Designing Effective Climate Policy: Cap-and-Trade and Complementary Policies

Abstract

In this article, Professor Carlson tackles a difficult and surprisingly under-examined issue about how to reduce greenhouse gas emissions most effectively at the lowest cost. If policy makers commit to using cap-and-trade as a central regulatory mechanism – the dominant policy choice to date – to what extent should they also adopt additional regulatory programs that contain more traditional direct regulation (so-called complementary policies)? Cap-and-trade is by definition designed to harness market forces to allow polluters to make choices about whether and how they will reduce their own emissions or trade for a right to emit more while another polluter cuts emissions more dramatically. Complementary policies, by contrast, designate in advance how greenhouse gases must be reduced and from which sources. While complementary polices can effectively reduce emissions, they also constrain the market options available under cap-and-trade by limiting the choices emitters have about how to reduce their emissions. That constraint can also lead to higher compliance costs. Though policymakers may enact complementary policies for reasons other than greenhouse gas emissions reduction (renewable portfolio standards to promote job creation or air pollution reduction, for example), if the goal is solely about reducing greenhouse gases most cost-effectively cap-and-trade alone may be a better choice – with one exception. If systematic market failures prevent emitters subject to a cap-and-trade system from choosing the lowest cost compliance options, then from a climate policy perspective complementary polices to correct the market failure make sense. Energy efficiency measures appear to fit this exception. If no market failure exists, policymakers should recognize the trade-off inherent in limiting the market mechanisms cap-and-trade is designed to promote and evaluate whether ancillary benefits justify the reduction in market flexibility and the potentially higher costs.

Keywords: cap-and-trade policies, green house emissions, climate policies