From the July 2009 issue of Investment Advisor • Subscribe!

How To Make Cap and Trade Work

According to the Environmental Defense Fund, a successful market-based cap and trade program for carbon emissions requires a few minimum elements. All of the following are absolutely essential to an efficient and effective program:

o A mandatory emissions "cap." This is a limit on the total tons of emissions that can be emitted. It provides the standard by which environmental progress is measured, and it gives tons traded on the pollution market value; if the tons didn't result in real reductions to the atmosphere, they don't have any market value.

o A fixed number of allowances for each polluting entity. Each allowance gives the owner the right to emit one ton of pollution at any time. Allocation of allowances can occur via a number of different formulas.

o Banking and trading. A source that reduces its emissions below its allowance level may sell the extra allowances to another source. A source that finds it more expensive to reduce emissions below allowable levels may purchase allowances from another source. Buyers and sellers may "bank" any unused allowances for future use.

o Clear performance criteria. At the end of the compliance period (e.g., one year, five years, etc.), each source must hold a number of allowances equal to its tons of emissions for that period, and must have measured its emissions accurately and reported them transparently.

o Flexibility. Sources have flexibility to decide when, where, and how to reduce emissions.

An active cap-and-trade market enables those who can reduce pollution cheaply to earn a return on their pollution reduction investment by selling extra allowances. It enables those who can't reduce pollution as cheaply to purchase allowances at a lower cost than the cost of reducing their own emissions. It enables all participants to meet the total emissions cap cost effectively. And it gives all emitters incentives to innovate to find the least-cost solutions for total pollution control.

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