A simplified example of how a cap-and-trade policy might work to reduce pollution more
cost-effectively than a command-and-control policy.
Consider a situation in which two facilities, A and B, each emit 50 tons of SO2 per year. Assume
that under a newly enacted standard the regulatory authority requires the facilities to reduce their
total aggregate emissions from 100 tons to 90 tons. Assume further that the cost of reducing
emissions is $10 per ton at Facility A and $20 per ton at Facility B. This cost difference may
result from the relative age or size of the plants, the availability of alternate fuels, the quality of
pollution abatement technologies already installed, or other factors. Under a conventional
command-and-control policy approach, the regulatory agency might require the same level of
emissions reductions at each facility. In the case under consideration, an equal-reduction
approach would require both facility A and facility B to reduce emissions by 5 tons. Given the
per-unit costs of reducing emissions at the two plants, the total cost of achieving the 10-ton
reduction this way would be $150 ($50 for facility A plus $100 for facility B).
Under a cap-and-trade regime, the regulator instead would give each facility 45 permits, with
each permit allowing the emission of 1 ton of SO2. This sets the cap at 90 tons of SO2. The
regulator would also allow the facilities to establish a market for the permits. In this situation,
facility A could choose to reduce its emissions from 50 tons to 40 tons, instead of simply
reducing to the 45 tons for which it has permits. It could then recoup the additional cost of going
below 45 tons—and some of the cost of its initial 5-ton reduction, as well—by selling the 5
emission permits it no longer needs to facility B. Facility B could thereby maintain its emissions
at 50 tons and avoid incurring its higher per-ton reduction cost. As long as the two facilities
negotiated the sale for between $10 and $20 per permit, both facilities would be better off than
they would have been under the conventional command-and-control policy mandating equal
reductions. The distribution of costs of compliance between the two firms would depend on the
negotiated price of the permits. But in any event the total social cost of reducing the aggregate
emissions to 90 tons—that is, the cost that would ripple out through the economy—would be
$100 (facility A’s cost for reducing its emissions by 10 tons) rather than the $150 that would
occur under a conventional, non-market regulatory regime.
As we discussed, this actually worked in the real world under the cap-and-trade program for SO2
enacted in the 1990 Clean Air Act Amendments. About 110 coal-fired power plants in the Ohio
Valley region were required to participate. Analysts estimate that SO2 emissions were reduced at
a substantially lower cost than would have occurred under a conventional command-and-control
approach.