Cap and Trade

The Administration has stated that it is looking favorably at the concept of “cap and trade” as a way of controlling the generation of carbon dioxide from power plants, and concurrently encouraging power generation from renewable and sustainable sources that do not generate these gases. So it is reasonable to ask what exactly “cap and trade” is, and what else we might know about it.

I started by going to the MIT study (pdf) on the subject that was published in 2007. Looking for a simple definition of the term I found:

The term “cap-and-trade” is used to describe a policy that identifies greenhouse-gas-emitting entities covered by the system, sets caps on their emissions and allows trading in the resulting emissions allowances. The “entities” are the points of responsibility for emissions and they may be defined at various levels in the economic system from the coal mine and refinery gate (upstream) to the firm or gasoline station (downstream). At these points the emissions accounting is carried out. Emissions allowances (actually entries in an electronic bookkeeping system) are distributed such that the total is equal to the national cap, and covered entities must surrender allowances equal to their emissions, or the emissions that result when the fuel they supply is burned. Market trading in these allowances establishes a price on emissions that in turn creates economic incentives for cost-effective abatement.1 It is common practice to distribute allowances to the entities that are the point of regulation, but this procedure is not a requirement of the system. Allowances could be distributed without charge to any persons, firms or other organizations in the economy, or they could be auctioned.

In other words the mine/power plant/car owner is first assessed to determine how much carbon (which is short for carbon dioxide) that source will emit. After individual entities have been assessed there is a national summation of the volumes that are emitted. Knowing that, and the individual sources, a source is given a maximum capacity (cap) or allowance that it can produce in a year. As it produces the carbon, the allowance must be given up. Once the allowance is used up then, presumably, the source must be shut down until the start of the new year. If the owner of the source wants to continue using it (you still need to get to work, for example) then he/she must purchase an unused allowance from someone else who wants to sell it. The initial assumption is that the seller will do this at a price that is established in the free market. This is the “trade” part of the term. Initial prices set in the abstract to the MIT report suggest a value of $30 to $50 a ton of CO2 as the price for this allowance.

DOE and NASA have combined to create the North American Carbon Program, and there is a map available that shows the relative levels of CO2 around the nation. It is rumored that there will be a ruling, fairly soon, from the EPA finding that CO2 is a danger to the public. This ruling will likely drive standards for allowable emissions of the gas, particularly from automobiles.

"EPA's going to look at Mass. Vs. EPA and will make an endangerment finding," Browner told Dow Jones Newswires in an interview. The Supreme Court ordered the EPA in the Mass. Vs. EPA case to determine if carbon dioxide endangered public health or welfare.

The ruling will bring with it the need for rules for sources that generate CO2, and the current date for these announcements has been suggested as April 2, the anniversary of the Mass judgement. Congress is hoping to have legislation approved by Memorial Day.

There is a web site that allows you to calculate, based on your car, and how many miles you drive, how much carbon you produce. I input the information on the Camry (15,421 miles since I bought it last January, using 455 gal of gas) and I get a carbon production of 8,893 lbs – or roughly 4.5 tons. If we assume a price per ton of $45, then the cost, if I were to buy the allocation would be $200. The car I replaced was a Buick Regal, and for the same amount of driving I would have generated 13,339 lbs of carbon (682 gal of gas). The price of the carbon would be $300. (Incidentally it also allows you to calculate the carbon cost of an airline ticket – so my flight to Washington is going to cost 645 lb of carbon). The Web site I was doing the calculation on is one that allows trading in carbon offsets. These are defined as

A carbon offset is a certificate representing the reduction of one metric ton (2,205 lbs) of carbon dioxide emissions, the principal cause of global warming. Although complex in practice, carbon offsets are fairly simple in theory. If you develop a project that reduces carbon dioxide emissions, every ton of emissions reduced results in the creation of one carbon offset. Project developers can then sell these offsets to finance their projects.

There are hundreds of different types of carbon reduction projects. For example, a wind farm generates clean energy, which reduces carbon emissions from coal-burning power plants. In order to finance its operations, a wind farm can sell these reductions in the form of carbon offsets.

In the above example with the trading of my car I generated around 2 tons of carbon that I no longer used. In theory I could sell that offset to someone who needed the credit.

(In practice it is unlikely to work that way, or at that level, but it illustrates, perhaps, the point, which would apply if I did something on a much larger scale). Using a car as an example is not bad, from the point of view that about a quarter of emissions come from them in the United States, but it is difficult, short of just putting a simple tax on gasoline or diesel, to monitor how much driving an individual does, and thereby to impose penalties for driving too much.

The initial approach will therefore begin with businesses that generate significant amounts of energy, or conversely, generate power without creating carbon, and which thus would have allocations to sell. It almost has to be a national program since, as the LA Times pointed out

All existing cap-and-trade programs have one thing in common: They regulate the source of the emissions. The power plant or refinery or factory churning out the carbon is responsible for controlling its own emissions and trading credits. That won’t work in California, because from 22% to 32% of our power is generated out of state, and California can’t regulate plants outside its borders. Moreover, those out-of-state plants tend to be much dirtier than local ones. So how does a statewide cap-and-trade program account for all that pollution?

Europe provides an example of a situation where cap and trade is already in existence. It has some current problems :

The price of a ton of carbon dioxide in the current phase of the trading system has fallen to record lows recently. And although there are few suggestions the price could collapse entirely, the recent drop still is a worrying reminder that a market-based system to reduce emissions can be subject to significant volatility.

The question of price, and who gets the “profit” is obviously one that governments must decide. It has been suggested that the White House hopes that the sale of credits might raise as much as $80 billion a year, starting in 2012.

In Europe last summer a carbon credit cost $40 a ton (31 EUR) it now costs $10 (8.2 EUR). This has a negative impact on the drive for change, as Julian Glover notes:

A year ago European governments allocated a limited number of carbon emission permits to their big polluters. Businesses that reduce pollution are allowed to sell spare permits to ones that need more. As demand outstrips this capped supply, and the price of permits rises, an incentive grows to invest in green energy. Why buy costly permits to keep a coal plant running when you can put the cash into clean power instead?

All this only works as the carbon price lifts. As with 1924 Château Lafite or Damian Hirst's diamond skulls, scarcity and speculation create the value. If permits are cheap, and everyone has lots, the green incentive crashes into reverse. As recession slashes output, companies pile up permits they don't need and sell them on. The price falls, and anyone who wants to pollute can afford to do so. The result is a system that does nothing at all for climate change but a lot for the bottom lines of mega-polluters such as the steelmaker Corus: industrial assistance in camouflage.

"I don't know why industrials would miss this opportunity," said one trader last week. "They are using it to compensate for the tightening of credit and the slowdown, to pay for redundancies."

In Europe he considers that the cost of the credits would need to be in the $40 - $60 range to allow renewables to compete with fossil fuel.

It will be interesting to see how the rules over here develop.