by Bob Shively, Enerdynamics’ President and Lead Instructor

In the mid-1990’s, environmental regulators came up with a new concept to let markets and engineers figure out the best way to reduce pollution at the lowest cost possible.  This was a regulatory mechanism called Cap and Trade.  Cap and Trade will get further use with two new regulatory actions that will take effect in the U.S. in 2012.

Barring last-minute action by Congress or the courts, the Environmental Protection Agency (EPA) will implement the new Cross-State Air Pollution Rule (known as CSAPR), which will significantly increase limitations on sulfur dioxide (SO₂) and nitrous oxide (NO_x) emissions in 27 states in the Eastern and Texas interconnects. Meanwhile, California is set to implement regulation of greenhouse gas emissions. (We touched on these issues in a recent blog post titled “Will New EPA Regulations Impact Gas and Electric Markets Across the U.S.?”)

Both new rules will utilize Cap and Trade.  This method is designed for flexibility in allowing the marketplace to determine the most efficient ways of meeting an emissions cap set by the regulator.

Under Cap and Trade:

• the regulatory agency starts with a historical amount of emissions in a specific geographical area
• the regulator then sets a cap that will be allowed that is lower than the historic emissions
• typically, the cap is further reduced over time to result in lower and lower emissions as the program is implemented over multiple years

Using the mandated cap to determine the amount of allowances, the regulator allocates allowances to emit regulated substances to various market participants who own power plants.  These may be allocated for free, or they may be auctioned.  At the end of a compliance period, power plant owners must submit a number of allowances equal to the amount of emissions they have put into the air during the period.  Failure to do so results in significant fines or other penalties.

Cap and Trade

To facilitate efficient solutions, market participants are permitted to trade allowances.  Thus participants that can cost-effectively reduce emissions can then trade unutilized allowances to other parties who have a higher cost of reducing emissions.  This means that the market should be able to find the least-cost way of reducing emissions to a specific cap.  This methodology has been used since 1995 for SO₂ and more recently for NO_x in certain regions of the U.S.  In general it has proved successful in reducing emissions at low cost.

During discussions about a national greenhouse gas law in the U.S. over the last few years, opponents from the right argued that Cap and Trade amounted to no more than a burdensome tax. Opponents from the left argued that it was too lenient in that it allowed parties to pay to pollute.  As the new regulations implemented in 2012 play out, we will all get a further chance to evaluate the benefits and costs of Cap and Trade regulation.