Cap and Trade in a Nutshell

Throughout this blog, I talk about Kyoto and the EU ETS and cap and trade, and I realize I haven't quite explained what I mean by those terms. Here's the theory of how these regulations work in a nutshell.

The solution to fighting global warming that seems to drawing the most support is by instituting a regulatory scheme called a “cap and trade” system. The goal is to reduce carbon dioxide and other greenhouse gas emissions to slow down climate change. Unlike a traditional regulation that might say “every coal plant can only emit X amount” – this style of regulation uses a market and trading mechanism. Companies are required to get a permit for each ton of carbon dioxide they emit – these permits are usually called carbon allowances. The government rachets down the total number of allowances that are available for everyone every year – reducing the total carbon emitted (this is the cap). Companies can trade or sell allowances to each other (this is the trade), so that if I’m really good about reducing my carbon emissions and you aren’t so good…I can sell you some of my extras. This is arguably economically efficient. On top of this, most of these schemes also allow companies to get extra carbon allowances (often called offsets), if they invest in projects that reduce carbon dioxide in other parts of the developing world (so you can get credits for building a wind farm in China, or by planting trees in Brazil).

It’s a really complicated system – there are lots of questions about how you divvy up the allowances at the start – do you give them away, or make companies buy them. Or a little of both…and who gets them, and what does the money the government gets from selling them get used for. And there’s a whole “carbon trading” system that is set up to implement it – almost like a mini-Wall Street just trading these emissions rights, and options and derivatives and all sorts of complicated financial stuff. The EU's Emissions Trading Scheme (EU ETS) is by far the largest cap and trade scheme for greenhouse gases. The Kyoto Protocol created an offset system called the Clean Development Mechanism that gives credits for investments that reduce carbon emissions in the developing world. Credits from this mechanism can be used to meet the requirements of the EU ETS. London is the world epicenter of the carbon trading community. I've been learning the nitty gritty of how these systems work.