Understanding Cap-and-Trade

Special Publications | Energy and Natural Resources | Global Warming

Thursday, June 24, 2010
by H. Sterling Burnett

There are a number of ways to reduce carbon dioxide (CO2) emissions, if that is a worthwhile goal.  Among the two most often discussed are a direct tax on carbon and "cap-and-trade."  While economists generally agree that the most direct, efficient and transparent way to reduce emissions is to tax carbon production directly, the bills before Congress and ideas being promoted by the Obama administration pursue emission reductions through a cap-and-trade mechanism.

How Cap-and-Trade Works.  Under a cap-and-trade system, the government would place a cap (or limit) on total emissions.  The government would then either auction or give away allowances that permit affected industries to emit a certain amount of carbon dioxide.  Companies could buy and sell these allowances, trading among themselves or with others.

Cap and Trade Producers that can reduce emissions below their allotted limit (by, for example, improving their energy efficiency or by using alternative energy) would be able to sell their excess emission credits.  Companies that were either unable to cut emissions enough or who found purchasing credits cheaper than making cuts could purchase emission allowances in the market.  Some companies would find it cheaper to close up shop and open new factories overseas in countries that do not mandate emission reductions.

Likely Results of Cap-and-Trade.  Because the goal of cap-and-trade is to limit the use of carbon-based fuels, energy prices would have to rise.  The more stringent the emissions cap, the more valuable the allowances will be and the higher energy prices will rise.  As fossil fuels become more expensive, alternative energy (such as nuclear power) will become more cost competitive and experience increased demand and use.

For consumers, the effects of a cap-and-trade policy would be similar to that of a carbon tax.  The cost of these credits will be passed on in the form of higher prices.  Consumers' response will be to reduce consumption of products that require high CO2 emissions in their production and switch to alternative energy-based products.