Cap-and-Trade: A Market-Oriented Approach That Works

There is a lot of confusion and misinformation circulating about the cap-and-trade mechanism in the energy and climate legislation being debated before the Congress. By capping and trading carbon emission we can reduce greenhouse gases that cause global warming. While cap-and-trade may seem like a confusing concept, it has actually been around for almost 20 years, effectively reducing sulfur dioxide that causes acid rain and nitrogen oxides that cause smog.

The 1990 Clean Air Act Amendments, signed into law by George H.W. Bush, established the first cap-and-trade program, which now serves as a model for the program being proposed to reduce carbon emissions. Cap-and-trade was proposed by business interests and Republicans as a means of using market forces to reduce pollution more efficiently than the alternative of requiring each polluter to reduce its pollution by a fixed amount.

How does cap-and-trade work? First, we calculate all the pollution that is being emitted and by whom; this becomes the initial "cap." In the 1990s, that pollution was sulfur dioxide and nitrogen oxides; today it is carbon. Under the legislation being considered in Congress only very large emitters would be included.

Next we determine our goal for reducing that pollution. Let's say our goal is to reduce carbon, global warming pollution 20 percent by 2020. That means that the total amount of pollution that may be released, the "cap," would decrease by 2 percent per year between now and 2020.

Here is where the trading comes in. Each year the large companies that emit carbon regulated under the cap have to decide how they will effectively reduce their carbon by 2 percent. Some businesses will find it in their best interest to make an investment that could substantially reduce their carbon pollution emissions by more than 2 percent. Let's say Company A emits 10 million tons of carbon per year. In the first year it would be obligated to reduce its carbon emissions by 200,000 tons or 2 percent. If it is able to reduce its carbon pollution by 5 percent or 500,000 tons, it has 300,000 in surplus carbon "credits."

Now suppose another business, Company B, which also emits 10 million tons of carbon per year determines that it cannot reduce its pollution this year for whatever reasons. It is obligated to reduce its pollution by 200,000 tons as well. Instead of making that reduction, Company B is able to buy the surplus credits that Company A generated. These surplus credits are traded on an open market, just like stocks. This is the "trade" in cap-and-trade, and Company B pays the market rate for these pollution credits.

So cap-and-trade creates a market in which those companies which find it in their best interest to reduce their pollution more quickly than is required are able to sell those credits to other companies that chose not to make those reductions. The forces of the market promote the most efficient means by which companies reduce their pollution, and because the "cap" goes down every year by 2 percent, each year society makes progress on its goal of reducing global warming pollution.

The good news is that cap and trade has been around for almost 20 years and it has worked to significantly reduce acid rain from the sulfur dioxide emitted from coal-burning facilities like power plants. It is also now being used to reduce nitrogen oxides that cause smog. In each case, the market forces have worked and the costs of making these pollution reductions have been substantially less than were predicted. For example, the predicted cost of sulfur dioxide pollution reductions was projected to be $776/ton or more in 1991 but in September 2008 SO2 allowances were selling for $140/ton.

Of course, if you don't believe in global warming, then cap-and-trade may seem unnecessary, but with polls showing 75 percent of Americans believing that climate change is real, and wanting their government to take some action, cap-and-trade is a proven approach to reducing pollution efficiently. Many companies will reduce their carbon pollution by investing in efficiency measures and renewable energy, stimulating our economy and moving us toward a clean energy future.

Glen Besa is the director of the Sierra Club in Virginia. Contact him at (804) 225-9113 x 104 or .