How Does A Cap And Trade System Work?

how-does-a-cap and-trade-system-work

image: Danilo Rizzuti /

The Cap and Trade system (C&T) is a market-based climate policy, which fixes the quantity of carbon emissions (the cap) allowed for certain regulated entities, and lets the price of carbon allowances work out itself. After the cap is fixed, carbon allowances are distributed to regulated industries through either free allocation or auction. The EU ETS is a good example of free allocation, which generates huge wind-fall profits for regulated industries.

How does a cap and trade system work?

The price of carbon allowances can change dramatically in response to different market conditions and policies. For instance, when banking and borrowing of allowances between policy stages are allowed, industries would be likely to accumulate allowances today with the expectation that marginal abatement costs will be increasing in the future. With higher demand, the allowance price is likely to increase, and the vice versa.

Another example is the potential market flooding of carbon credits from the REDD program. Abatement cost from reduction in deforestation and forest degradation is often much lower than low-carbon clean technology. If the post-Kyoto system allows the trading of REDD carbon credits in a global carbon market, then there is a potential decrease in carbon price. The great variation of carbon prices under the C&T scheme is one of the mostly criticized weaknesses of C&T approach.

Allowance reserve, which is a special type of safety valve, allows government to sell additional allowances once allowance price reaches the ceiling, and to buy back extra allowances once price reaches the floor. Usually, only a certain percentage of the total allowances is available at the safety valve, and this is called the “reserve”.

Adopting this approach, government will be able to contain allowance price between the price ceiling and floor in most cases. An unlimited sell of additional allowances at the ceiling price will then be impossible, which is often criticized of leading to the failure of the whole C&T program due to enlarging of the cap.

About the Author Shan Zhou

Shan Zhou is a PhD candidate at the School of Public Policy, Georgia Institute of Technology (USA). Her research interests include diffusion of smart grid technologies, contingent valuation method, ecosystem service payment, and REDD program. Prior to Georgia Tech, she received her Master’s degree from the European Erasmus Program -Environmental Sciences, Policy, and Management (MESPOM), jointly operated by Lund University (Sweden), Central European University (Hungary), University of the Aegean (Greece), and University of Manchester (UK).

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