Regulating Carbon Emissions: The Cap-and-Trade Program by ProQuest


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Regulating Carbon Emissions:
The Cap-and-Trade Program
By Cletus C. Coughlin and Lesli S. Ott

                                                                                                                                                © Michael Prince /cOrBiS

I  ncreased concentrations of greenhouse
   gases have heightened concern through-
out the world about climate change and
                                                  As long as the firm’s incremental costs stay
                                                  less than or equal to $15, then it will reduce
                                                  its emissions; if not, assuming it is profitable
                                                                                                     Meanwhile, the marginal cost (MC) curve
                                                                                                     is sloped positively to reflect the assumption
                                                                                                     of increasing marginal abatement costs. In
global warming. One manifestation of this         to do so, then the firm will pay the tax or buy    other words, as a firm attempts to abate more
concern in the United States is reflected in      the permit. (Note that part of a firm’s adjust-    and more carbon emissions, incremental costs
a market-based approach termed “cap and           ment to the higher price to pollute might          to the firm of additional abatement increase.
trade” to regulate carbon dioxide emissions;      entail a cut in its production of goods.)
this is contained in the proposed American           Second, incentives are provided so that         figure 1

Clean Energy and Security Act of 2009.1 This      pollution is reduced relatively more by firms      Cap-and-Trade

legislation requires a 17 percent reduction in    with relatively lower costs of doing so. In
emissions of carbon dioxide by 2020 from          other words, if firms must pay $15 per ton         P                                     MC

2005 levels.2 While there are numerous con-       of carbon emissions, then firms that can
troversial provisions in this legislation, this   reduce pollution at relatively lower cost will
article focuses on the economic principles        undertake relatively more abatement than           P*
underlying the cap-and-trade proposal.3           will higher-cost firms.
                                                     Third, market-based approaches provide
Reducing Carbon Emissions Efficiently             incentives for innovative activity that can                                              MB
   Various regulatory approaches exist for        lower the cost of reducing pollution. Sim-
controlling pollution. A common one is            ply put, firms can increase their profits by       O                   Q*        Q (emissions abated)
“command and control.” One example in the         finding ways to lower the cost of reducing
context of carbon emissions is the Corporate      pollution.                                            Given the curves in Figure 1, the ideal
Average Fuel Efficiency (CAFE) standards,            Under a cap-and-trade program, the              quantity of abatement is indicated by Q*.
which mandate minimum fleet mileage stan-         quantity of carbon emissions is capped. Given      This quantity of abatement will result in a
dards for motor vehicles sold in the United       an upper limit on the quantity of carbon           price of carbon emissions of P* per unit. This
States. Generally speaking, economists tend       emissions, market participants will determine      efficient outcome reflects the fact that emis-
to prefer market-based approaches, such as a      the price of these emissions. The supply and       sions abatement should continue until the
cap-and-trade program, to other regulatory        demand diagram in Figure 1 can be used             point at which the marginal benefits equal
approaches for reducing carbon emissions.         to illustrate the basics of a cap-and-trade        the marginal costs. Additional abatement
   Various economic reasons exist for prefer-     program. The horizontal axis measures the          beyond Q* is inefficient because the marginal
ring market-based approaches. First, all pol-     quantity (Q) of carbon dioxide emissions           costs exceed the marginal benefits.
luters face the same marginal cost of reducing    abated, while the vertical axis measures              In the preceding example, the marginal
pollution, which is a necessary condition for     the value (benefits or costs) per unit (P) of      benefit and cost curves were assumed to be
reducing pollution in the most cost-effective     carbon abated. Note that by cappi
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