Addressing Global Climate Change with a Comprehensive U.S. Cap-and-Trade System

Abstract

There is a growing impetus for a domestic U.S. climate policy that can provide meaningful reductions in emissions of CO2 and other greenhouse gases. The paper describes and analyzes an up-stream, economy-wide CO2 cap-and-trade system which implements a gradual trajectory of emissions reductions (with inclusion over time of non-CO2 greenhouse gases), and includes mechanisms to reduce cost uncertainty. Initally, half of the allowances are allocated through auction and half through free distribution, with the share being auctioned gradually increasing to 100 percent over 25 years. The system provides for linkage with emission reduction credit projects in other countries, harmonization over time with effective cap-and-trade systems in other countries and regions, and appropriate linkage with actions taken in other countries, in order to establish a level playing field among domestically produced and imported products.

The impetus for a meaningful U.S. climate policy is growing. Scientific evidence has increased, public concern has been magnified, and many people perceive what they believe to be evidence of climate change happening right now. A large and growing share of the U.S. population now beleives that government action is warranted, and the momentum is building toward the enaction of a domestic climate change policy. Meaningful action to address global climate change will be costly. This is a key "inconvenient truth" that must be recognized when policymakers construct and evaluate proposals, because a policy's specific design will greatly affect its ability to achieve its environmental goals, its costs, and the distribution of those costs.

There is general consensus among economists and policy analysts that a market-based policy instrument targeting CO2 emissions — and potentially some non-CO2 greenhouse gas (GHG) emissions — should be a central element of any domestic climate policy. This is reflected in international assessments of national policy instruments, as well (Intergovernmental Panel on Climate Change 2007c). While there are tradeoffs between two alternative market-based instruments — a cap-and-trade system and a carbon tax — the best and most likely approach for the short to medium term in the United States is a cap-and-trade system.

It is critical to identify the most effective, lowest-cost, and most equitable policy design at the outset, because any policy design once in place can be difficult to change. The environmental integrity of a domestic cap-and-trade system for climate change can be maximized and its costs and risks minimized by: targeting all fossil-fuel-related CO2 emissions through an upstream, economy-wide cap; setting a trajectory of caps over time that begin modestly and gradually become more stringent, establishing a long-run price signal to encourage investment; adopting mechanisms to protect against cost uncertainty; and including linkages with the climate policy actions of other countries. Importantly, by providing the option to mitigate economic impacts through the distribution of emission allowances, this approach can establish consensus for a policy that achieves meaningful emission reductions. It is for these reasons and others that cap-and-trade systems have been used increasingly in the United States to address an array of environmental problems, including the phase out of leaded gasoline in the 1980s, the reduction of sulfur dioxide (SO2) and nitrous oxide (NOX) emissions from power plants beginning in 1995, and the phaseout of CFCs.

A well-designed cap-and-trade system will minimize the costs of achieving any given emissions target. While firms have flexibility regarding precisely how much they emit, because they have to surrender an allowance for each ton of their emissions they will undertake all emission reductions that are less costly than the market price of an allowance. Through trading, this allowance price adjusts until emissions are brought down to the level of the cap. Firms' ability to trade emission allowances creates a market in which allowances migrate toward their highest-valued use, covering those emissions that are the most costly to reduce. Conversely, as a result of trading, the emission reductions undertaken to meet the cap are those that are least costly to achieve.