Making cap-and-trade work: the history and future of a proven program

Commentary by: Owen Reynolds
December 09, 2013

While the merits for slowing climate change will be treated here as a given, the method for doing so looms elusive. In a recent article, I described pricing carbon through carbon taxes and carbon credits as a way to mitigate greenhouse gas emissions and slow global climate change. As there has been some emotive controversy towards both of these, I would like to analyze them more deeply, starting here with carbon credits.

There has been much ado about carbon credits and the cap-and-trade systems in which these essentially financial instruments are traded. My initial instincts translated cap-and-trade into "pay-to-pollute," a concept that conflicted with my environmental sensibilities. After researching and studying the economics of cap-and-trade, I started to see it more as a "penalty-to-pollute." That sat better with me.

Cap-and-trade for carbon credits can rein-in global carbon emissions, as well as other greenhouse gases. It also provides the framework for global cooperation and specific tools to save tropical rainforests by valuing the carbon trapped in its biosphere. The precedents have been tested, though the movement has had some stumbles.

First cap-and-trade

Coal plant in the US. The vertical towers are spewing sulfur, which causes acid rain. Photo by: Analogue Kid
Coal plant in the US. The vertical towers are spewing sulfur, which causes acid rain. Photo by: Analogue Kid/Creative Commons 2.5.

The history of cap-and-trade both starts and ends in the United States. The 1990 Title IV Amendment to the Clean Air Act, also known as the Acid Rain Program, was the world's first cap-and-trade system. Sulfur dioxide (SO2) and nitrous oxides (NOX) were identified as the biggest contributors to acid rain in the Northeastern states during the 1980s. Title IV capped SO2 emissions across the country, first in the largest power plants, and later nationwide, eventually incorporating NOX limitations. Allowances were then given to each plant in accordance with generation capacity, historical emissions and priority on the grid, and were then allowed to trade these allowances in a common market.

The cap-and-trade system created huge incentives for companies to cut emissions. Those that cut emissions cheaply sell their excess allowances to companies that cannot—so that the latter pay a penalty-to-pollute. As the cap on emissions is ratcheted down every year and restrictions are tightened, the price for each allowance goes up and the incentive to lower emissions increases. Consequentially, total SO2 emissions have dropped 40 percent since the 1990s and acid rain levels have dropped 65 percent since 1976 in the U.S1. The cap-and-trade system is also a boon for companies in comparison to a "command-and-conquer" method by which the government mandates specific protocols or technologies to be adopted by the industry. Because each power plant is different, cost-effective technology for one may be inappropriate for another. This promotes localized innovation for each company to find the best way to cut emissions. Companies know their machinery best, and with the right incentives, their engineers are the most effective agents of change.

The Acid Rain Program has been largely touted as a success by environmentalists, politicians and economists, as well as the energy industry—both because of its success in lowering emissions and providing lower-than-expected compliance costs for firms. Part of the program's success is also due to full compliance—100 percent of US power plants signed on within five years of Title IV's implementation. This full participation created a sustainable demand for these allowances, and became the crux of the program's comprehensiveness and longevity.

The Kyoto era

Recorded global temperature rise from 1880-2012. Graph courtesy of NASA.
Recorded global temperature rise from 1880-2012. Graph courtesy of NASA.

Inspired by the resounding success of a US cap-and-trade system, international policy-makers quickly set out to implement similar systems in order to tackle the growing global issue of climate change. The Kyoto Protocol was thus designed to usher in a global "low-carbon economy," similar to the Acid Rain Program's mission for a low-SO2 energy sector in the US.

The 1992 UN Conference on the Environment and Development in Rio de Janeiro outlined the UN's new Framework Convention on Climate Change (UNFCCC). The first Convention of the Parties (COP) of the UNFCCC declared emission reduction targets for developed nations, recognizing "that developed countries are principally responsible for the current high levels of GHG emissions in the atmosphere as a result of more than 150 years of industrial activity, and places a heavier burden on developed nations."

The Protocol incorporates more than just CO2 emissions. While carbon is the primary problem due to the sheer volume of emissions, many other gases are potent greenhouse gases—from methane and chloro-fluorocarbons (CFCs) to water vapor. Six families of greenhouse gases are included in the Kyoto Protocol, all of which are more potent than CO2 (water vapor was not included). These gases are measured by their "carbon equivalency," or how many tons of CO2 emissions each ton of said gas represents. These allowances, no matter what their source, are called carbon credits. This tool measures, values and makes interchangeable the greenhouse effects of each of the targeted gases.

The Kyoto Protocol also details a specific tool to benefit developing countries' economies and incent them to lower greenhouse gas emissions—and may one day be leveraged to stop deforestation. The Clean Development Mechanism is designed to help developing countries create carbon credits by lowering their emissions, and selling their surplus credits to developed countries. Because it's often easier for developing countries with lax regulations to lower emissions, this could translate into profit; and as greenhouse gas emissions are global, it likewise benefits the world.

One of the many parts of the Clean Development Mechanisms is an allowance—or carbon credit—from trees. The CO2 in trees can be approximated and valued, just like carbon reductions from power plants. Already, it is valued and credited through reforestation initiatives. A project called REDD (Reducing Emissions, Deforestation and Forest Degradation) intends on expanding that to tropical forestland. By valuing the carbon sequestered in forestland, the Mechanisms can give a new income stream to rural families in developing countries anathema to the drive to deforest, thereby saving forestland from being lost to industries such as cattle, sugar cane or palm oil.

With these and other goals in mind, the 192 UN Parties concluded the Protocol in Kyoto in 1997. The United States signed it in November of 1998. The Clinton Administration, however, signed the Kyoto Protocol without support from the Senate, which must ratify such bills to become law. Despite the Protocol explicitly stating that developed countries are most culpable for global carbon emissions, the US Senate demanded that developing countries also accept binding emissions reductions before the Protocol was ratified. Thus, the US became the only signatory and non-ratifying country to participate in the Kyoto Protocol. Then under the Bush Administration, the nation formally disengaged from the initiative.

The biggest shame is that the Kyoto Protocol's efficacy depended largely on the United States. As with the Acid Rain Program's full participation—and the resultant sustainable demand for emission allowances—the Kyoto cap-and-trade system required full buy-in from the biggest players. As the world's largest economy, the refusal of the US to ratify the agreement was an early death knell for the Protocol's first go-around.

Since its inception, the Kyoto Protocol has been lackluster, and is at best judged a moderate success. At worst—and more frequently—it is declared a complete flop. While there were also a litany of technical problems with its implementation, the lack of legislated demand on the part of the US most hampered the development of an international "penalty-to-pollute" scheme.

A curve-ball

Apparently turning a corner, recent commentary is patting US industry on the back for reaching Kyoto Protocol targets without ever even aiming at them. But when something sounds too good to be true, it often is.

There is, in fact, a downward trend in CO2 emissions, especially by the electric generation industry. However, because of myriad greenhouse gases—including the six that the Kyoto Protocol explicitly details—considering only CO2 emissions does not capture the full story.

The reduction in CO2 emissions since 2007 is largely explained by the recent glut in natural gas. Fracking, the hydraulic fracturing of shale rock to extract gas and oil, has significantly lowered the price of natural gas as an electric energy-producer in comparison to coal. Coal subsequently looks less attractive as a power source. Many power companies are already switching over to gas, leaving new coal reserves untouched.

As coal emits more CO2 than natural gas when burned, total US CO2 emissions are dropping. However, incorporating methane (CH4) emissions reveals a smoke screen in their greenhouse gas accounting. Natural gas is largely composed of methane, just under half-a-percent of which escapes during fracking extraction, and less for traditional gas extraction. While that doesn't seem like much, the US natural gas industry extracted over 29 trillion cubic feet last year2. And because methane is a more potent greenhouse gas than CO2, most reports conclude that fracked gas affects no net decrease in greenhouse gas emissions—despite the lowered CO2 emissions and the "clean burn" branding.

The potential and the reality

Carbon emissions are also causing ocean acidification. Map shows acidification changes in the world's oceans from the 1700s to the 1990s. Photo by: Plumbago.
Carbon emissions are also causing ocean acidification. Map shows acidification changes in the world's oceans from the 1700s to the 1990s. Photo by: Plumbago/Creative Commons 3.0.

While the Kyoto Protocol's cap-and-trade program was thwarted by an original signatory, and some still claim that the US has reached its goals, the current situation for US greenhouse gas emissions is not stellar. What is needed is less confusion about what can work. There was no groundswell movement in the US parallel to that in Europe, largely because of a lack of common rhetoric and understanding of effective strategies.

While a market-based cap-and-trade system initially seems anti-environmental, it may be one of the best ways to slow global warming. Cap-and-trade was already beta tested through the Acid Rain Program—a huge success. It is increasingly viewed as sound economic policy, and 23 states in the US have individually taken it on. California has the most developed cap-and-trade market, soon to trade internationally with the province of Quebec, with a potential to extend to Pacific players. California is part of the Western Climate Initiative, along with six other states; the Regional Greenhouse Gas Initiative includes ten Northeastern states; the Midwestern Regional Greenhouse Gas Reduction Accord includes six states and the province of Ontario.

The US support that the Kyoto Protocol needed for efficacy may come through despite the Federal Government's inability to act initially. If the many stakeholders involved understand the positive effects of a carbon cap-and-trade system, it can still be effective. While there are many serious steps to be taken to mitigate global warming—much less stop it—a functioning international cap-and-trade policy is certainly one of them. It's never too late to act, though never early enough.

Owen Reynolds is an Economist in Washington D.C.

  • Environmental Protection Agency. 2013. "Reducing Acid Rain." Retrieved from: http://www.epa.gov/acidrain/reducing/index.html.
  • Energy Information Administration. 2013. "Natural Gas Gross Withdrawals and Production." Retrieved from: http://www.eia.gov/dnav/ng/ng_prod_sum_dcu_NUS_m.htm.

AUTHOR: Jeremy Hance joined Mongabay full-time in 2009. He currently serves as senior writer and editor. He has also authored a book.

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Commentary by: Owen Reynolds (December 09, 2013).

Making cap-and-trade work: the history and future of a proven program.