As the climate changes globally, we’re confronted with economic scenarios that the textbook writers could only dream of, with billions of individual actors making choices and being affected by a problem that they can only solve through collective action. Governments have tried to find ways to organize these efforts and incentivize individuals to behave for the common good, but many methods are impractical or unappealing.
A concept that’s been around for only a few decades aims to create financial incentives for the world’s biggest polluters to adopt more eco-friendly technologies. In California, this “cap and trade” system was recently extended to 2030 with more ambitious targets. But so far it’s been hard to measure the program’s success, and this market-based approach can have many of the same flaws and failures found in other markets.
A modern cap and trade system is designed to reduce greenhouse gas emissions through a flexible market rather than one-size-fits-all regulation. By putting a price on carbon and creating a market to trade it, the system creates economic incentives for firms to reduce carbon emissions in the way that’s most efficient for a firm.
To illustrate how this works in practice, let’s imagine you run a natural gas power plant and you produce 100 tons of CO2-equivalent in a year (in reality, this figure would be much higher). Knowing that you emit 100 tons, the California Air Resources Board would issue you 100 carbon credits. You’d get most of them for free, but a few would require you to purchase credits on the market, either from the state or from other polluters. The idea is that you would save money by taking steps to reduce your emissions rather than purchasing credits, and then if you use fewer than what you’re given for free, you can sell the rest and make a profit. The total number of credits given by the state decreases every year to encourage emissions reductions.
California’s cap-and-trade system began on Jan. 1, 2013, with large power plants and industrial facilities. It was expanded to fuel distributors in 2015, meaning that cap-and-trade now affects about 85 percent of greenhouse gas emissions in the state. Some major companies in the state, like electric utility Pacific Gas and Electric, which serves nearly two-thirds of California’s geographic area, have said they support the program as the best way to address climate change.
“A lot of businesses, instead of being overburdened, they make money,” USC environmental economist Kate Svyatets said in an interview. “It’s possible to have both a cleaner environment and economic growth, and California shows how to achieve it.”
In the United States, California has the most extensive cap-and-trade system, which affects all companies emitting more than 25,000 tons of CO2 in a year. By 2018, its market will be linked to both the Quebec and Ontario emissions markets (more on this later). There’s also a regional cap and trade system for electric utilities in New England, and there have been others in the past, such as one created in the 1990s to reduce acid rain-causing emissions. But no nationwide emissions trading system exists today in the U.S. The last big effort to create one, the Waxman–Markey bill in 2009, passed in the House but fell through in the Senate after facing opposition from senators from coal-reliant states.
The state’s goal is to reach 1990 levels of greenhouse gas emissions by 2020 despite a projected population increase of nearly 37 percent over 1990. Looking at the state’s climate policies as a whole, it is so far on track to meet that goal and grow the economy at the same time. Critics of cap-and-trade policy say it’s burdensome for businesses and have pointed to high-profile companies like Toyota moving their operations out of California, but Svyatets said it’s hard to pin down the cause.
“For one reason or another, [some companies] do leave and move to Texas or other states which have much less stringent legislation,” she said. “However, we have other companies come in, so the economy overall is still growing and people are employed. Whether cap and trade is to blame, you can’t really say 100 percent.”
The California Air Resources Board said “advanced energy” jobs employed more people in the state than entertainment or aerospace, and the Department of Energy found that more people worked in the solar energy industry nationwide than in coal.
For most economists, cap-and-trade is the “preferred solution” for regulating greenhouse gas emissions, UCLA researcher Ann E. Carlson wrote in the Harvard Journal on Legislation. Other methods of emissions control, like a carbon tax or mitigation rules, require direct government enforcement and are not as efficient as a market system can be.
But every market is prone to fail if not designed properly. Carlson said that split incentives, information barriers, and externalities can all distort the cost of pollution, rendering the cap-and-trade market less effective.
“It’s hard for the government to decide exactly how many carbon credits to allow,” Svyatets said. “The carbon experts say it’s not expensive enough yet. It’s still better than nothing, but it’s not expensive enough for some companies to switch to clean technology.”
When emission credits don’t cost enough, it becomes cheaper for firms to pollute than to invest in methods that would reduce their emissions in the long term. The European Union is an example of this. It started its cap-and-trade system in 2005, but the European Commission allowed too many credits in the market and the cap on emissions was greater than firms’ actual emissions. Prices fell to ineffective levels by 2008, and companies were profiting off the EU’s mistake by selling the extra credits.
Carlson said that when emissions trading systems don’t work, “policymakers may need to enact complementary policies to address those market failures.” California, unlike the European Union, instituted a price floor on its emissions auction. It also has supplemental requirements like the Renewable Portfolio Standard, which requires an increasing portion of electricity sold in the state to come from renewable and emissions-free sources. As of this writing, the price of a California emissions credit on the secondary market is about $13, compared to the roughly $7 price for a ton of emissions in the EU.
One common issue in many markets is a lack of competition or the monopolization of resources, but despite some speculative activities in emissions trading, anti-competitive behavior hasn’t been a problem in large markets like the European Union. German researchers found that those kinds of issues only arise in small trading pools, such as the RECLAIM market for nitrous oxide and sulfur oxide emissions in Southern California.
“Firms within the same industry do not want to sell allowances to buyers with whom they [otherwise] compete,” the researchers wrote. But in large cap-and-trade systems with diverse stakeholders, this has not been a problem.
To make emissions trading systems even more competitive, governments have sought to link their markets with others, allowing credits to be sold across them. More buyers and sellers of emissions means more competition and less room for market abuse.
“If you have a very small market, what if nobody wants to buy your allowances? Just imagine you want to sell a used car or your cell phone or something,” Svyatets said. “If it’s just you and I in this market and nobody else, what if I don’t want your cell phone? What if I don’t want your car? If you involve other people, then it’s much easier to buy and sell.”
Linked emissions systems don’t even have to be geographically close — California’s market is linked to the province of Quebec and soon to Ontario, while the European Union has started the process of linking its system to Australia’s. The thought is that in tackling a global problem, it doesn’t matter where greenhouse gas emission reductions happen as long as they happen somewhere.
But linkages introduce a problem seen in other cases of cross-jurisdictional common markets, like the European Union. When the Greek debt crisis struck that country in 2008, leaders at the European Central Bank found their hands tied when it came to monetary policy to relieve the nation’s ensuing recession. According to UCLA researcher Juliet Howland, linked emissions trading systems could face a similar problem in which one government “may not be able to regulate the price of carbon credits in order to prevent serious damage to [its] economy.”
But California has taken steps to ensure local benefits for its cap-and-trade program. Revenues from the sales of emission credits on auction go toward programs that the state says promote public health, and by law, one-quarter of revenues must benefit “the state’s most disadvantaged and burdened communities.”
Those communities, it turns out, are some of the most affected by climate change. California’s cap-and-trade system aims to reverse course on greenhouse gas emissions to help protect these communities, and all communities, from the harmful results of global climate change. This state does not have the largest, newest, or most elegant emissions trading system, but it is now one of the most successful.