulfur Dioxide and Nitrous Oxide

The United States has two major emissions cap-and-trade programs that cover multiple states.² The Acid Rain Program is a nationwide program that caps SO₂ emissions from large electric power units. The program took effect in 1995 and was expanded to cover additional units in 2000. It currently covers about 3,000 generating units at more than 700 power plants. The initial free allocation of allowances was based on each unit’s fuel input in the mid-1980s, multiplied by an emissions performance standard. Units were allocated 30 years’ worth of allowances, and those allowances could be banked indefinitely, meaning that an allowance for a ton of emissions in any given year could be used in that year or in any future year.

The Acid Rain Program is run by the Environmental Protection Agency (EPA) and is widely viewed as being very successful, bringing about large reductions in SO₂ emissions for lower-than-expected costs. Banking provisions contributed to the program’s cost-effectiveness, but the free allocation of allowances did not. The method of allocating allowances would have a substantial impact on the distribution of policy costs but, in general, would not affect the overall cost of achieving a cap. (An exception is that free allocations to regulated utilities could increase the cost of achieving a cap by preventing price increases that are essential for triggering cost-effective emission reductions.) Further, giving allowances to firms, as opposed to selling them, could preclude the government from using the proceeds from selling allowances to reduce existing taxes that dampen economic activity.³

The NO_x Budget Trading Program is a multistate trading program that caps nitrous oxide emissions from large industrial boilers and electricity generating units in 19 states, the District of Columbia, and portions of two additional states. That program, which originally encompassed nine northeastern states in the late 1990s, is a partnership between the federal government and state governments. States have responsibility for allocating emission allowances; the EPA implements an emissions and allowance registry, verifies emissions data, runs the trading program, and reconciles emissions and allowances (to determine compliance) at the end of each year. As under the SO₂ trading program, the NO_x allowances are bankable.

In addition to those multistate programs, the South Coast Air Quality Management District, a local air pollution agency in southern California, has operated the Regional Clean Air Incentives Market (RECLAIM) since 1994. That program caps SO₂ and NO_x emissions from various sectors (including the power sector and some industrial sectors). Unlike the Acid Rain and NO_x Budget Trading programs, no banking is allowed under RECLAIM because of concern that banking would lead to unacceptably high emissions in a future year. The lack of banking is thought to have contributed to a severe price spike for NO_x emission rights in California in 2000 (see Chapter 1).

U.S. and European Programs for Greenhouse Gases

No mandatory cap-and-trade programs for greenhouse-gas emissions such as carbon dioxide currently exist in the United States, but state-level efforts to develop them are under way. For example, 10 states—Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, and Vermont—are developing a multistate cap-and-trade program covering greenhouse-gas emissions, the Regional Greenhouse Gas Initiative (RGGI). RGGI will begin capping emissions in 2009 and will initially cover CO₂ emissions from power plants in participating states. In the future, RGGI may be extended to include other sources of CO₂ emissions and other greenhouse gases.⁴

Further, the state of California is actively considering the feasibility of implementing a cap-and-trade program for CO₂ emissions. In September 2006, California enacted legislation that directs the California Air Resources Board (CARB) to establish a comprehensive program that would reduce the state’s greenhouse-gas emissions to 1990 levels by 2020.⁵ The legislation does not specifically require the use of a market-based system, such as a cap-and-trade program, but instructs CARB to consider other proposed or existing trading programs, including RGGI.

The largest cap-and-trade program for CO₂ emissions at present is the European Union’s Emission Trading Scheme (ETS). The initial phase of the ETS—the warm-up phase—went into effect in 2005 and continued through 2007. The second phase, which is in effect from 2008 through 2012, coincides with the initial phase of the Kyoto Protocol. The ETS currently covers carbon dioxide emissions from roughly 12,000 sources across the 27 countries of the European Union. Sources of covered emissions include factories that produce iron and steel, cement, glass and ceramics, pulp and paper, electric power, and petroleum products. Other greenhouse gases and other sectors, such as aviation, may be added in the future. Allowances valued at $23 billion and covering more than 1 billion metric tons of emissions were traded in the EU’s ETS in 2006.

The warm-up phase of the ETS provides several lessons for avoiding potential problems in the future. For example, observers of the program note that member states had insufficient historic emissions data for some participating installations. As a result, some member states based their allocations of allowances on estimates rather than actual emissions. The resulting inaccuracies led to caps that were less stringent than anticipated, and the market price for allowances dropped significantly when that overallocation became apparent.⁶

1

See J.H. Dales, Pollution, Property, and Prices (Toronto: University of Toronto Press, 1968). Also see David W. Montgomery, "Markets in Licenses and Efficient Pollution Control Programs," Journal of Economic Theory, vol. 5 (1972); and Tom H. Tietenberg, Emissions Trading: An Exercise in Reforming Pollution Policy (Washington, D.C.: Resources for the Future, 1985).

2

For a summary of these programs, see Joseph A. Kruger and William A. Pizer, "Greenhouse Gas Trading in Europe: The New Grand Policy Experiment," Environment, vol. 46, no. 8 (October 2004), p. 14. For more detailed descriptions of the multistate trading programs for sulfur dioxide and nitrous oxide, see the "Clean Air Markets" section of the Environmental Protection Agency’s Web site, available at www.epa.gov/airmarkets (with links to "Acid Rain Program" and "NOx Trading Programs"). For a detailed description of those programs as well as the Regional Clean Air Incentives Market program, see A. Denny Ellerman, Paul L. Joskow, and David Harrison Jr., Emissions Trading in the U.S.: Experience, Lessons, and Considerations for Greenhouse Gases (Arlington, Va.: Pew Center on Global Climate Change, May 2003), available at www.pewclimate.org/global-warming-in-depth/all_reports/emissions_trading.

3

For a discussion of the distributional and efficiency aspects of alternatives for allocating allowances, see Congressional Budget Office, Trade-Offs in Allocating Allowances for CO₂ Emissions (April 2007).

4

For more information, see the Regional Greenhouse Gas Initiative’s Web site at www.rggi.org.

5

See Jonathan Ramseur, Climate Change: Action by States to Address Greenhouse Gas Emissions, CRS Report for Congress RL33812 (Congressional Research Service, January 18, 2007).

6

See Kruger and Pizer, "Greenhouse Gas Trading in Europe"; and Senate Committee on Energy and Natural Resources, "Full Committee Roundtable: European Union’s Emissions Trading Scheme" (March 26, 2007), available at http://energy.senate.gov/public/index.cfm?FuseAction=Hearings.Hearing&Hearing_ID=1615. In addition, the United Kingdom initiated a voluntary emissions-trading system in 2002. Thirty-three organizations adopted emission-reduction targets to reduce their emissions against 1998–2000 levels. That trading scheme ended in December 2006. See "UK Emissions Trading Scheme" at www.defra.gov.uk/environment/climatechange/trading/uk/index.htm.