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How does cap and trade work?

2010 April 13

When I was an undergraduate at Johns Hopkins, I took a course on management ethics.  As part of this course we had to do research on cap and trade and decide if we were for or against it.  At the time, I thought that cap and trade was something that could work, in theory, but I was skeptical whether it could deliver results.  Now, after working with EPA on the Acid Rain Program for several years I’ve seen for myself that cap and trade is a successful tool for achieving environmental results.

We hear the phrase “cap and trade” a lot these days, but what exactly is it and how does it work?  Cap and trade is a market-based approach to controlling large amounts of emissions from a group of sources.  The regulating authority, such as the EPA, sets a limit or a “cap” on the total amount of emissions for a group of sources for a specific amount of time.  The EPA then divides this cap and gives each source a specific amount of allowances.  Each allowance gives the source the authority to emit a set amount of pollution.  When added together, the allowances held by each source equals the cap. Each source must measure how much pollution it emits and report the amount to the EPA.  At the end of the year, each source must give back to the EPA enough allowances to cover the amount of pollution the source emits.  If a source doesn’t have enough allowances at the end of the year, it can buy allowances from other sources that had more than they needed. If a source has more emissions than allowances, there is a heavy automatic penalty. It’s the cap that causes sources to reduce emissions, and the emissions reductions improve the environment and human health.

I’m sure this is confusing, so I’ll use EPA’s Acid Rain Program as an example.   Each power plant that is regulated by the Acid Rain Program is given allowances every year to emit a set amount of sulfur dioxide.  Every three months, the power plant has to report to the EPA the amount of sulfur dioxide emissions it put out into the environment.  Power plants must make sure that they have enough allowances in their account before the end of the year to cover the amount of emissions they put into the environment.  If they don’t have enough they can buy allowances from another power plant.  At the end of the year, if the power plant does not have enough allowances, they automatically pay a fine and forfeit some of next year’s allowances.  Some power plants reduce their emissions below their allocated allowances, so they have extra allowances at the end of the year.  In this case, they can sell these allowances, or they can save them and use them in the future.

The fact that allowances can be bought and sold gives the power plants incentive to reduce their emissions sooner.  The power plants that can make emission reductions cheaply, which often tend to be the highest emitting plants, make emission reductions and then sell the extra allowances, often to small emitters. Importantly, it’s the control of the amount of available allowances that lowers pollution. So, cap and trade ends up getting more environmental benefits sooner, and cheaper, than some other ways of regulating emissions.

In order for cap and trade programs to work, all of the emissions data that are collected from the sources must be “transparent.”  This means that all of the data must be available to the public so anyone can see if a source has reduced its emissions.  Because all the data is public and there are stiff, automatic penalties, compliance with the program is always 99-100%.  The data that the EPA has collected in our Acid Rain Program are available in the Data and Maps area of our website.  Or, you can take a look at our Quarterly Tracking page to see if power plants near where you live have reduced their emissions, how quickly they reduced, and by how much.

When I was studying cap and trade while I was in college, it was still new and unproven.  Now that I’ve worked with EPA’s Acid Rain Program, I’ve seen that cap and trade works, and it works well.  Under the Acid Rain Program, power plants are reducing their emissions in a way that is best for them, and at the same time we are all benefiting from those emissions reductions.

Cap and trade can be a very confusing topic and we hope that we’ve explained it well.  If you’re still not sure how cap and trade programs work, or if you have any questions, please let us know.

Cindy Walke has a Master’s Degree in Environmental Science and Policy from the Johns Hopkins University.  It’s this degree that inspired her to seek employment with EPA’s Clean Air Markets Division, where she currently manages website communications.

Editor's Note: The opinions expressed here are those of the author. They do not reflect EPA policy, endorsement, or action, and EPA does not verify the accuracy or science of the contents of the blog.

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2 Responses leave one →
  1. Francine permalink
    April 13, 2010

    A more compelling title would be “Does cap and trade work?”

  2. S. Kafka permalink
    April 14, 2010

    The article is about HOW cap and trade works, not IF it works, so I think the title is accurate.
    This is a very clear explanation of something we hear about all the time. Thank you, EPA!

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