Understanding Cap and Trade: Policy, Examples, & Effectiveness

Cap and trade is a policy instrument designed to curb greenhouse gas (GHG) emissions. It involves setting a cap on the total amount of GHGs that can be emitted by regulated entities, such as corporations. Entities with emission levels below their allocated caps are allowed to sell or 'trade' their surplus allowances to those who exceed their limits. The overall goal of this system is not only to control corporate emissions but also to create an economically efficient market for carbon trading. 
 
Thomas Crocker, an economics scholar from the University of Wisconsin in the 1960s, is credited with developing the concept of cap and trade as a solution for environmental pollution. However, it wasn't until 2005 when the European Union implemented its Emissions Trading Scheme (ETS), marking the official debut of a government-backed cap-and-trade system. 
 
The EU's ETS remains one of the largest examples of international cap-and-trade policies today, covering all 27 member countries plus Iceland, Liechtenstein, and Norway. Despite being recognized as its creator, Crocker expressed skepticism about whether his mechanism was indeed the most effective way to regulate carbon. 
 
Under this scheme, firms receive EU emissions allowances (EUAs), each equivalent to one metric ton of CO2 or CO2 equivalent, which they can obtain either through free allocation based on past emissions or via auctioning—now considered standard practice within many schemes globally. To ensure accurate tracking and reporting of emissions data, each firm submits these EUAs at year-end through a registered account. 
 
However impressive these declarations might sound, it’s important that we understand what actual impact has been achieved so far using Cap & Trade systems around the globe. 
 
In terms of results since its inception in 2005 till end-2019, sectors covered under ETS have reduced their combined emissions by approximately 21%, compared with levels back in the year starting point, i.e., year-2005, while the entire region managed to achieve almost double, i.e., around 43% reduction in total emissions. 
 
Apart from the EU, several other countries and regions have also implemented cap-and-trade systems, including New Zealand, Kazakhstan, Tokyo, Korea, the UK, and Canada, among others. According to the World Bank's Carbon Pricing Dashboard, as of now, more than 80 national and subnational initiatives are already in place, covering nearly one-fourth of global GHG emissions. 
 
China, the world’s largest emitter of GHGs, rolled out its own nationwide ETS in 2021 after years-long regional pilots, which led to a significant drop in emission intensity despite low carbon prices. Despite some initial hiccups, like false reporting by power plants, etc., China is pinning high hopes on this tool for achieving its peak emissions target by 2030 and the eventual carbon neutrality goal set for 2060. 
 
In US context, the Regional Greenhouse Gas Initiative (RGGI) has been gaining ground since it was first launched back in 2009 with nine founding member states. A decade later review revealed that under the RGGI framework, CO2 emissions from participating power plants fell by almost half while their combined GDPs increased equivalently; moreover, electricity prices dropped slightly compared with the rest of the country, where they actually rose marginally during the same period! 
 
Despite being an effective tool to reduce greenhouse gas emissions globally, there are critics who argue against the cap-and-trade mechanism, citing various reasons ranging from potential spikes in energy costs due to higher pricing in the in the carbon credits market or possible ineffectiveness if not managed properly at the policy level itself, etc. 
   
Nevertheless, the future outlook towards adopting such programs remains largely positive, primarily because these can be hybridized with other tools like carbon tax, etc., thereby offering much-needed flexibility for policymakers looking to achieve climate change mitigation targets efficiently and cost-effectively over time ahead!