Question

California (CA) is often cited as the leader in climate policy within the U.S. and in 2013 the state launched its cap and trade system (hereafter referred to as CTS) which regulates six different types of emissions for industrial and energy sectors within the state. These two sectors account for an estimated 85% of all emission sources within the state. The main appeal that market based policy instruments like a CTS (another example is a pigouvian tax) has is that it theoretically acheives an environmental goal at the least cost to society. In other words, polluters that can reduce pollution the cheapest will do so before those who can only do so at a high cost under a market based policy instrument. For more background on what a general CTS is, click here. To learn more about CA’s CTS, click here or here or here.

Question 1: Proponents of CA’s CTS claim that the system is a success, reaching CA’s annual emissions targets at least cost. What assumptions must hold for this claim to be true? Question 2: Suppose that the CA’s CTS is able to acheive any environmental target at least cost. Why might there still be an optimality issue? In other words, even if CA’s CTS can acheive a cap at least cost, why might this system still fail to acheive the optimal level of greenhouse gases?

Answer 1

Q1. Assumptions for the clain of CA

A cap and trade system is a market based system that allows the companies to buy and sold permit of emissions. The assumptions that must hold for the success of this approach is

i) Total costs of reducing emissions under CTS approach should be less than command and control approach

ii) Efficiency of this transaction would have lower costs if prior approval of government is not required.

iii) cap should less than usual emissions incurred by businesses.

iv) high level of regulations, compliances and rules are required for the success of the CTS approach

v) Provisions for companies to save permits for later use

Q2. Reasons for optimality issues:

Experiences have shown that CTS approach has an immense success in cost savings and emission reduction if a compliance option is allowed. States of USA have achieved a reduction in Co2 emission and other pollutants reduction generated from the power sector. This approach determines a price on emissions either through direct taxes or indirectly through a market of tradable rights of emissions. Marginal abatement costs instead of emission levels are equated across different sources of emissions.

The main issue in achieving optimality through CTS approach is equity concern. It has regressive impact on low income households for increasing energy prices. As the companies are allowed to purchase rights for emission, some fossil-fuel power plants and refineries still continue to operate in spite of high emission of pollutants such as green house gases in the environment. Hence, the target of achieving optimal level of green house gases is hampered.