Cap and Trade

Following the Kyoto Protocol, Energy Trading Schemes (ETS) — also called cap and trade — emerged as the primary method to put a price on carbon. The first was in the European Union, launched in 2005. There is now a form of Energy Trading Scheme in nineteen regions or countries, with more being developed.

In cap and trade, a cap of carbon emissions is set by the government on various parts of the economy, such as power plants, manufacturing, and transportation.  The cap is based on previous emissions and declines over time.  Each emitter must have permits sufficient for their emissions. These permits — or “allowances” — are sold at auction by the government.  If a company does not have sufficient permits for their emissions, they can buy permits on the open market from those who have more permits than they need.   Thus the emissions levels are set by the government, and the eventual price is set by the market.  Emissions are monitored and tracked by the Environmental Protection Agency in the U.S. and local equivalents, as well as by industries themselves.

Energy Trading Schemes and what sectors are included are shown in the table.

Click on table to enlarge. ETS Table 3

Some systems allow purchase of permits for future years in separate auctions, and some systems allow for “banking” of permits from year to year.

In some cases, free permits (allowances) are allocated to specific companies or industries.  This allows some companies to avoid paying for some of their emissions, which will skew the free market, giving an unfair advantage to those companies and their shareholders.  These free permits or allocations are meant to decrease over time. Giving too many allowances is one of the reasons ETS in some countries have struggled.

Also, in some cases, “offsets” are allowed.  That is if a business funds a project to sequester carbon, such as planting trees, or a wide range of other methods, the emissions of that business can be “offset” and permits are not required for the amount of carbon emissions offset by sequestering.

European Union – ETS

The EU ETS is a cap and trade system in place since 2005.  It is by far the largest system for trading GHG emission credits.  Emissions covered include power plants, large industrial plants, and aviation in 31 countries.

In 2020, emissions from sectors covered by the EU ETS will be 21% lower than in 2005. It is currently proposed by the governing Commission that by 2030 emissions would be 43% lower.

The cap limits emissions and is set to decline to meet the emissions goals set out in the previous paragraph.  Within the cap, companies receive or buy emission allowances which they can trade on the open market as needed. They can also buy limited amounts of international credits from emission-saving projects around the world. The limit on the total number of allowances available ensures that they have a value.

Allowances not used can be banked for future years.  Some free allowances are given.  These were excessive in the early years of the EU ETS and have been significantly reduced in Phase 3, currently underway.

Phase 3 Changes

Phase 3 running from 2013 to 2020 is significantly different from Phases 1 and 2.  It builds on learnings from the earlier attempts and is meant to strengthen the system.  As quoted from the EU-ETS site, Phase 3 has the following attributes:

  • “A single, EU-wide cap on emissions applies in place of the previous system of national caps;
  • Auctioning, not free allocation, is now the default method for allocating allowances. In 2013 more than 40% of allowances will be auctioned, and this share will rise progressively each year;
  • “For those allowances still given away for free, harmonised allocation rules apply which are based on ambitious EU-wide benchmarks of emissions performance;
  • “Some more sectors and gases are included;
  • “300 million allowances set aside in the New Entrants Reserve to fund the deployment of innovative renewable energy technologies as well as carbon capture and storage through the NER 300 programme.”

California Cap and Trade

California’s cap and trade is part of a series of legislation steps to reduce greenhouse gas (GHG) emissions and combat climate change dating back to 2002.

In 2011, Cap-and-Trade was established to set a declining cap on allowed GHG emissions.  The cap-and-trade plan is a central part of of the Global Warming Solutions Act (AB 32) of 2006.  Under cap-and-trade, the largest carbon emitters, including refineries, power plants, industrial facilities, and transportation fuels, are required to meet the caps or buy credits.

The program is being phased in.  From 2012 through 2014, major electricity generators, industrial facilities and suppliers of carbon dioxide for industry were regulated.  From 2015 through 2017, fuel suppliers and distributors, including suppliers of natural gas, transportation fuels and liquefied petroleum gas, will be regulated.

Each year, CARB determines the total cap on GHG emissions from all covered sources.  That number is then divided into “allowances”. The cap, and corresponding allowances, is reduced each year sufficient to reach a 15% reduction of GHGs by 2020.

Since California announced a cap on carbon in 2006, according to the Environmental Defense Fund, more than $12 billion in clean energy venture capital has come into the state, a figure higher than all other states combined.

RGGI Example

The Regional Greenhouse Gas Initiative (RGGI) is a cooperative effort among the states of Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New York, Rhode Island, and Vermont to cap and reduce CO2 emissions from the power sector.  The 2014 RGGI cap is 91 million short tons, which then declines 2.5 percent each year from 2015 to 2020.  According to the Environmental Defense Fund, the RGGI has reduced greenhouse gases from the power sector by 40% since 2005.

Each participating state develops its own plan for investing revenues, but overall proceeds are allocated as follows:

  •  52 percent to improve energy efficiency
  • 11 percent to accelerate deployment of renewable energy technologies
  • 14 percent to provide energy bill payment assistance, including assistance to low-income ratepayers
  • 1 percent for a wide variety of greenhouse gas reduction programs, including programs to promote the development of carbon emission abatement technologies, efforts to reduce vehicle miles traveled, and programs to increase carbon sequestration.