— Ch. 1 · Market Mechanism Fundamentals —
Emissions trading.
~6 min read · Ch. 1 of 7
A coal power plant in Germany stands as a visual reminder of the stakes involved. Emissions trading transforms this industrial reality into an economic calculation. The system allocates or sells a limited number of permits, known as a cap, to allow discharge of specific pollutants over set time periods. Polluters must hold permits equal to their actual emissions. Those wishing to increase output buy permits from others willing to sell them. This mechanism incorporates economic costs directly into production expenses. Corporations now consider investment returns and capital expenditure decisions through models that include carbon prices. Organizations that do not pollute may also trade these financial derivatives. Participants can bank allowances for future use or donate permits to nonprofits for tax deductions. Environmental groups sometimes purchase and retire permits to drive up remaining permit prices according to demand laws.
Historical Development Phases
Micro-economic computer simulation studies between 1967 and 1970 first demonstrated the efficiency of what later became known as cap-and-trade. Ellison Burton and William Sanjour conducted these studies for the National Air Pollution Control Administration. They used mathematical models of several cities and emission sources to compare control strategies. Each abatement strategy was compared with the least-cost solution produced by a computer optimization program. Results showed the least-cost solution was dramatically less expensive than conventional abatement strategies. The U.S. Environmental Protection Agency introduced computer modeling with least-cost abatement strategies in its 1972 annual report to Congress. This led to the concept of cap and trade as a means of achieving the least-cost solution for a given level of abatement. The development over time divides into four distinct phases: gestation, proof of principle, prototype, and regime formation. The prototype phase launched the first cap-and-trade system under Title IV of the 1990 Clean Air Act. C. Boyden Gray conceived this acid rain related system while working with the Environmental Defense Fund. The new emissions cap on nitrogen oxides and sulfur dioxide gases took effect in 1995. Acid rain emissions dropped three million tons that year according to Smithsonian magazine.