Walls, Nelson, Safirova
Telecommuting and Environmental Policy
The direct benefits of emissions trading arise from the lower total costs of compliance. Trading
per se does not reduce aggregate emissions; those remain a function of goals or standards set by
regulation. However, indirect environmental benefits can result from trading. The federal emissions
offset program, for example, requires maintaining “trading ratios” so that firms must in effect purchase
“extra” emissions reductions to achieve compliance. In addition, credits and allowances can be retired—
that is, purchased by or donated to an entity (often an environmental group) that opts not to use them to
comply with regulations. Finally, if a trading program lowers the costs of regulation, the government
may be able to set more aggressive environmental targets than would otherwise be the case.
In the United States, two basic types of interfirm trading regimes are currently used in air pollution
policy: allowance-based cap and trade and emissions reduction credit trading. Emission credits are
generally used in two types of programs: emissions offset and open-market trading programs.
3.2. Allowance-Based Cap and Trade
In a cap-and-trade system, an overall limit is placed on aggregate emissions during a specified
compliance period. Emissions allowances that entitle the holder to emit a set amount of a pollutant are
allocated to firms, with the total number of allowances set equal to the cap.10 Allowances may be traded
among eligible sources, but at the end of the compliance period, each firm must hold sufficient
allowances to cover its emissions for the period. Usually, there are provisions for limited banking of
allowances for later use. The attraction of a cap-and-trade system is that it retains the certainty of a hard
target through the cap on total emissions while allowing firms flexibility in reaching the target.
The flagship cap-and-trade program is the SO2 allowance market created under Title IV of the
1990 Clean Air Act Amendments. The program, designed to reduce emissions that lead to acid rain,
caps annual SO2 emissions from electric utilities’ generation facilities at 8.95 million tons
(approximately 50% of 1980 levels). Firms possessing surplus allowances may either sell them or bank
them for future compliance needs. The program is widely considered a major success. A review of
published estimates reveals a general consensus that the SO2 trading system has resulted in, and will
continue to account for, substantial cost savings over a command-and-control regime (Burtraw and
Palmer 2003).
The program’s success is attributed to many factors, but foremost among these is the flexibility
it allows in compliance options and the timing of reductions. The fact that the regulation does not
mandate a specific technological approach has enabled firms to take advantage of alternative ways of
reducing emissions, such as using low-sulfur coal from Montana and Wyoming (made more available
through rail deregulation). The program is also credited with spurring more process innovation than
would have occurred under mandated technology standards.
Besides SO2 allowance trading, other prominent examples of cap and trade include programs to
control regional emissions of nitrogen oxides (NOx) in the Northeastern US and state programs in
California, Illinois, and Texas.
In 2005, the European Union will inaugurate a highly ambitious cap-and-trade program
covering CO2 and other greenhouse gases.11 In the United States, there are competing proposals to
extend cap and trade for further SO2 reductions and the national regulation of NOx. Several northeastern
states have NOx and carbon cap-and-trade programs that are slated to begin in the next few years. The
cap-and-trade approach has also been proposed for addressing mercury emissions and CO2 in the US at
the national level.
3.3. Emissions Reduction Credit Trading
Unlike cap-and-trade programs, in which the emissions cap establishes the level of pollution
allowed by the polluting industry, emissions reduction credit programs rely on other regulatory policies,
10 The number of allowances equals the emissions cap if 1 allowance is equal to 1 ton of emissions, as is often the
case (as in the SO2 program), but any fixed ratio between emissions and allowances is acceptable.
11 See Kruger and Pizer (2004) for an overview and potential pitfalls in the program.