Pricing Carbon Under Cap-and-Trade Programs - An Overview

The United States Congressional Budget Office is one of the
best sources of unbiased information on key policy and program
issues pertaining to key issues currently before governments. This
CBO Rport Summary “
Managing Allowance Prices in a
Cap-and-Trade Program” provides a
clear and insightful
overview on carbon pricing and is reproduced here for the benefit
of GLOBE-Net readers. The full report and its associated charts and
graphs is available also.

Washington, D.C. - The
accumulation of greenhouse gases in the atmosphere–particularly
carbon dioxide released as a result of deforestation and the use of
fossil fuels–could create costly changes in regional climates
throughout the world. Concern about the damage from such changes
has led policymakers and analysts to consider policies designed to
reduce emissions of those gases.

Many proposals have focused on cap-and-trade programs, which
would limit the number of tons of greenhouse gases emitted into the
atmosphere over several decades from certain sectors of the U.S.
economy. Under such a program, lawmakers would set gradually
tightening annual caps on greenhouse gas emissions that together
would imply a cumulative limit over the duration of the policy.

Rights to emit the gases, referred to as allowances, would then
be distributed to businesses or other entities, such as state
governments, in amounts that corresponded to those limits. (One
allowance would permit one ton of emissions.) The government could
distribute the allowances by either selling them, possibly in an
auction, or giving them away. Once the allowances were distributed,
they could be bought and sold in the secondary market for them that
would develop.

Firms subject to the caps–for example, firms that emitted large
quantities of greenhouse gases or that produced or imported fossil
fuels that released emissions when burned–would be required to
submit allowances to the agency charged with implementing the
program. Under most proposed programs, firms could shift their use
of allowances from one year to another by “banking” unused
allowances for the future or, to a more limited degree, by
“borrowing” allowances from future allocations.

That trading and flexibility in timing would allow firms to
undertake emissions reductions where, how, and to some extent when
it was least costly for them to do so.

In choosing the level of the annual caps on emissions,
policymakers would be making decisions complicated by uncertainty
about the damage that might result from greenhouse gas emissions,
and thus the benefits to be gained from reducing them, and about
the costs of such reductions. Those costs would increase what firms
spent in producing goods and services and would be borne by
households in the form of higher prices.

In establishing a program’s annual limits on emissions,
policymakers ideally would have reliable information about the
allowance prices that would be associated with the various caps
they might consider.

Those prices would reflect the cost of the most expensive
reduction in emissions made to comply with the program at a given
point in time. But projections of allowance prices are inherently
uncertain. Once a cap-and-trade program was in place, actual prices
would vary on the basis of current conditions, such as the weather
and the economy, and firms’ expectations about factors affecting
their compliance costs over the duration of the policy.

In fact, prices in the allowance market would be continually
changing and could reach levels that were much higher or lower than
policymakers had anticipated. Changes in prices that were caused by
new information could help ensure that the caps on emissions were
met at the least possible cost.

Higher allowance prices, for example, would encourage firms to
invest more in emissions-reducing equipment in the near term as a
way to curtail their longer-term costs for meeting the caps.

However, unexpectedly high (or low) allowance prices would make
the cost of meeting the caps much higher (or lower) than
policymakers had expected, which could alter the trade-off between
costs and benefits that policymakers had anticipated when they
selected the caps.

Concerns about unexpectedly high or low allowance prices have
led to proposals to place upper or lower limits on those prices.
The Congressional Budget Office (CBO) has examined the possible
effects of several features that would change the number of
allowances available to firms at various prices and in so doing
help limit the range of allowance prices.

CBO’s Findings

CBO examined the effects on allowance prices and greenhouse gas
emissions of three mechanisms that would help prevent allowance
prices from reaching unexpected highs and lows: a class=”Emphasis”>price ceiling, which would be implemented by
offering an unlimited number of allowances for sale at a given
price, thereby placing an upper bound on allowance prices; an class=”Emphasis”>allowance reserve, in which a limited number
of additional allowances would be offered to firms at or above a
given price, thereby curtailing but not eliminating price increases
beyond that level; and a price floor,
which would be implemented by decreasing the number of allowances
available at a given time to maintain a lower bound on prices.

An upper bound on allowance prices could prevent the policy’s
costs to the economy from being unacceptably high, but it could
also cause emissions to exceed the cumulative cap because the bound
would be sustained by adding allowances to the program. The effects
of a lower bound would depend on whether firms could bank

If banking was not permitted, a lower bound could motivate firms
to make additional cuts in emissions over the duration of the
policy beyond those that would otherwise be required by the cap. If
banking was permitted, firms would probably not make such
additional cuts.

A Price Ceiling

Policymakers could set an upper limit, or ceiling, on allowance
prices by allowing firms to buy an unlimited number of allowances,
in addition to those created under the cap, at a specified “ceiling
price.” Such a policy would have the following consequences:

  • It would provide an upper limit on
    allowance prices but not on emissions.

  • The higher the ceiling price was set above the projected path
    of allowance prices, the less likely it would be that firms would
    buy additional allowances and if they did buy them, the fewer they
    would buy. As a result, a higher ceiling would generally lead to
    fewer additional emissions than would arise under a lower

  • Provided that firms were able to shift allowances from one year
    to another–that is, bank and borrow them–a ceiling could dampen
    the price of allowances, even when the market price was below the
    ceiling price. Such price dampening, which would be most likely
    when the market price of allowances was near the ceiling price,
    would occur because firms would attach a lower value to an
    allowance today to reflect the fact that its price in the future
    could not rise above the ceiling price.

  • If the ceiling lowered allowance prices, it would diminish
    firms’ incentives to invest in equipment that reduced emissions and
    in efforts to develop new lower-cost emissions-reducing
    technologies. That decrease in investment would lower firms’
    spending for emissions reductions in the near term but could
    increase it in the future, when firms’ compliance costs rose.

An Allowance Reserve

Alternatively, policymakers could offer to sell firms a limited
number of “reserve” allowances at or above a given price, referred
to here as an “access price.” Such a reserve would have the
following effects:

  • It would impose an upper limit on emissions–which might be
    different from the cap–but would not set an upper limit on the
    price of allowances.

  • The environmental and economic consequences of using the
    allowances in the reserve would depend on whether the reserve
    increased or decreased the number of allowances that would
    otherwise be permitted under the cap.

    • A reserve created by supplementing the
      number of allowances supplied under the cap
      would allow a
      limited loosening of the cap when costs were high. A
      supplemental-allowance reserve would tend to increase emissions and
      lower allowance prices relative to a policy with the same cap but
      no reserve. All else being equal, the larger the reserve and the
      lower the access price for releasing the allowances it contained,
      the more likely that the reserve would dampen allowance prices and
      allow emissions to exceed the cap.

    • A reserve created by withholding
      allowances that would otherwise be distributed under the cap

      could increase firms’ compliance costs but allow fewer emissions
      than those under a program with the same cap but no reserve. All
      else being equal, the larger the reserve and the higher the access
      price, the more likely that the reserve would increase prices and
      curb emissions to a greater extent than would a similar program
      without a reserve.

  • The effect of a reserve on emissions and allowance prices might
    be greater but would be less certain if regulators could restock
    the reserve by using offset credits, which reflect reductions in
    domestic or overseas emissions that would not otherwise be subject
    to the cap. Under such an approach, regulators would purchase the
    credits, then retire them and add a corresponding number of
    allowances to the reserve. Allowing regulators to restock the
    reserve in that way could lower firms’ costs for compliance because
    the number of reserve allowances would rise. However, that reliance
    might also prompt questions about the credibility of the cap:
    Regulators could find it challenging to verify that offset credits
    represented actual reductions relative to projected emissions in
    the absence of the cap-and-trade program.

  • If the federal government used auctions to sell the reserve
    allowances it created, it would capture their full value.
    Alternatively, if the reserve allowances were distributed by
    offering firms options to purchase them at a fixed price, the
    government and firms would share the allowances’ value.

A Price Floor

Another approach, a price floor, would set a lower limit on the
price of all traded allowances. With a “hard” price floor, the
simplest form of such an approach, the government would be required
to purchase an unlimited number of allowances at a predetermined
price. Broadly speaking, including a price floor in a cap-and-trade
program would tend to boost allowance prices in the near term but
would probably not result in fewer emissions over the duration of
the policy if firms were permitted to bank allowances. CBO’s
analysis also indicates the


  • The further below the projected path of allowance prices that
    the floor price was set, the less likely it would be that the floor
    would become binding–that is, prevent any further decline in

  • At the time that it was binding, a price floor would increase
    firms’ compliance costs, relative to a policy with the same cap and
    no price floor, because it would require firms to reduce emissions
    more than they otherwise would.

  • To the extent that a price floor increased the price of
    allowances, it would strengthen firms’ incentives to invest in
    emissions-reducing capital equipment and to develop new lower-cost
    technologies for reducing emissions. Those investments would boost
    firms’ spending in the near term but decrease their compliance
    costs (and lower allowance prices) in the future.

  • If firms could shift allowances from one period to another, a
    price floor would probably not result in cumulative emissions over
    the life of the policy (typically several decades) that were less
    than the amount permitted under the policy’s cap. Instead, a floor
    would shift reductions forward in time.

  • Policymakers could try to set a lower limit on the price of
    allowances by establishing a minimum bid price for the allowances
    sold in a government-run auction. But that bid price would
    establish a floor for prices in the secondary market only if the
    demand for allowances was great enough that firms would want to buy
    at least some of the allowances being auctioned.

Unintended Consequences of Managing Allowance Prices

Actual experience in managing allowance prices through the
approaches that CBO examined is quite limited, which could make it
harder to anticipate the effects of such features if they were
included in a cap-and-trade program for greenhouse gas

For example, a hard price floor might turn out to be very costly
to implement. Also, some analysts are concerned that a price
ceiling or an allowance reserve could result in allowances being
added to the program under circumstances–including firms’ attempts
to manipulate allowance prices through those features–that in the
end might not be justified by actual compliance costs.

A further consideration is that the mere presence of a price
ceiling or a price floor might cause allowance prices to gravitate
toward those levels. Moreover, allowing firms to buy an unlimited
number of allowances at a ceiling price could complicate possible
efforts to tighten the annual caps in the future: Firms could bank
allowances during the time that the price ceiling was in effect and
then use those allowances to exceed the tighter caps established
for future periods.

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