Cap and trade systems and command and control regulation both involve the limiting of emissions in polluting sectors of the economy. However, cap-and-trade provides economic incentives for private sector actors to engage in mitigation, thereby making it the most efficient method of achieving an environmental target. Cap-and-trade is already the policy instrument of choice in many U.S States, the EU and Australia, and has proven to be effective in the U.S Acid Rain Program.
The principal advantages of emissions trading are:
Cap-and-trade achieves the objective.
Where it is clear that there is an urgent need to achieve a given amount of reduction of emissions or pollution by a given time, as appears to be the case now with global greenhouse gases, setting a cap with appropriate sanctions for breach is the most direct and effective approach. And allowing trading within that cap and deadline is the most effective way of minimizing the cost. Determining physical actions that companies must take, with no flexibility, is not guaranteed to achieve the necessary reduction. Nor is setting a price, since the appropriate price is not known in advance.
Cap-and-trade discovers prices
The world has only just started to realize the importance of achieving reductions in greenhouse gases. Many technologies in many sectors can help achieve these reductions. Even though indicative cost curves and comparisons are widespread, it is a commonplace that when the power of the market is turned onto an area where previously there has been little incentive to reduce costs and prices, remarkable reductions can be achieved, as improvements driven by competition leapfrog each other. It is unsafe and potentially expensive to assume the costs of the technologies are known, and a price or a choice of specific technologies can be made by the regulator. Only a cap and trade system gives full rein to the market to discover prices.
Cap-and-Trade incentivizes investment in low-cost emissions abatement
Allocating allowance permits for emissions and then trading between firms enables abatement to occur where the marginal cost is lowest. This is because firms are seeking to reduce emissions in the most cost-effective way possible, motivating them to devise economically efficient investments in new technology or production methods, or to search out external suppliers who can reduce emissions cheaper than they can. Efficiency is therefore the driver of investment decisions under an emissions trading system, with firms all motivated by the need to reduce emissions with the lowest cost impact possible.
Conversely, in a command and control system there is only one way emissions are limited, and that is through pure regulation. Pure regulation does not foster the necessary inputs of the competitive marketplace to discover the relative marginal abatement costs between covered entities. In other words, there is no motivation for companies to seek the lowest cost solutions, or even to factor costs, but instead to comply with directives from government authorities, regardless of cost. This inefficiency impacts productivity and vitality in those businesses confronting these regulations, and dampens growth in the national economy.
Cap-and-trade does not impose solutions, but encourages economically efficient investment decisions by companies
Innovation is necessary for mitigating serious climate change. The emissions-reducing technologies available now require further improvements to increase their efficiency and effectiveness, and new technological concepts need to be devised. A marketplace for the emissions reductions provides the incentives to improve and uncover these technologies. A cap-and-trade system also adds the prospect of an immediate reward for the companies who are best at using technology to reduce their emissions. It therefore aligns incentives for investors and stakeholders to reduce their emissions through technological innovations, intended to outperform competitors.
The use of inflexible command and control-type regulatory tools fails to deploy these incentives, and thus hampers technological progress. Enforcing compliance with no mechanism for fomenting competition amongst businesses results in stagnant and stale ideas. Governments and regulators cannot foresee the technologies and innovations that will clear the path for future emissions reductions, but under the regulatory approach they impose technology restrictions on companies by defining what they must do to comply, rather than letting them choose how to meet compliance targets.
Cap-and trade optimises improvements and investments in capital stock
Emissions trading allows for necessary investments in carbon reduction to come about at the most cost-effective time within the overall compliance target set for the economy, as firms can make a series of make-or-buy decisions according to their own cost curves and the price signals from the market. Companies can avoid assets being stranded by the decisions of the regulator, and can also accelerate investment if they see that earlier production of emissions reductions could be beneficial or profitable.
Command and control, however, often has the unintended effect of prolonging capital investments in new plants and equipment. For example, a power plant facing new restrictions on plant design will stretch out the life of its current, dirtier, plant in order to delay costly compliance. The motivation is to extend the life of existing assets, delaying the inevitable costs of replacing until absolutely necessary. The net effect of this is to actually drive up pollution and drive down investment, by making new investment unattractive to industries that are subject to these regulations. Yet where regulations are imposed from a certain date on all plant, assets with a continuing productive life can be closed down.
Cap-and-trade has proven effective
Cap-and-trade has proven its effectiveness in the US through the acid rain program, where it quickly and effectively reduced pollution levels at a far lower cost than expected. The European Union Emissions Trading System has shown that cap-and-trade can be extended to carbon and can be done so in an agreed-upon manner across many countries, and in doing so creates a price on carbon that drives emissions reductions. Reductions in pollution that industry feared would be excessively costly were achieved at a fraction of the original estimates.
On the whole the use of direct regulation as a policy instrument to achieve emissions reductions that could be spread geographically and through a time period without damage to the policy objective is a blunt tool. It can increase the costs of emissions reductions, and it can have negative economic implications for businesses and society as a whole. Where a market can operate effectively, and where there is a premium on keeping costs to a minimum, a cap and trade route should be chosen.
There are, however, some instances in which cap-and-trade is unable to operate effectively, and therefore regulations can be the most useful tool. One widespread example is private road transportation, where vehicle emissions standards can be used to affect changes in the production of motor vehicles often more effectively and with lower transaction costs than bringing those directly responsible for the emissions together in a market. It is hard to capture and verify the actual emissions of automobiles during their use, and regulating from the pre-production stages can produce better overall results. In other cases a mixture of cap and trade, direct regulation, tax and incentivisation by subsidy will produce the optimum outcome. Cap and trade is not a panacea, but there are good economic arguments for always considering it first, even if supply-chain characteristics and market failures mean that a special mix of other policies has to be created as well.
But in direct comparisons with command and control, where that is appropriate, there is a clear winner. By not providing a profit incentive for companies to invest in further emissions reductions, command and control sets a rigid and staid framework for industries to base their strategies for low carbon growth upon. Harnessing market forces allows for reductions to come more efficiently, and bringing about innovations necessary to achieve sustainable economic and environmental conditions.