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Cap-and-trades schemes represent a promising method of curbing greenhouse gas emissions. The approach, which proved successful in reducing sulfur dioxide emissions (and acid rain) in the U.S. during the 1990s, draws on the power of the marketplace to reduce emissions in a cost-effective manner.

Emissions trading is founded on the notion that markets are an efficient means of allocating finite resources. In the cap-and-trade approach, companies are given emissions allowances. Typically, a single allowance permits the holder to emit one ton of a given pollutant. On the whole, these allowances add up to an amount of pollution that is smaller than status quo levels. The capping and trading approach offers participants a degree of flexibility and can lower the overall costs of achieving emissions reduction targets.

The most memorable and successful such program was a U.S. federal program aiming to reduce acid rain by controlling sulfur dioxide (SO2) emissions. Beginning in 1995, power plants were given tradable allowances. Each allowance permitted the holder to emit one ton of SO2. Companies that wished to emit above the level permitted by their allowance were required to purchase additional allowances from firms that had already managed to reduce their emissions.

These days, the cap and trade approach is increasingly being applied to greenhouse gas emissions. In 2005, the European Union launched the world’s first mandated carbon trading system (ETS).

Here in the U.S., companies that wish to make voluntary commitments to lower their emissions are able to do so by joining the Chicago Climate Exchange (CCX). But let’s take a close look at the European scheme to see what we can learn from both its success and its shortcomings.

ETS: The EU’s Answer

In 2005, the European Union launched the European Emission Trading Scheme (ETS). The program, which concludes its trial phase at the end of this year, was constructed to help member states reach their individual commitments under the Kyoto Protocol. The second phase, running from 2008 through 2012, coincides with the Kyoto emissions reduction targets. While the ETS has been plagued by several early mishaps, the EU’s efforts have yielded some valuable lessons on effectively applying a cap-and-trade approach to carbon emissions.

The concept behind the ETS is relatively simple. (The array of rules and stipulations enshrining the concept, however, is anything but.) Here’s the gist of it:

Under the ETS, each EU country creates a National Allocation Plan (NAP), which grants companies allowances for CO2 emissions—the “cap.” Each allowance permits the holder to emit one ton of CO2. Companies that are able to keep their emissions below the target are able to sell their excess allowances to companies that are unable to do so—the “trade.” Finally, those that emit beyond what their allowance holdings permit are penalized with a stiff 40-euro fine for each ton of carbon.

Now, how does it work? In essence, the European Commission creates scarcity by ensuring that each member state issues a total number of allowances that is below the current level of emissions. By doing so, the ETS works to create a market, from which a per-ton price for carbon is established via supply and demand. Once a price is established, so the logic goes, individual firms are able to weigh relative costs to arrive at an efficient solution. For example: Is it most cost-effective for Company A to invest in solar power? Or should Company A continue with a business as usual plan and purchase additional allowances from Company B? It is ultimately up to the firm’s managers to determine their comparative advantage and either reduce emissions or trade accordingly.

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