How does cap and trade work?

Dear Control Engineering: I see there is new environmental legislation moving through congress involving a system called “cap and trade.” How is that supposed to work?

Cap and trade environmental regulation schemes are intended to provide polluting industries an opportunity to reduce emissions in a way that makes economic sense rather than simply imposing an arbitrary limit that hits everyone the same way.

Consider this scenario as an example: In your fictitious country you have 100 coal-burning power plants of roughly the same size. Let’s say the group breaks down as follows:

40 burn low-sulfur coal, putting out 1,000 tons SOx each;
20 burn low-sulfur coal and have scrubbers, putting out 750 tons SOx each;
20 burn high-sulfur coal but have scrubbers, putting out 1,000 tons SOx each;
20 burn high-sulfur coal but have no scrubbers, putting out 2,000 tons SOx each.

Collectively, the plants put out 115,000 tons, but your environmentalists determine that the most the atmosphere  can tolerate is 100,000 tons. You could just decree that the amount any one plant puts out needs to be cut to 1,000 tons. However if you do that, the people that run the high polluting plants will claim the law targets them disproportionately, and they will have to make drastic improvements to meet the regulations. Jobs will be lost, consumer’s rates go up, etc.

So the government calls in an economist to help apply the law more evenly. The economist wants to use the price system as a mechanism to cause the companies to meet the overall reduction in total, without caring what any individual plant does.

One implementation approach is for the government to give permits to pollute to all the plants. Each plant gets a permit to release 1,000 tons which equals the total cap. Nothing changes for the plants operating at 1,000 tons. The plants that are below that figure have a surplus that they can trade (sell) to the hogs and create a new revenue stream. The hogs are now faced with a choice: either they have to negotiate with the sellers to buy those surplus permits, or they have to reduce emissions by buying low-sulfur coal or adding scrubbers. The reality could be a mix of both. If they can’t work something out, they simply shut down.

The plants that are operating at 1,000 tons or less can also look at their operations and see if they can reduce that number in order to sell surplus permits. Ultimately, when the system works, the overall industry will find a way to get the total number down to the required level in a way that reflects the most efficient cost. The plants that can reduce output the most easily and cheaply will do so while the others will have to look for a better solution over a longer term. If the government determines that it has to make a greater reduction, it gives away fewer permits.

There are variations on this scheme. Sometimes the government auctions permits to all potential buyers and leaves the market to determine an equilibrium point. Every company has an incentive to reduce emissions to minimize the permit cost. This approach has been in use in Europe for decades in various applications, and it can work when administered properly.

The current legislation will apply to carbon (usually as CO₂) rather than specific pollutants such as SOx, NOx, mercury, or other toxic gasses. Once the government stops giving away permits and companies have to pay for all of them, the system effectively becomes a tax because emitters will have to pay for every unit of carbon or seek ways to reduce the output. The market (with heavy government regulation) will determine the tradeoffs for better or worse. Eventually we’ll all pay.

–Peter Welander, process industries editor
(BS Economics, 1976)