Cap and Trade Rules
Analysis Shows How Cap-and-trade Plans Can Cut Greenhouse Emissions

November16, 2008

Researchers at MIT's Center for Energy and
Environmental Policy Research have produced a report concerning key design
issues of proposed "cap-and-trade" programs that are under consideration in the
United States as a way of curbing greenhouse gas emissions. The first
contribution of the three-part study found that, based on an examination of the
European Union's system and of similar U.S. programs for other emissions, such a
program can indeed be effective in reducing emissions without having a
significant economic impact.

"The European experience confirms much of what has been learned from similar
U.S. systems for other emissions, namely, that cap-and-trade systems can be
constructed, that markets emerge to facilitate trading, that emissions are
reduced efficiently, and that the effects on affected industries are less than
predicted," said A. Denny Ellerman, the study's lead author and a senior
lecturer in the MIT Sloan School of Management.

The study found that the most controversial aspect of the European program was
how to allocate the permitted emissions levels to different producers. Initial
free allocation of allowances, they found, was the necessary price for gaining
political acceptance, as it has been in U.S. systems. Over time, the clearly
established trend in the E.U. is to phase out the free allocation of permits in
favor of auctioning them.

The second part of the report looked at mechanisms that can be used to control
the costs that will be imposed on power producers as a result of implementing a
cap-and-trade system. Several alternatives were analyzed, including such things
as a "safety valve," banking and borrowing of allowances, and renewable
portfolio standards. Rather than a single best choice, the study found that
different mechanisms work best for addressing uncertainties associated with
long-term, short-term and start-up costs.

The report's third section examined the relationship between state and federal
regulations on greenhouse gas emissions. With no federal policy now in place,
many states are moving forward with their own initiatives, which range from
commitments to reduce greenhouse gases to a regional, multi-state cap-and-trade
program slated to begin in 2009.

While federal legislation is expected in the next few years, it is unclear how
it will define the relationship between a federal cap-and-trade program and
other state or regional initiatives. The report analyzes the economic and
environmental impacts of the range of possible interactions between the federal
program and state or regional programs.

Differences in the abatement costs among states can create economic
inefficiencies that make achievement of the climate goal more costly than it
need be. This inefficiency can be avoided by either federal preemption of
duplicative state programs, the authors found, or by a "carve out" of more
demanding state programs from the federal cap with linkage.

In addition to Ellerman, the research was co-authored by Mort D. Webster,
assistant professor of engineering systems in the Engineering Systems Division;
John Parsons, senior lecturer at the Sloan School and Executive Director of the
Center for Energy and Environmental Policy Research (CEEPR); Henry D. Jacoby,
professor of management at the Sloan School and Co-Director, Joint Program on
the Science and Policy of Global Change; and Meghan McGuinness, who was a
researcher in the CEEPR. The study was funded by the Doris Duke Charitable Foundation.


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