Policymakers evaluating strategies for reducing greenhouse gas GHG emissions have two general approaches to consider. A cap-and-trade system curbs emissions by limiting the quantity of a pollutant e. A carbon tax curbs emissions by raising the price of fossil fuels based on their carbon content. Each approach has advantages cap disadvantages, and a well-designed system of either type will be more effective than a poorly designed system of the other type. With this approach, a regulatory body e. The total emissions allowed under cap cap are divided into individual permits, each representing the right to emit a certain quantity of the pollutant e. The permits are then allocated to the sources covered by the program. There are a variety of allocation methods, including free distribution to the capped entities, an auction, or some combination of the two. At the end of the compliance period e. Since the total number of permits is limited by the cap, the permits take on financial value and can be traded on the open market. Companies that are able to reduce their emissions at low cost can sell their surplus permits to companies for whom the cost of reducing emissions is high. Each company has the flexibility to choose how to meet its emissions target, but market incentives encourage companies to invest in new technologies or employ conservation measures to lower the cost of reducing emissions. Over time, the emissions cap is tightened to achieve more aggressive pollution-reduction targets, requiring companies to adjust their strategies to comply with the new levels. The most successful cap-and-trade system to date is the Acid Rain Program created under the Clean Air Act Amendments. It set a permanent cap on the total amount of sulfur dioxide SO2 that could be emitted by electric power plants across the country. At full implementation in —after increasingly stringent emissions limits have been imposed—the program is expected to have reduced annual SO2 emissions to one-half the amount emitted in Regulated sources electric power plants are allocated allowances permits based on historic fuel consumption and emissions rates prior to the start of the program. At the end of each year, every source must hold enough allowances to cover its emissions for the year. The allowances needed to match its emissions are deducted from the utility's compliance account and retired from the system. Sources that have excess allowances may sell them or bank them to use or sell in future years. Emissions trading gives each source the flexibility to design its own compliance strategy. Monitoring and stiff penalties promote compliance. Designing an effective cap-and-trade program to reduce GHG emissions is far more complex than was creating a system to reduce emissions of SO2. The Acid Rain Program covered just one sector—electric power plants, the principal source of SO2 emissions. Major sources of CO2 and other GHGs, on the other hand, include electric power plants, transportation, industry, residential and commercial sectors, and agriculture. Deciding which GHGs and emissions sources to include and where in the fossil fuel supply chain the point of regulation will occur are key issues for policymakers. An upstream program is implemented where carbon enters the economy. It requires producers and importers of fossil fuels to submit allowances equal to the carbon emissions released when their fuel is burned. The producers pass along the cost of the allowances to fuel consumers, and the higher prices in turn encourage adoption of fuel- and energy-saving technologies and practices. An upstream program can cover virtually all fossil-fuel-based emissions while keeping administrative costs low because only a relatively small number of firms need to be regulated. A downstream program is implemented where GHGs are emitted. It can apply economy-wide to all GHG emissions sources, which would involve regulation of large stationary sources as well as vehicles, small industrial and commercial sources, and the residential sector—presenting huge administrative challenges. Or the program can apply only to large stationary sources, such as electricity generators and large industrial facilities. Although more manageable administratively, this latter approach would cover only about 50 percent of GHG emissions. This approach combines downstream regulation of large stationary sources of emissions with upstream regulation of fossil fuels used by other sectors e. The design challenge is to ensure that each ton of emissions is counted only once in the system. Upstream fuel suppliers, for example, would be required to hold permits covering the carbon content of their fuels—except for those fuels to be delivered to electricity generators, who would be required to hold permits for their emissions. This would increase the administrative complexity of the program. This option combines downstream regulation of large stationary sources with upgraded efficiency standards for smaller sources, such as vehicles, appliances, and residential and commercial buildings. It builds trade existing efficiency standards programs and would achieve coverage of roughly 80 percent of energy-related CO2 emissions without the problem of the potential double-counting of emissions. On the other hand, efficiency standards do not provide incentives to reduce usage, and it would take time for the more efficient products to penetrate the system. Emissions reductions from sources that are not easily covered by a cap-and-trade program e. Design considerations—Method of Allowance Distribution 7. Allowances are extremely valuable assets, worth tens, perhaps hundreds, of billions of dollars a year, so the way they are distributed has important implications for the equity of the program. Allowances could be given free of charge to the capped entities according to one of several allocation methods—based on their historic emissions "grandfathering"their current level of emissions, or some environmental performance "benchmark. Research indicates, however, that most of the cost of meeting the emissions cap would be passed on to consumers in the form of higher prices, leaving the regulated entities with substantial profits. Alternatively, the government could sell the needed allowances to the regulated entities through an auction. This method would generate sizable revenues that could then be used to achieve other desired goals. A mix of free distribution and auction of allowances could also be used. Over time, the free allocations could be phased out entirely. Design considerations—Flexibility and Cost Controls 9. Some features help limit price volatility by providing firms with flexibility as to when and where to achieve their emissions reductions. Others provisions provide assurance that the cost of compliance will not climb beyond a specified level. This feature adds flexibility by allowing capped entities to save unused allowances for use in future years. Firms would have an incentive to bank allowances when the cost of making larger-than-needed emissions reductions is lower than they expect costs cap be in the future. Banking would boost demand for permits when the price was relatively low because of a mild winter, for examplehelping to maintain incentives for investment in low-carbon technologies. And it would encourage larger emissions reductions in the near term, resulting in earlier progress towards environmental goals. This provision would allow companies to borrow allowances from future years and pay them back perhaps with interest by reducing emissions more sharply in the future. It would provide relief if permit prices spiked unexpectedly and would give firms more time to modify their operations. Multi-year compliance periods would provide similar flexibility. Limiting the amount of borrowing and the length of the payback period could help preserve the integrity of the cap over the long term. Safeguards would be needed to ensure repayment. These are GHG reductions from sources not covered by the cap-and-trade program and that regulated entities can use to meet their and obligations. Firms could cover some of their emissions by purchasing credits created through offset projects, trade as methane capture at a landfill or avoided deforestation. An offset program can significantly reduce compliance costs by providing carbon to lower-cost emissions reduction options. The program could be limited to domestic projects or could include international projects as well. The quantity of offsets could also be limited so as to maintain incentives for investment in new clean-energy technologies. Care must be taken to ensure that only high-quality offset projects are included—lest the environmental goals of the cap-and-trade program be compromised. Emissions reductions must be real, additional beyond what would have occurred anywayverifiable by an independent third party, permanent, and enforceable. This cap provision would establish a "ceiling" on the price of allowances. If the permit price rose to this pre-determined level, the government could sell additional permits at this ceiling price—or firms could be allowed to pay into a fund instead of acquiring additional permits—thus allowing emissions to exceed the cap. By ensuring tax the price of allowances would not exceed a certain level, this feature could reduce firms' incentives to invest in more expensive clean-energy technologies, which might be needed to achieve emissions-reduction goals. And by permitting firms to purchase additional allowances rather than make emissions reductions, it would allow firms to delay action into the future, thereby undermining the environmental effectiveness of the cap. This mechanism would freeze a gradually declining emissions cap if the permit price rose above a predetermined level. It would offer firms some protection from high compliance costs if the development of new technologies lagged behind the pace of the cap's decline. Such a feature, however, could undercut incentives to invest in low-carbon technologies and delay achievement of environmental goals. As typically envisioned, a carbon tax would be imposed on fossil fuel suppliers at a rate that reflects the amount of carbon that will be emitted when the fuel is burned. The tax would be included in the price of the coal, oil and natural gas supplied to wholesale users and ultimately passed on to consumers tax the price of electricity, gasoline and other energy-intensive products. Coal, which generates the greatest amount of carbon per unit of energy BTUwould be taxed at a higher rate per BTU than oil or natural gas. A federal carbon tax would affect all sectors of the economy. Tax proponents suggest that it be levied at the wholesale stage as far "upstream" as practicable—namely at the point at which the fossil fuel passes from the producer e. Electric power generators, for example, would pay the tax on the coal, oil, or natural gas they purchase and then pass the cost on to retail electric utilities "downstream," which in turn would pass it along in the rates trade charge their customers. A carbon tax could be revenue-neutral: The carbon tax can be set to reflect what economists call the social cost of carbon SCC"the present value of additional economic damages now and in the future caused by an additional ton of carbon emissions. The tax rate could also be designed to achieve a given stabilization target. A cap-and-trade system and a carbon tax are both market-based policy instruments that create incentives to reduce carbon emissions. A cap-and-trade system is a quantity-based instrument; it fixes the total quantity of emissions and allows the price of energy and energy-related products to fluctuate according to market forces. A carbon tax is a price-based instrument; it fixes the price of carbon-based energy and allows emissions levels to vary according to economic activity. The strength of the cap-and-trade approach is that it can set firm limits on emissions. The cap is set at a level designed to achieve a desired environmental outcome e. A "flexible cap" approach, on the other hand—one that includes a safety valve feature, for example—would no longer provide certainty that emissions reduction targets will be met. A carbon tax does not guarantee achievement of a particular emissions target. It allows the quantity of emissions to fluctuate as the demand for energy rises or falls. Allowing emissions to vary from year to year system firms the flexibility to abate less and pay more in taxes when abatement costs are unusually high and vice-versa when abatement costs are low. The tax could be designed to rise steadily over time to achieve a certain stabilization target e. The advantage of a carbon tax is that it can fix the price of carbon emissions. It creates a permanent incentive to reduce emissions, and if set at the appropriate level, it encourages investment in alternative fuels and energy-efficient technologies that have high up-front costs. Under a cap-and-trade system, the price of emissions system may vary considerably from year to year. An especially cold winter, for example, or sudden growth in a particular industry could increase the demand for energy and cause a spike in the price of permits. This potential volatility could have a disruptive effect on markets for energy and energy products and could make business planning more difficult. Both major cap-and-trade programs in existence today—the Acid Rain Program and the European Union's Emissions Trading Scheme ETS —have experienced significant volatility in the price of emissions permits. In carbon case of trade Acid Rain Program, SO2 prices tax considerably in the early years of the program and then spiked dramatically indespite a large bank of allowances. During the three-year ETS trial period system, allowance prices that were initially high dropped precipitously in April —after it was discovered that emissions were significantly lower than expected, causing the demand for allowances to plummet. The effectiveness of a cap-and-trade system depends on a variety of design features. Will reductions be deep enough to have a meaningful impact on climate change? Are they set high enough to spur investment in clean energy technologies? Will any portion of these be invested in energy efficiency and low-carbon technologies? Similar issues must be addressed in designing a carbon tax system, such as whether a credible commitment has been made to keep the tax in place, whether exemptions will be granted to certain sectors or industries, and how revenues will be used. Basically, however, the effectiveness of the tax depends in large part on whether the tax rate is set high enough to create real market incentives that lead to developing and adopting climate-friendly technologies. An economy-wide carbon that is scheduled to rise steadily over time sends a consistent and long-term price signal that encourages investment in clean energy technologies and energy efficiency. Both a carbon tax and a cap-and-trade system raise the cost of products like electricity and gasoline. These price increases would disproportionately affect lower-income households inasmuch as they spend a larger percentage of their income on energy products than do higher-income households. The way in which the two regulatory systems handle any revenues they raise would determine the extent to which each is able to reduce this disparity. A carbon tax directly raises substantial revenues. If the revenues were rebated equally to all citizens or used to reduce regressive taxes e. In contrast, wealthier households, which use more energy on average flying, driving, living in big houseswould pay more in carbon taxes than they would receive in rebates or tax savings. Similarly, a cap-and-trade system that auctioned permits to the capped entities would generate sizable revenues that could be rebated to citizens or used to reduce other taxes, thereby offsetting the regressive effects of higher energy prices. Free distribution of the permits, on the other hand, could lead to significant windfall profits for the firms receiving the permits. Research indicates that only a modest portion of the allowance value—less than 15 percent—is needed to compensate for the cost of meeting the cap. The remainder would be passed along in higher prices to consumers "downstream. A cap-and-trade system would require a new administrative structure—a system to allocate emissions permits, markets where firms can buy and sell those permits, and a means of monitoring emissions and trades. Free permit allocation would make it difficult to estimate the economic impact of and cap-and-trade system on consumers and industries. Auctioning permits, on the other hand, would create a carbon carbon price signal and provide greater transparency to the system. A carbon tax could build on the well-developed administrative structure of existing taxes, such as the current excise taxes on coal and petroleum. Numerous legislative proposals addressing global climate change were introduced during the th Congressincluding ten economy-wide cap-and-trade bills. The Lieberman-Warner Climate Security Act S. It sought a 70 percent reduction in GHG emissions from covered sources representing 80 percent of total U. There is every expectation that addressing climate change will be a priority for the th Congress. In the absence of action on climate change at the federal level, a number of states have joined forces to launch regional emissions-trading programs. The Regional Greenhouse Gas Initiative RGGI is a cooperative effort of ten Northeast and Mid-Atlantic states that took effect on January 1, It establishes a "downstream" cap-and-trade program for CO2 emissions from power plants of at least 25 megawatts in size. The initial cap for the ten states was set at approximately levels and, starting inis scheduled to decline 10 percent by Allowances are to be distributed primarily by auction, with proceeds used to promote energy and and clean energy technologies as well as reduce ratepayer impacts. Power plants can use approved domestic offsets to meet up to 3. The Western Climate Initiative WCI is a collaborative effort of seven states and four Canadian provinces now in the process of designing a cap-and-trade program to reduce GHG emissions by 15 percent below levels by Phase one of the program is to cover emissions from electric power plants and large industrial and commercial sources, beginning January 1, The second phase, to begin inwill expand the program to emissions from transportation and residential, commercial and industrial fuel use not otherwise covered. Flexibility mechanisms include three-year compliance periods, allowance banking, and limited use of offsets. The Midwest Greenhouse Gas Reduction Accord MGGRA was established in by six states and one Canadian province. Participants have agreed to set GHG system reduction targets and to develop a multi-sector cap-and-trade program. Valuable as these state efforts are, they risk creating an inefficient patchwork of regulations that would pose additional challenges for business. A comprehensive and effective federal program to reduce GHG emissions would provide important certainty and consistency. Environmental Protection Agency, Acid Rain Program Basic Information. Acid Rain Program Basics. Thus, reductions achieved in the electric power sector could be partially offset by increased emissions from natural gas and heating oil. For a discussion of these issues as well as other hybrid options, see Robert R. Nordhaus and Kyle W. Danish, Designing a Mandatory Greenhouse Gas Reduction Program for the U. Contrary to what one might expect, free distribution of permits does not prevent consumer prices from rising as a result of the cap. Firms that receive the free permits have the option of forgoing production and selling the permits to other producers. If instead they use the allowances to cover the carbon emissions of their product, they will give up the income they could have earned by selling the allowances. They will pass this "opportunity cost" on to their customers just as they would actual expenses. Thus, free distribution could yield windfall profits for firms' owners and shareholders. The resulting revenue would be dedicated exclusively to financing emissions reductions by uncapped sources, such as of non-CO2 greenhouse gases, or to buy back allowances in future years. This is very different from standard proposals for a 'safety valve,' both because the environmental integrity of the program the cap is maintained by using the revenue for specific uses just mentioned, and because the high predetermined price has no effect unless there are drastic price spikes. Cap-and-Trade System to Address Global Climate Change, The Brookings Institution Octoberp BTU—British Thermal Unit—is a basic measure of the heat, or energy, value of fuels. IPCC, Contribution of Working Group II, Summary for Policymakersp In discussions of the social cost of carbon and suggested carbon tax rates, it is important to distinguish between estimates quoted in terms of tons of carbon and those expressed in terms of tons of CO2. One ton of carbon equals 3. Climate Change Science Program Julyp Denny Ellerman and Paul L. Joskow, The European Union's Emissions Trading System in Perspective, Pew Center on Global Climate Change May and, pp See also Gilbert E. Metcalf, A Proposal for a U. An Equitable Tax Reform to Address Global Climate Change, The Brookings Institution Octoberfor a detailed proposal for a revenue- and distributionally-neutral carbon tax. See endnote 8 above. Lessons Learned from Existing Cap and Trade Programs, written testimony for the U. House of Representatives, March 29, Burtraw notes that "the best market design is simple and transparent. This is the best guarantee that a cap-and-trade market is fair and efficient. If, as they say, the devil is in the details, then the more details there are, the more places there are for the devil to hide. In many cases, details that seem compelling to appease one group or to fix one problem only beget other problems, opening the door for unintended consequences. A CO2 tax based on the sales of coal or petroleum would be an additional excise tax and could, presumably, be implemented at a relatively modest incremental cost. While natural gas is not subject to a federal excise tax, many natural gas processors are subject to a corporate tax tax. A chart outlining the provisions of the ten economy-wide cap-and-trade bills introduced in the th Congress is available at http: A description of the two carbon tax bills is available at http: Fill 1 Created with Sketch. By Eleanor Revelle LWVIL and LWVUS Climate Change Task Force Member Policymakers evaluating strategies for reducing greenhouse gas GHG emissions have two general approaches to consider. CAP-AND-TRADE With this approach, a regulatory body e. An example of cap-and-trade The most successful cap-and-trade system to date is the Acid Rain Program created under the Clean Air Act Amendments. Design Considerations—Scope and Point of Regulation Designing an effective cap-and-trade program to reduce GHG emissions is far more complex than was creating a system to reduce emissions of SO2. CARBON TAX As typically envisioned, a carbon tax would be imposed on fossil fuel suppliers at a rate that reflects the amount of carbon that will be emitted when the fuel is burned. Emissions certainty The strength of the cap-and-trade approach is that it can set firm limits on emissions. Price predictability The advantage of a carbon tax is that it can fix the price of carbon emissions. Equity Both a carbon tax and a cap-and-trade system raise the cost of products like electricity and gasoline. 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