The accumulation of greenhouse gases in the atmosphere--particularly carbon dioxide released as a result of deforestation and the use of fossil fuels--could create costly changes in regional climates throughout the world. Concern about the damage from such changes has led policymakers and analysts to consider policies designed to reduce emissions of those gases.
Many proposals have focused on cap-and-trade programs, which would limit the number of tons of greenhouse gases emitted into the atmosphere over several decades from certain sectors of the U.S. economy. Under such a program, lawmakers would set gradually tightening annual caps on greenhouse gas emissions that together would imply a cumulative limit over the duration of the policy. Rights to emit the gases, referred to as allowances, would then be distributed to businesses or other entities, such as state governments, in amounts that corresponded to those limits. (One allowance would permit one ton of emissions.) The government could distribute the allowances by either selling them, possibly in an auction, or giving them away. Once the allowances were distributed, they could be bought and sold in the secondary market for them that would develop.
Firms subject to the caps--for example, firms that emitted large quantities of greenhouse gases or that produced or imported fossil fuels that released emissions when burned--would be required to submit allowances to the agency charged with implementing the program. Under most proposed programs, firms could shift their use of allowances from one year to another by “banking” unused allowances for the future or, to a more limited degree, by “borrowing” allowances from future allocations. That trading and flexibility in timing would allow firms to undertake emissions reductions where, how, and to some extent when it was least costly for them to do so.
In choosing the level of the annual caps on emissions, policymakers would be making decisions complicated by uncertainty about the damage that might result from greenhouse gas emissions, and thus the benefits to be gained from reducing them, and about the costs of such reductions. Those costs would increase what firms spent in producing goods and services and would be borne by households in the form of higher prices. In establishing a program’s annual limits on emissions, policymakers ideally would have reliable information about the allowance prices that would be associated with the various caps they might consider. Those prices would reflect the cost of the most expensive reduction in emissions made to comply with the program at a given point in time. But projections of allowance prices are inherently uncertain. Once a cap-and-trade program was in place, actual prices would vary on the basis of current conditions, such as the weather and the economy, and firms’ expectations about factors affecting their compliance costs over the duration of the policy.
In fact, prices in the allowance market would be continually changing and could reach levels that were much higher or lower than policymakers had anticipated. Changes in prices that were caused by new information could help ensure that the caps on emissions were met at the least possible cost. Higher allowance prices, for example, would encourage firms to invest more in emissions-reducing equipment in the near term as a way to curtail their longer-term costs for meeting the caps. However, unexpectedly high (or low) allowance prices would make the cost of meeting the caps much higher (or lower) than policymakers had expected, which could alter the trade-off between costs and benefits that policymakers had anticipated when they selected the caps.
Concerns about unexpectedly high or low allowance prices have led to proposals to place upper or lower limits on those prices. The Congressional Budget Office (CBO) has examined the possible effects of several features that would change the number of allowances available to firms at various prices and in so doing help limit the range of allowance prices.
CBO examined the effects on allowance prices and greenhouse gas emissions of three mechanisms that would help prevent allowance prices from reaching unexpected highs and lows: a price ceiling, which would be implemented by offering an unlimited number of allowances for sale at a given price, thereby placing an upper bound on allowance prices; an allowance reserve, in which a limited number of additional allowances would be offered to firms at or above a given price, thereby curtailing but not eliminating price increases beyond that level; and a price floor, which would be implemented by decreasing the number of allowances available at a given time to maintain a lower bound on prices.
An upper bound on allowance prices could prevent the policy’s costs to the economy from being unacceptably high, but it could also cause emissions to exceed the cumulative cap because the bound would be sustained by adding allowances to the program. The effects of a lower bound would depend on whether firms could bank allowances. If banking was not permitted, a lower bound could motivate firms to make additional cuts in emissions over the duration of the policy beyond those that would otherwise be required by the cap. If banking was permitted, firms would probably not make such additional cuts.
Policymakers could set an upper limit, or ceiling, on allowance prices by allowing firms to buy an unlimited number of allowances, in addition to those created under the cap, at a specified “ceiling price.” Such a policy would have the following consequences:
Alternatively, policymakers could offer to sell firms a limited number of “reserve” allowances at or above a given price, referred to here as an “access price.” Such a reserve would have the following effects:
Another approach, a price floor, would set a lower limit on the price of all traded allowances. With a “hard” price floor, the simplest form of such an approach, the government would be required to purchase an unlimited number of allowances at a predetermined price. Broadly speaking, including a price floor in a cap-and-trade program would tend to boost allowance prices in the near term but would probably not result in fewer emissions over the duration of the policy if firms were permitted to bank allowances. CBO’s analysis also indicates the following:
Actual experience in managing allowance prices through the approaches that CBO examined is quite limited, which could make it harder to anticipate the effects of such features if they were included in a cap-and-trade program for greenhouse gas emissions. For example, a hard price floor might turn out to be very costly to implement. Also, some analysts are concerned that a price ceiling or an allowance reserve could result in allowances being added to the program under circumstances--including firms’ attempts to manipulate allowance prices through those features--that in the end might not be justified by actual compliance costs. A further consideration is that the mere presence of a price ceiling or a price floor might cause allowance prices to gravitate toward those levels. Moreover, allowing firms to buy an unlimited number of allowances at a ceiling price could complicate possible efforts to tighten the annual caps in the future: Firms could bank allowances during the time that the price ceiling was in effect and then use those allowances to exceed the tighter caps established for future periods.