What is 'Cap And Trade'?

Cap and trade, or emissions trading, is a common term for a government regulatory program designed to limit, or cap, the total level of specific chemical by-products resulting from private business activity. Cap and trade's purpose is to create a market price for emissions or pollutants that did not previously exist and address possible negative externalities.

BREAKING DOWN 'Cap And Trade'

Cap and trade is often used as a more palatable alternative to a carbon tax. In either case, the goal is to offset any negative environmental damages that are not represented as costs in the production process. .

How Cap and Trade Works

There are different versions of emissions trading programs worldwide. The program proposed by President Barack Obama and the Environmental Protection Agency in 2009 relies on the government to set a total limit on annual emissions of greenhouse gases. This is the “cap.” The cap is designed to shrink each year.

After the cap has been determined, allowances for portions of the total limit are allocated. Such allocations, or permits, are either handed out to businesses that have relationships with the Federal government or auctioned off to the highest bidder. Companies are taxed if they produce a higher level of total emissions than their permits allow, but they can also sell off any unused allowance to other producers. This is the “trade.”

Market System

The cap-and-trade system is sometimes described as a market system. This is because it ostensibly creates an exchange value for emissions and uses many of the same methodologies as neoclassical economics. For example, produced emissions may represent a market failure in the perfect competition model, leaving room for a government-based solution.

The perfect competition model posits that markets are only efficient when firms internalize all their production costs. If costs are imposed on third parties rather than being borne by the business, it creates a negative externality. This leads to an overproduction of pollutants relative to the theoretical social optimal level.

To help incorporate the external costs for producing emissions or pollution, the cap-and-trade program creates higher production costs. By extension, it is relatively more expensive to produce those emissions compared to other production processes. In theory, this imposes costs on those who create emissions rather than on taxpayers or other third parties.

Challenges

The system is afflicted by many of the problems inherent in the perfect competition model. For example, it is not clear that the government will impose the correct cap on the producers of emissions. Imposing an incorrect cap, either too high or too low, will inevitably lead to over- or under-production of the optimal social amount of pollution or emissions.

Whether emissions are taxed or limited by a shrinking cap, economists and policymakers must apply the appropriate discount rate to apply to the forecasted benefits and costs. In other words, any cap and trade scheme requires a correct estimation of future deadweight loss. This is extremely challenging, if not impossible.

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