How a Cap-and-Trade
System Works
Although the design details will vary,
in any cap-and-trade program, the
regulating body sets an emissions cap
that starts on a certain date and speci-fies who is covered. The regulator then
distributes to the regulated entities
allowances equal to the cap, thus ensuring emissions will stay within the cap.
One allowance generally represents the
right to emit 1 ton of emissions. At the
end of a compliance period, if an entity’s
emissions are higher than the number
of allowances owned, the entity must
reduce emissions (e.g., via fuel switching
or energy efficiency) or purchase allowances from the market. If an entity has
fewer emissions than allowances, it can
bank these allowances or sell them into
the market.
In the example shown here, plants
A and B each emits 200 tons of CO and
2
receives 100 allowances (per compliance
period). Therefore, each plant needs to
reduce emissions by at least 100 tons.
The cost of reducing emissions is $5
per ton for Plant A and $15 per ton for
Plant B. The market price is $10 per 1-ton
allowance. Plant A can reduce 200 tons
of emissions for $1,000, then sell 100
allowances onto the market, for a net
cost of zero. If plant A chooses to reduce
emissions by only 100 tons, the cost is
$500. Plant B can spend $1,500 to reduce
100 tons of emissions at the plant level,
or keep emitting 200 tons and purchase
100 allowances to cover all of its emis-
sions for a cost of $1,000 (saving $500).
Allowing the plants to trade thus can
save $1,000 in overall costs.
To ensure the market operates effectively, the regulating entity must track
allowances, monitor market activity and
enforce compliance.
Company needs to decide if it is more cost-effective
to reduce emissions or purchase emissions.
PLANT A
• Emitting 200 tons of CO , given 100
2
allowances
• Cost of reducing = $5/ton
• Cost of reducing 200 tons = $1,000
• Sells 100 tons of allowances to Plant B
for $1,000
• Net cost = $0 (vs. $500 to reduce
100 tons)
Sells 100 allowances,
market price $10/ton
PLANT B
• Emitting 200 tons of CO , given 100
2
allowances
• Cost of reducing = $15/ton
• Cost of reducing 100 tons = $1,500
• Buys 100 tons of allowances
for $1,000
• Net cost = $1,000 (vs. $1,500 to reduce
100 tons)
Once a GHG cap-and-trade program exists,
the best policy option for allowing renewables
to contribute to emissions reductions is to
account for expected renewable energy generation when setting and lowering the level of
the cap, or by retiring allowances on behalf of
expected or actual generation from renewables
in the voluntary or mandatory markets, or both.
This option accounts for all of the emissions
reductions from renewable energy markets and
results in the lowest overall emissions, at least
in the short term.
The second-best option for reducing
emissions is to give renewable energy generators allowances (e.g., using an output-based
methodology for allowance distribution) or
the opportunity to obtain allowances via set-asides. In this scenario, some generators will
likely retire allowances in order to encourage
demand for renewable electricity, thereby
reducing emissions below the cap.
The latter option may be less effective, however, because some renewables generators will
not retire allowances, but will instead choose
to sell their allowances back into the cap-and-trade market. However, in the long term, pro-
viding allowances for renewables may be the
best option for reducing emissions because
investing in these technologies could bring
advances that make them more viable. (This
possibility is not noted in the matrix, however,
because of the uncertainty involved.)
In renewable energy markets, policymakers should specify that reducing emissions
is a primary goal via language in RPSs (as is
done in New Jersey’s RPS) or through certifying renewable energy products and they
should advocate one of the options detailed
above. If renewable energy generators are
awarded allowances or have the opportunity
to obtain allowances, the policies should also
specify that allowances must be assigned to and
retired along with associated purchases or RPS
requirements. New York’s RPS is an example
of such a policy.
Policy Goal: Increase
Renewable Energy
The best policy option for designing a GHG
cap-and-trade system that increases renewable
energy is one that allots allowances for renewables. This can be accomplished either by using
Once a cap-and-trade system exists, while net carbon emissions will decrease, renewable
energy markets may no longer have the opportunity to reduce emissions below the cap.
