NCPA - National Center for Policy Analysis

Trading Pollution Allowances

August 1, 2001

As an alternative to inflexible regulations, the U.S. started experimenting with a more market-oriented solution to pollution in the late 1970s. The process is called cap-and-trade.

  • It involves the government mandating a cap on pollution at an "acceptable" level and then issuing pollution allowances that reflect that level.
  • Firms that produce less pollution than their allowances can then sell their excess allowances to firms that produce more than their allowances.
  • This creates financial incentives for firms to develop pollution-reduction strategies or innovations because they will directly benefit through lower abatement costs, lower payments for pollution allowances and/or sales of unneeded allowances.
  • Creating a market in pollution allowances is more efficient than command-and-control regulation, because firms that can reduce pollution at relatively lower costs will reduce more and sell their allowances -- while firms that have higher costs will reduce less and buy allowances.

A key element to a cap-and-trade program is how it is designed -- specifically, who will reap the value of the emissions allowances. The Congressional Budget Office has studied several designs as they might apply to carbon emissions.

The designs are quite complicated. But suffice it to say that firms which must buy allowances will certainly pass along to consumers that increased business cost. The largest increases will show up in the prices of electricity, natural gas, fuel oil and coal, and gasoline.

The CBO estimates, for example, that an allowance price of $100 per metric ton of carbon would cause a 2.8 percent increase in the general price level.

Source: Susan Lee, "How Much Is the Right to Pollute Worth?" Wall Street Journal, August 1, 2001.

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