A Meaningful US Cap-and-trade System to Address Climate Change

In (Stavins, 2008), command-and-control standards, such as energy efficiency for appliances or emission performance standards for vehicles and electricity generators, are discussed as a major alternative to a cap-and-trade system. These standards mandate specific actions for firms and consumers to reduce emissions. Standards can either replace or complement a cap-and-trade system. For example, instead of including vehicle emissions under a cap, emission reductions could be achieved through more stringent Corporate Average Fuel Economy (CAFE) standards. 

The costs of standards are often hidden except for those directly affected by them. Standards are considered to offer less flexibility to consumers and firms regarding how emission reductions are achieved and could miss many low-cost emission reduction opportunities. The effectiveness of standards, in comparison to cap-and-trade systems, is uncertain as they cover only part of nationwide emissions leaving many sources unregulated. In contrast, market-based policies such as cap-and-trade system, can cover all fossil fuel-related CO₂ emissions and can essentially ensure that emission targets are met. Firms directly regulated by climate policy usually face two main impacts: (1) direct regulatory costs that cut into their profit margins, and (2) shifts in demand for their products. Due to these price changes, firms not directly regulated by the climate policy could also see shifts in their profits and demand. How much firms pass on climate policy costs to consumers or suppliers depends on market characteristics and consumers’ price responsiveness. The author explains that although policy discussions often centre on the impact of climate policies on firms, it is ultimately households that bear economic impacts in their roles as consumers, investors, and workers. 

The author highlights some limitations of using standards as emission policies: 

• New standards typically target new equipment, limiting opportunities for immediate emission reductions from existing equipment. 

• New standards can encourage delaying the replacement of old equipment, delaying emission reductions. 

• When applied within a cap-and-trade system, standards offer no additional CO₂ benefits if the cap is binding. 

• A standards-based approach requires frequent adjustments to maintain cost-effective emission reductions. In contrast, a cap-and-trade system only needs periodic changes to the emission cap. 

• Compared to market-based policies, standards provide weaker incentives for developing new emission-reduction technologies. 

• By reducing operating costs, standards that enhance the energy efficiency of equipment can incentivise more intensive use than would otherwise occur. 

The paper also compares the weaknesses of credit-based program or emission reduction credits (i.e. Carbon credits). Emission reductions generate credits that others buy to offset obligations. Credit-based programs encourage reductions outside the scope of cap-and-trade, emissions tax, or standards-based policies. However, they face challenges in measuring (or more likely, estimating) the reductions that cannot be observed directly unlike measured emissions themselves. These programs generally face difficulties reporting reductions ensuring reductions wouldn’t have happened without the program (unobservable hypothetical). Despite these issues, credit-based programs can still offer cost savings for specific activities like carbon-saving land management that otherwise would be too costly or infeasible to integrate into a cap-and-trade system. It highlights the importance of making offsets available for both underground and biological carbon sequestration (i.e., capturing and storing carbon dioxide (CO₂) from the atmosphere in natural systems) to provide short-term cost-effectiveness and long-term incentives for technological change. 

The author also addresses the pros and cons of Carbon tax as an emission policy compared to cap-and-trade systems.