Cap-and-Trade: An Analysis of the Application of Market-Based

Strategies in the U.S. to Reduce Emissions of Greenhouse Gases

Brandon Bratsafolis

Spencer W. G. Byrne

Paul Comet

Christopher Dengler

Gregory Thome

Justin Waney

2

Abstract

This paper examines the economic impact, feasibility, and environmental benefits

of implementing a national cap-and-trade policy in the United States to confront the

mounting issue of climate change. By considering the applications of emissions trading

across the United States and China, we have provided an in-depth analysis of the barriers

to a liquid, transparent, and efficient market for greenhouse gas allowances to be traded.

Following the investigation of both regional and national emissions trading systems, we

identify the best practices of each exchange and propose a plan titled the “Federal

Greenhouse Gas Initiative”. Supported by a quantitative analysis of the potential

reductions that would result from emissions trading across all fifty states, we reach the

conclusion that a federal cap-and-trade program presents the most economically and

environmentally viable option to reduce emissions.

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TABLE OF CONTENTS

I. Introduction ....................................................................................................................4

II. The Problem ..................................................................................................................5

Greenhouse Gases Connection to Climate Change Solutions .................................5

Largest Sources of Emissions ..................................................................................6

III. Cap-and-Trade ............................................................................................................8

Greenhouse Gas Solutions .......................................................................................8

The Cap ....................................................................................................................9

Emissions Trading .................................................................................................10

An Example ...........................................................................................................10

Added Benefits of Cap-and-Trade .........................................................................11

Cap-and-Trade in Application ...............................................................................11

IV. China Case Study ......................................................................................................13

An Overview of the Chinese Pilot Program ..........................................................13

Organization of Pilot Programs .............................................................................13

Program Challenges ...............................................................................................16

Carbon Pricing .......................................................................................................16

Liquidity .................................................................................................................17

Timeline to National ETS ......................................................................................18

A Push Towards a Greener Economy ....................................................................20

V. Regional Greenhouse Gas Initiative ..........................................................................21

Introduction ............................................................................................................21

Operations ..............................................................................................................22

Reinvestments ........................................................................................................24

Reinvestment Examples .........................................................................................27

Conclusion .............................................................................................................27

VI. Application to the U.S. ..............................................................................................29

RGGI Economic Benefits ......................................................................................29

U.S. Applications of Cap-and-Trade: Acid Rain Program ....................................30

U.S. Applications of Cap-and-Trade: Chicago Climate Exchange........................31

Chinese Plurilateral Market Evolution: RegionalNational ................................33

Federal Greenhouse Gas Initiative Proposal ..........................................................34

VII. Quantitative Analysis ..............................................................................................37

VIII. Conclusion ...............................................................................................................40

IX. Acknowledgements ....................................................................................................43

X. References ....................................................................................................................44

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I. Introduction

In Le Bourget France, 193 member states are currently meeting for the United

Nations Climate Change Conference lasting two weeks, their objective: to achieve a

binding and universal agreement on climate. The reason for calling the summit is clear;

the world’s climate is undeniably changing due to human influence, driven by the over-

emission of greenhouse gases into the atmosphere. The conference personifies the globe’s

growing concern over the issues resulting from climate change as well as their efforts to

find a lasting and impactful solution. Additionally, primary emitters of greenhouse gases

such as the U.S., China and the EU understand the gravity of their environmental

footprint and have stepped up to spearhead the initiative. One such solution that many

have turned to as a means to control greenhouse gas emissions involves a market-based

approach that enforces a cap on aggregate emissions while enabling polluting entities to

trade emitting rights, often referred to as a cap-and-trade market. The U.S. has had

success instituting a cap-and-trade market regionally, however this paper will argue that

the most efficient and comprehensive solution to the U.S.’s greenhouse gas dilemma

involves introducing a national cap-and-trade market. The plausibility of the proposed

national emissions trading system (ETS) in the U.S., denoted the Federal Greenhouse Gas

Initiative (FGGI), can be supported by an analysis of the progress of the national

emissions market that is currently being established in China. Further, by looking at the

current successes of regional cap-and-trade markets in the U.S., one can adequately

foresee the success and potential impact of a national cap-and-trade market in the U.S.

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II. The Problem

Carbon is the single most important building block of life; however, high

concentrations of carbon dioxide and other greenhouse gases can cause detrimental

change in our climate. Such change has been observable globally; as arctic glaciers have

thawed away, ice sheets have retreated, and sea levels have risen, consuming once useful

land. Scientists have predicted that greenhouses gas emissions would cause climate

change, but not nearly at the rate at which it appears to be occurring. Although land

produces carbon dioxide and other greenhouse gases, climate change has primarily

resulted from human use, or misuse, of the natural resources.

Greenhouse Gases’ Connection to Climate Change

The major greenhouse gases other than carbon dioxide are methane, nitrous oxide,

and tropospheric ozone. Global economies’ high demand for resources has accelerated

the increased releases of carbon dioxide and methane each year through industrial

processes. As the emissions of GHGs increase, our global temperature inevitably warms

because long-wave infrared light from the sun reaches Earth’s surface, and GHGs in the

atmosphere prevent them from escaping, warming our planet.1

As humans pump greenhouse gases into the atmosphere, the earth continues to

warm at an increasing rate. The rising global temperature has negatively impacted our

environment by altering a climate upon which many ecosystems and environmental

processes depend. For example, atmospheric warming causes heavier downpours that can

1 Nathanson, Jeffrey A. "Air Pollution." Encyclopedia Britannica Online.

6

dry up and alter river flows or extend growing seasons. This can impact our water and

energy supplies, agriculture, as well as animal habitats and ecosystems.2

Largest Sources of Emissions

In addition to its environmental impacts, greenhouse gases are notorious for

contributing to toxic levels of air pollution. A large number of factories and

manufacturers result in a large amount of air pollution produced to supply the demands of

global economies. These factories produce fossil fuel emissions, chemical solvents, and

other byproducts that contribute to the issue. Ozone, another harmful atmospheric gas, is

created by the combination of sunlight, nitrous oxide, and volatile organic compounds.3

Similar to other GHGs, ozone contributes to climate change in the same way by

preventing heat waves from the escaping the atmosphere. High concentrations of these

greenhouse gases can be harmful to the human respiratory system, as can high

concentration of carbon dioxide.4

Rapid climate change and globally high rates carbon dioxide emissions are

concerning given the biological and environmental effects, yet high demand goods and

services present a long-term issue to policymakers. This poses a problem for the world’s

largest contributors of greenhouse gases, China and the United States, two countries

combatting the problem with market-based solutions to environmental issues.

2 Fischer, Douglas Fischer. "Global Warming Impacts In Every Corner of the United States." Scientific

American. June 17, 2009. 3 Nathanson, Jeffrey A. "Air Pollution." Encyclopedia Britannica Online. 4 "Health Effects." Health Effects.

7

The graph below depicts, in GT of carbon dioxide, the world’s leading producers of

carbon dioxide emissions.

8

III. Cap-and-Trade

Greenhouse Gas Solutions

In response to the “inconvenient truth” that is global warming, several nations

around the world have committed to reducing greenhouse gas emissions through the

implementation of cap-and-trade markets, often referred to as emissions trading, in an

effort to take control of the primary driver of global warming. Before introducing and

elaborating upon cap-and-trade markets, it is first important to discuss alternative

methods for reducing greenhouse gases that have been popular in the past so that we can

understand why emissions trading is such a powerful solution. The most obvious and

straightforward way to reduce greenhouse gases is to simply decrease our overall

consumption of carbon-based fuels, which would mean limiting the use of energy sources

such as natural gas, oil, coal and gasoline. Another alternative includes the increased use

of carbon-free energy sources like wind power, solar power, hydropower and nuclear

power that do not directly produce any carbon emissions. Furthermore, there exists

another strategy for reducing carbon emissions in the atmosphere known as carbon

sequestration. This technique involves capturing and storing carbon dioxide that would

otherwise have been a part of the atmosphere by utilizing soil and plants as well as

methods that capture carbon dioxide before or after fossil fuels have been burned so that

they may be later stored in the earth.5 While all of these strategies for reducing emissions

are useful and beneficial for the cause, the advent of emissions auctions and trading

markets is the most efficient and impactful solution available and is the future of

greenhouse gas reduction due to its ability to promote innovation, enforce strict

5"Ways to Reduce Carbon Dioxide Emissions." Tribal Energy and Environmental Information.

9

environmental accountability and ultimately lower greenhouse gas emissions unlike any

other alternative.

The Cap

The cap-and-trade framework is a unique tool utilized by several governmental

entities across the world to control aggregate emissions while enabling polluting entities

to trade emitting rights in a way that incentivizes the private sector to invest in cleaner

technology and more energy efficient operations. To begin, a cap-and-trade market first

and foremost functions as a solution for reducing greenhouse gas emissions. The central

component used to control emissions within the cap-and-trade system is the “cap,” or

emissions target, that represents the aggregate amount of greenhouse gas emissions

polluting entities are permitted to emit over some period of time in a particular region or

country.6 This cap is typically established and policed by a government or inter-

governmental body and is often determined based on the historical emissions of the

polluting entities. Additionally, the government or regulating agency in charge of the cap-

and-trade system is also tasked with distributing units of emissions or “allowances” to

each polluting entity under their jurisdiction. This cost could be fully funded by the

revenues gained form auctions, as demonstrated in U.S. cap-and-trade programs. These

allowances typically represent the right to emit one ton of greenhouse gases.7 Further, the

sum of all of the allowances between every polluting entity for any given period equals

the established cap for that particular period. With control over the emissions cap,

regulating agencies have the ability to gradually reduce the set cap every year, which in

effect would reduce total greenhouse gases for that particular region or country. To

6"Cap and Trade | US EPA." US Environmental Protection Agency. May 10, 2012. 7"Cap & Trade Basics." IETA | International Emissions Trading Association.

10

reiterate, the cap-and-trade system’s ultimate goal is to reduce greenhouse gases,

therefore proper manipulation and enforcement of the cap is a fundamental element in

attaining the goal.

Emissions Trading

Although the overarching goal to reduce greenhouse gas emissions can be

achieved simply by enforcing an emissions cap on all polluting entities, the genius behind

the cap-and-trade program is rooted in the trading aspect of the system that drives

polluting entities to innovate and discover new techniques for reducing pollution in order

to maximize profits. After the regulating agency or government has determined the

emissions cap and distributed the appropriate amount of allowances to each polluting

entity for a given period, they then create a market for emission allowances to be traded

among permitted polluting entities. On this emissions market, polluting entities have the

ability to buy and sell allowances from one another. In practice, this framework allows a

polluting entity with a surplus of emissions allowances for a given period to trade away

or sell some of their allowances on the emissions market for a profit. In contrast, a

polluting entity that may be having trouble meeting their permitted emissions limit and

requires more allowances, is now able to enter into the emissions market and buy

additional allowances.

An Example

To better illustrate the way a firm may behave in a cap-and-trade market, one can

consider the following example. A major manufacturer of automobiles is permitted by

their federal government to emit 100 tons of greenhouse gases for a given year. The firm

has had an unexpected spike in automobile orders and must produce more cars than was

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previously expected for the year and consequently will require emitting more greenhouse

gases than was originally planned. As a result, the firm decides that it must emit 10 more

tons of greenhouse gases, or 10 more allowances, and purchases them on the emissions

market for the currently traded rate for the allowances. From the opposite perspective,

one can imagine the scenario where the automobile manufacturer doesn’t emit its allotted

100 tons of greenhouse gases due to slower production levels thus leading the firm to sell

its extra allowances on the emissions market for a profit.

Added Benefits of Cap-and-Trade

After considering the above example, it is evident how the institution of a cap-

and-trade system incentivizes polluting agencies to reduce their emissions footprint. The

ability to buy and sell allowances upends the once perceived notion that emitting

greenhouse gases are without cost, where firms would disregard the amount they polluted

so long as they maximized profits. Now with the advent of emissions trading, firms must

take into account the added cost of over emitting as well as the opportunity cost of using

allowances that could have been sold in the open market for profit. As a cap-and-trade

market grows older and continues to gradually reduce the aggregate cap on greenhouse

gas emissions, some companies will find it hard to be profitable if they are in constant

need of purchasing allowances on the market. For other firms, altering their business

plans to reduce their emissions and meet their allotted cap may be easier and will profit

from it accordingly. As a result of the new emissions landscape, firms are incentivized to

find cost-effective pollution cuts, to innovate and to invest in cleaner technology now that

pollution cuts can be turned into revenue.8

8"How Cap and Trade Works." Environmental Defense Fund. February 20, 2013.

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Cap-and-Trade in Application

Despite being a relatively new solution to greenhouse gas emissions, cap-and-

trade markets have proven to be successful in application as evidenced by the success of

the first fully functional cap-and-trade market in the U.S., the Acid Rain Program. The

Acid Rain Program officially began in 1995 and sets a cap on major emissions of sulfur

dioxide and nitrogen oxides, the primary factors that produce acid rain in the northeast

U.S., and has successfully reduced these emissions by 50% since its inception.9 Other

effectively implemented cap-and-trade markets exist in the U.S. like the Regional

Greenhouse Gas Initiative as well as abroad in the EU and China, which will be

elaborated upon in greater detail throughout the rest of the paper.

9"Acid Rain Program." EPA.

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IV. China Case Study

An Overview of the Chinese Pilot Programs

The plausibility of the proposed national emissions trading system (ETS) in the

U.S., can be supported by an analysis of China’s progress related to creating a national

emissions market.

In November 2014, the United States and China announced a joint statement

signaling a personal commitment to mitigate climate change.10 As a result, both nations

have outlined plans to change domestic policy with the goal of building green, low-

carbon, and climate-resilient economies. Analyzing China’s pilot programs, and its

subsequent plurilateral market evolution, supports the plausibility of moving towards a

federally regulated ETS in the United States.

Over the past two decades, rapid development and growth have driven up Chinese

emissions outputs. China’s first global warming policy, announced in 2007, targeted a

20% carbon emissions reduction by 2010. In 2009, China announced further carbon

reduction goals and subsequently unveiled plans to implement an ETS pilot program.

Working to meet the established emissions reduction goals, the regionally-based cap-and-

trade pilot programs were the inaugural point towards establishing a unified national

ETS.11

Organization of Pilot Programs

China’s pilot programs are located in Beijing, Shanghai, Guangdong, Tianjin,

Shenzhen, Hubei, and Chongqing.12 The locations were specifically chosen so that they

10 “U.S.-China Joint Presidential Statement on Climate Change”. www.whitehouse.gov (pg 1). 11 IETA: Climate Challenges Market Solutions. China: An Emissions Trading Case Study (pg 1). 12 Ranping Song. “Emissions Trading in China: First Reports from the Field. www.wri.gov (pg 1).

14

would represent a variety of economic, social, and geographic conditions.13 Furthermore,

in an effort to test a variety of different market structures, each program was designed

independently and locally. By allowing regional officials to develop their own systems,

China hoped to identify a framework that would work efficiently on a national level.

Each city was responsible for establishing the following:

1. Emissions cap

2. Allowance allocation methodologies

3. Monitoring, reporting, and verification system (MRV)

4. Emissions registry and allowance tracking

5. Trading platform

13 IETA: Climate Challenges Market Solutions. China: An Emissions Trading Case Study (pg 4).

15

Pilot Program Details:14

14 IETA: The Chinese ETS Pilots: An IETA Analysis. (pg 1).

16

Program Challenges

Because the pilot programs test market feasibility, it is necessary to explore their

challenges so that one may consider how these issues may or may not exist in a national

ETS implemented in the U.S. The primary challenges that were illuminated through the

various pilot programs are namely: low carbon pricing compounded with small trading

volumes, lack of market liquidity, and a seemingly low desire for companies to adopt a

carbon trading system.

Carbon Pricing

As is the issue in many ETS markets, carbon prices remain low—almost too low

to elicit any significant market action. Analyzing the Shenzhen pilot program can show

this, as the abatement cost in order to achieve a 5% emissions reduction is $20 per ton of

carbon.15 This creates a problem when comparing abatement cost to the average price of

carbon in Shenzhen. Because the average price in Shenzhen is near $10 per ton of carbon,

there is little to no incentive for firms to invest in the market. One way to mitigate the

problem of inconsistent, low pricing would be to increase the stringency of credit

allocation.16 A more stringent cap would suppress excess supply, and drive up carbon

pricing. Another potential solution option would be transitioning from a free allocation

system to that of an auction style. Of the pilot programs, Hubei utilizes auction pricing in

the credit allocation process; despite being one of least developed markets, the price of

carbon remains comparatively high. Inconsistent carbon pricing, could also be attributed

15 Stephen Zhao. Chinese Carbon Trading Pilots – Progress and Current Status. 16 Munnings, Morgenstern, Wang, Liu. “Assessing the design of Three Pilot Programs for Trading in China (pg. 33)

17

to the structure of China’s electricity sector.17 The wholesale and retail prices of

electricity in China are still regulated. Because of this regulation it is hard to pass carbon

ETS costs onto the consumers. Furthermore, the electricity sector is largely dominated by

long-term contracts. Both obstacles reduce the feasibility of an ETS market.

Liquidity

Because all of the pilot markets utilize spot trading, it is hard to facilitate

transactions.18 As a result, trading volume in China remains relatively low when

compared to other ETS programs, like RGGI, which has multimillion trade volumes

monthly. Unlike RGGI, the Chinese markets suffer from a lack of funding. This lack of

funding is amplified by the fact that participating lack fluency related to emissions

trading. Additionally, at the commencement of the program, trading was completed over-

the-counter.19 There were no financial institutions involved that would have aided in

17 Xin Wang. “Building Successful Carbon Pricing Policies in China”. (pg. 1) 18 Lasse Ringius. “Emissions Trading in China: Early Lessons from Low-carbon Pilots”. 19 Stephen Zhao. Chinese Carbon Trading Pilots – Progress and Current Status.

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

$7.00

$8.00

$9.00

$10.00 Highest price (USD) Lowest price (USD)

18

streamlining the trade process, and as a result, there was no way to ensure that the most

cost effective options were taken. The lack of liquidity makes trading in the Chinese

market significantly more costly. The extent of the market’s illiquidity could even be

responsible for the relatively high carbon prices within the pilot programs. However, in

the case that illiquidity is not the driving force behind relatively high carbon prices, an

additional jump in price could provide liquidity. If carbon prices rise further, companies

would have a stronger incentive to actively participate in the market.

Timeline to National ETS

Granted that the programs have only been in place for a year, the many lessons

learned have been crucial as China now looks towards creating a unified national system.

In 2014, China announced its plan to transition to a national ETS. The market is

scheduled to launch in 2016, with the goal of exploring low-carbon development modes,

policies, systems, and mechanisms.20 The NDCR released a statement outlining the

guidelines that China intends to follow as they finalize the implementation process. The

main objectives announced were as follows: Reduce CO2 by 17% by 2020 and to reduce

overall national energy consumption by 16%.21 The document did not identify any

specific technical aspects of the program; however, it did breakdown the timeline to

launch into three stages. Funding for the program began in March 2015.

The first step of implementation is the Preparation Phase (2014-2015). The

purpose of the Preparation Phase is to establish and design the conditions of the ETS. The

national system will be finalized by issuing supporting details and technical standards,

20 IETA: Climate Challenges Market Solutions. China: An Emissions Trading Case Study (pg 2). 21 IBID

19

establishing universal GHG accounting methods across all industries, and defining the

features of the national ETS. In order to complete the first phase of implementation, the

government must also complete the national registry. The second phase is the Operational

Improvement Phase (2016-2020). The Operational Improvement phase has two stages.

The first half of the phase (2016-2017) is a test run in which all of the regulations

surrounding the national ETS are set in place—allowances will be given out, and market

operations will begin effectively blending the policies of the local markets into one

national system. The second stage of the Operational Improvement phase is full

integration of the national ETS and a move towards market stability. The final stage of

implementation could be defined as the Stabilization and Maturation Phase (beyond

2020). The Stabilization and Maturation phase will work to increase the number of

trades, stabilizing the market. In this ultimate step there will be an emphasis on enhancing

market capacity. Other ETS systems will be explored with the intention of fostering

market links.22

22 IETA: Climate Challenges Market Solutions. China: An Emissions Trading Case Study (pg 12).

Issue supporting details and

technical standards, define

national ETS features, complete

national registry

All regulations pertaining to the

national ETS come into play.

Allowances distributed into the

market and operations will

commence

Increase trading products in order to

stabilize national ETS and enable

enhancement of market capacity—link

with other existing ETS’s

20

A Push Towards a Greener Economy in the U.S.

The United Nations has pressured countries to build greener economies, and

mandated that every country submit a carbon emissions reduction plan ahead of this

year’s global climate summit in France. China’s decision to create a carbon market

emphasizes their seriousness related to climate change mitigation. Many believe the

United States should follow suit. Paul Bledsoe, a former top climate change advisor to the

White House argues, “There is a lot of irony that the U.S., which invented the free-

market approaches to stopping climate change, is using command-and-control regulations

while Communist China will use a carbon market.”23 Additionally, the challenges

identified through the Chinese pilot programs do not exist in already established regional

US markets. For example, RGGI does not struggle with low trading volumes and

illiquidity. Even in the face of these problems, China moved forward with their plan to

transition into a national ETS.

Additionally, the disparity between levels of economic development in US states

is significantly less than the disparity between Chinese provinces. The carbon market

subsisted in the most severely underdeveloped of Chinese economies, so it would

undoubtedly be able to subsist anywhere in the United States. China’s pilot programs

have successfully shown that ETS markets can be successful in all socio-economic

environments.

23 Coral Davenport. “Global Climate Pact Gains Momentum as China, U.S. and Brazil Detail Plans”.

21

V. Regional Greenhouse Gas Initiative (RGGI)

Introduction

In order to better demonstrate the benefits of implementing a federally regulated

cap-and-trade system in the United States, one must first understand how the program

might operate and reinvest its earnings. Fortunately, a cap-and-trade system has

previously been implemented in the United States through a program called the Regional

Greenhouse Gas Initiative (RGGI). By understanding how the RGGI program’s

operations subsequently decrease CO2 emissions and how its reinvestments fund

programs and services that promote clean-energy, it becomes apparent that an expansion

of this program to the national level would generate positive results for the United States

as a whole.

The RGGI program is the first GHG pollution reduction program for power sector

CO2 emissions in the United States24 and is currently composed of nine states in the

northeast: Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire,

New York, Rhode Island, and Vermont. By issuing a set amount of tradable allowances,

RGGI is able to implement a cap on the amount of CO2 pollution that power plants can

emit. They have already completed two 3-year compliance programs (2009-2011 and

2012 – 2014) where they have successfully lowered CO2 emissions and are now in the

middle of a third compliance program. The current goal of the RGGI program,

implemented in 2014, is to set a cap of 91 million short tons and then reduce it by 2.5%

each year until it reaches approximately 78 million short tons in 2020. By gradually

reducing the cap, the RGGI program is able to reduce the total amount of CO2 emissions

24 “Investment of RGGI Proceeds Through 2013,” RGGI.org, (pg. 4)

22

without drastically affecting CO2-emitting companies’ output. The key to being able to

cut CO2 without harming companies’ business is by allowing them to trade allowances to

suit their current and future needs.

Operations

The allowance market is comprised of each state’s own CO2 budget trading

program. This market, like any other financial market, is subject to economic forces and

establishes certainty to promote long-term investments. However, before any trading

occurs, CO2 allowances must first be distributed in the primary market through quarterly,

regional CO2 allowance auctions. It is these aforementioned auctions that generate the

funds that are reinvested to promote clean energy. The total CO2 allowances are allocated

differently to each state in ordinance with their applicable statutes and regulations.25

25 Potomac Economics, (pg.25)

Source: RGGI.org

23

Like any auction or market, the Allowance price changes from year to year based on

supply (the cap) and demand. The volume-weighted average auction clearance price

increased by 62% from 2013 to 2014, from $2.92 to $4.72. The auction prices peaked in

the fourth quarter, when the average clearing price was $5.21 on December 3rd. Unlike

the Chinese pilot programs, the RGGI auctions generate revenues that create market

liquidity, successfully combatting one of the main problems the Chinese faced.

After allowances have been allocated to companies and private investors,

attention turns to the secondary market, where the allowances can be traded. While

physical allowances can be traded, because of natural volatility in the market, traders

often use financial derivatives, such as futures, forwards, and options to manage risk.

Source: “Annual Report on the Market for RGGI CO2 allowances: 2014,” RGGI.org

24

From 2012 to 2013, the futures contract price has risen from $2.00 to $3.03, or 51.5%,

and from 2013 to 2014, 59% to $4.82. In Q4 of 2014, the futures contract price was at

$5.23.26

By use of effective primary and secondary markets, the RGGI program efficiently

distributes allowances so that companies can decide themselves what percent of the cap

they need. The economic forces of the market allow the price to adjust properly to

accommodate the 2.5% annual decrease. In both of the previous compliance periods, the

RGGI program has met all of its goals in reducing the number of CO2 emissions, as seen

in the graph below.27

Reinvestments

The cap-and-trade method is superior to just a standard cap because not only does

it cut CO2 emissions, but it also reinvests proceeds from the auctions towards programs

and services promoting clean energy. Rather than just set a maximum limit of CO2 for

26 Potomac Economics, (pg.18) 27 Hibbard et al., (pg. 4)

25

each company, the cap-and-trade method allows companies to trade for their optimal

emissions and subsequently raise money to promote clean energy at the same time. To

understand the extent of the positive impact the reinvestment process could have on the

United States if a cap-and-trade system were implemented, one can simply treat RGGI’s

past reinvestment successes as a case study that could be applied to the US.

All proceeds from the auction market are reinvested into programs and services

that promote clean-energy.28 As of recent, the RGGI program has reinvested over a

billion dollars that are projected to return more than $2.9 billion of energy bill savings to

approximately 3.7 million participating households and over 17,800 businesses.

28 “Investment of RGGI Proceeds Through 2013,” RGGI.org, pg. 4

26

The RGGI invests over 59% of its money, or over $582.5 million, into energy

efficiency. They have already avoided 10.3 million short tons of CO2 emissions. The

RGGI investment teams have made it possible for households and businesses to use

heating and cooling appliances more efficiently, thus burning less energy and

subsequently increasing savings on their electric bills. This is possible by improving

industrial processes, upgrading HVAC at offices, weatherizing and insulating buildings,

and upgrading appliances and lighting.29

The money that the RGGI program reinvests creates a domino effect that goes

much farther than promoting clean energy. By lowering energy costs, consumers are able

to spend there savings elsewhere, thus stimulating the economy. Struggling businesses

can work on getting back on their feet rather than spending the extra money on

electricity. Additionally, thousands of jobs have been sustained through the subsequent

increase in business competitiveness in the RGGI states and new programs that the RGGI

program has created have brought forth many more jobs.30

29 “Investment of RGGI Proceeds Through 2013,” RGGI.org, (pg. 4) 30 “Investment of RGGI Proceeds Through 2013,” RGGI.org, (pg. 4)

Source: “Investment of RGGI Proceeds Through 2013,” RGGI.org

27

Reinvestment Examples

One successful endeavor that has been created through RGGI investment is New

York’s EmPower program. The main focus of the EmPower program is to provide cost-

effective electric reduction measures to low-income households.31 Some of the upgrades

that the program offers are: Air sealing, Insulation, Replacement of inefficient

refrigerators and freezers, energy-efficient lighting, and free health and safety checks on

smoke detectors and other similar appliances. The EmPower program has been

extremely successful and at the end of 2013 had already eliminated over 4.1 million tons

of carbon dioxide-equivalent emissions in over 17,800 projects. In one case study, RGGI

proceeds in the EmPower program allowed one low-income family the opportunity to

have a contractor come over to inspect the home, upgrade the insulation, and give tips on

how to reduce electricity use. The family now spends significantly less on gas and is able

to heat their home with 65 degrees on the thermostat rather than the previous setting of

68. Although the three-degree difference may seem irrelevant, by improving the

installation, the family avoids an extra 10,483 pounds of greenhouse gas emissions that

they would have produced without help from EmPower.32

Conclusion

It is clear that the RGGI program has been very successful since it’s first

Compliance period in 2009. Not only has it significantly reduced CO2 emissions, but

also while doing so, has reinvested millions of dollars into programs and services, such as

EmPower, that promote clean-energy. On top of that, the RGGI program allows

thousands of families and businesses to save money on their electric bills and spend that

31 “EmPower New York,” energy.gov 32 “Investment of RGGI Proceeds Through 2013,” RGGI.org, (pg. 27)

28

money elsewhere, thus strengthening the economy. Additionally, RGGI and the

programs that it funds create and support thousands of domestic jobs for American

workers. By expanding the RGGI program to a national level, the United States could

significantly reduce CO2 and other greenhouse gas emissions, while strengthening the

economy and helping people at the same time.

29

VI. Application to the U.S.

RGGI Economic Benefits

The Regional Greenhouse Gas Initiative is one of many successful applications of

market-based solutions to the pressing environmental problem of increasing atmospheric

CO2. By applying cap-and-trade economic policy in the United States across seven

regional markets, they have successfully halved emissions while maintaining a growth

trajectory in terms of GDP since the inception of RGGI in 2009.

33

This recent application is a truly cohesive effort to combat Carbon Dioxide through a

long-term approach of allowance trading with a cap on total emissions declining by 2.5%

each year. Additionally, economic gains translated from the auction proceeds have

allowed states to initiate consumer benefit programs, showing the viability of an

emissions trading platform on a national scale due to the environmental, consumer, and

business benefits.

33 "Investment of RGGI Proceeds Through 2013." RGGI.

30

34

U.S. Applications of Cap-and-Trade: Acid Rain Program

Other applications of cap-and-trade in the United States have dated back to 1990,

as the Clean Air Act initiated the Acid Rain Program launching emissions trading on

Sulfur Dioxide and Nitrogen Oxide platforms in the United States. Having reduced

emissions by up to 40%, the program was successful in combatting these harmful

externalities of business by incentivizing firms through the prospect of economic gains.

This program allowed businesses to enact a transparent and cost effective route towards

reduction goals and truly spurred a technological advancement in the clean energy sector.

By taking a two-phase approach, the program accomplished its short-term emissions

plans and looked ahead by implementing required standards for technological and clean

energy strategies for reduction.

34 “RGGI Auction Prices Continue to Rise”. US Energy Information Administration

31

35

U.S. Applications of Cap-and-Trade: Chicago Climate Exchange

In 2003, the second larger scale application of a greenhouse gas reduction and

trading system was seen in the Chicago Climate Exchange. By including emissions of six

35“Emissions Reductions Progress Report”. US Environmental Protection Agency

32

gases, the CCX was an expansion upon the goals of the Acid Rain Program and served as

another brick in the foundation of a national cap-and-trade program. The sheer volume of

allowances traded and truly comprehensive scope of this national emissions trading

system made it the best of its kind.

36

The success of CCX is due to this combined short and long-term approach seen by the

Acid Rain Program and participants committed to an efficient and transparent market for

trading greenhouse gas allowances. The main notion that this GHG trading platform

operated off of is that by cutting the supply of allowances in the market on a yearly basis

through reduction of the total cap on a given emission, the demand will rise and price

volatility in the marketplace will spur transactions. Unfortunately, due to the lacking

urgency of global political forces and the voluntary nature of the CCX program, trading

36 “CCX Daily Settlement Price”. Intercontinental Exchange

33

volumes and price dropped through 2008 and by 2009 the commodity market had all but

ceased trading carbon emissions.

Chinese Plurilateral Market Evolution: RegionalNational

China enacted seven regional pilot programs to the pressing environmental issues

of climate change and air quality. The belief was that through plurilateral market

evolution, these markets would mature and converge into one uniform, efficient

marketplace for emissions.

37

The average allowance prices in three different regional pilot programs details the lack of

pricing consistency throughout the markets. It was impossible for China to consolidate

37 “Allowance Prices Dropping Attract Large Trades in China”. China Carbon.

34

these into one efficient marketplace for carbon allowances to achieve emissions reduction

goals due to these inconsistencies. Though the plan achieved its final goal of a national

emissions trading system, the regional programs did not garner the same success that the

U.S-based efforts achieved because these disjointed platforms did not provide investors

the same opportunity mainly due to issues of liquidity, excess allowances leading to

pricing abnormalities, and lack of incentive because of subpar returns.

Federal Greenhouse Gas Initiative

On the other hand, the RGGI provides a collaborative and transparent foundation

with a track record of success to build a national emissions trading system including all

key greenhouse gasses. Given the growing market cap, there appears to be an increasing

demand in the market for allowances indicating both economic advancement and

viability for the long-term presence of our original proposal the Federal Greenhouse Gas

Initiative (FGGI).

38

38 “Volume of CO2 Trading in RGGI”. RGGI.

35

The Federal Greenhouse Gas Initiative, inspired by the Chinese national emissions

trading system, would include the foundational basis set in place by the RGGI, but with

components of other initiatives previously discussed. Specifically, growth upon the

platform to include all major greenhouse gasses, similar to the Chicago Climate

Exchange framework, would be necessary to accomplish the large-scale reduction goals

in combatting climate change. By including this array of various businesses in multiple

sectors and a multitude of emissions allowances there would be constantly-traded

commodities in a efficient, and transparent, market. The allowances would be sold

initially through auction and on a secondary market through spot, futures, options, and

forwards emissions trading. Secondly, the two-phase methodology originated in the Acid

Rain Program would be a key component to ensuring a long and short-term approach to

reducing emissions. The short-term goals would be accomplished through active trading

of allowances, while the long-term goals would enact changes towards how businesses

deal with their emissions production in terms of service and technological advancements.

Another requirement would be a stringent cap on emissions continuing upon the yearly

limits established by RGGI with a reduction rate set at (6/7)*GDP to maintain economic

growth and promote environmental consciousness. By increasing the gradually declining

rate, it helps to prevent a repeat of the RGGI initial flooding of the market with

allowances and subsequent price drop, which would be guarded against in FGGI by a

bottom price limit. As well, limiting banked allowances would ensure businesses could

not stockpile them during periods of low demand. Finally, the FGGI would need to make

their marketplace obligatory to businesses in an effort to keep the market active and not

just encourage, but also mandate this enviro-economic policy to see tangible reductions

36

and sustainable economic growth. The FGGI would truly incorporate China’s idea of a

federally-regulated cap-and-trade system with the best components of each U.S trial

emissions trading program, ensuring an incentive driven market-based solution

combatting today’s environmental issues.

37

VII. Quantitative Analysis

The data below is from the U.S Energy Information Administration and can be

manipulated to represent the effect of the RGGI’s cap-and-trade method on CO2

emissions in all 50 states, as the FGGI proposes. The only difference in the data is that

the RGGI program focuses on CO2 emissions from the Electric Power sector, while this

data represents all energy sector CO2 emissions.

State energy-related carbon dioxide emissions by year (2009–2011)million metric tons of carbon dioxide

State 2009 2010 2011 Percent Absolute

Alabama 119.4 131.8 128.9 -8.0% -9.6

Alaska 37.7 38.5 38.4 -1.9% -0.7

Arizona 92.2 93.9 91.9 0.3% 0.3

Arkansas 60.9 65.1 66.6 -9.4% -5.7

California 365.3 358.4 344.8 5.6% 20.5

Colorado 92.3 94.7 91.0 1.4% 1.3

Connecticut 35.4 35.6 34.2 3.3% 1.2

Delaware 11.8 11.5 12.7 -7.7% -0.9

District of Columbia 3.1 3.2 3.0 3.2% 0.1

Florida 220.5 237.8 224.7 -1.9% -4.3

Georgia 160.4 169.5 154.2 3.9% 6.2

Hawaii 18.9 18.8 19.3 -1.8% -0.3

Idaho 14.9 15.6 15.4 -3.7% -0.5

Illinois 224.0 228.8 227.8 -1.7% -3.8

Indiana 206.2 217.0 209.3 -1.5% -3.2

Iowa 82.6 86.8 84.0 -1.7% -1.4

Kansas 75.1 75.2 73.5 2.1% 1.6

Kentucky 143.3 150.1 148.2 -3.4% -4.8

Louisiana 196.5 215.3 216.3 -10.1% -19.9

Maine 18.1 17.7 17.2 5.0% 0.9

Maryland 69.2 67.7 63.0 8.9% 6.1

Massachusetts 69.1 70.4 66.6 3.5% 2.5

Michigan 162.3 163.2 158.0 2.7% 4.4

Minnesota 91.5 91.1 90.8 0.7% 0.6

Mississippi 60.2 64.9 60.1 0.1% 0.1

Missouri 129.8 133.6 133.8 -3.1% -4.0

Montana 32.7 34.4 31.6 3.5% 1.2

Nebraska 46.9 49.4 51.8 -10.4% -4.9

Nevada 38.9 36.9 33.2 14.6% 5.7

New Hampshire 16.7 16.2 15.8 5.3% 0.9

New Jersey 109.7 112.2 113.1 -3.2% -3.5

New Mexico 57.7 53.8 56.2 2.7% 1.5

New York 171.3 171.5 162.0 5.4% 9.3

North Carolina 130.9 140.4 126.1 3.7% 4.9

North Dakota 51.2 52.0 53.5 -4.4% -2.3

Change

(2009-2011)

Ohio 236.3 246.9 235.1 0.5% 1.2

Oklahoma 105.7 105.3 107.0 -1.3% -1.4

Oregon 40.2 39.9 36.4 9.4% 3.8

Pennsylvania 242.7 253.7 246.2 -1.4% -3.4

Rhode Island 11.1 10.8 10.9 2.0% 0.2

South Carolina 80.2 83.1 78.9 1.7% 1.4

South Dakota 14.6 14.9 14.4 1.1% 0.2

Tennessee 101.0 108.2 104.7 -3.6% -3.6

Texas 564.2 596.6 616.3 -9.2% -52.1

Utah 64.3 63.4 63.9 0.6% 0.4

Vermont 6.0 5.7 5.7 6.3% 0.4

Virginia 103.9 106.6 97.7 6.0% 6.2

Washington 75.4 74.2 68.9 8.7% 6.6

West Virginia 89.2 99.4 96.7 -8.5% -7.6

Wisconsin 95.1 97.2 96.4 -1.3% -1.3

Wyoming 63.6 65.1 64.0 -0.6% -0.4

Total¹ 5,309.9 5,493.8 5,359.9 -0.9% -50.0

Source: U.S. Energy Information Administration (EIA), State Energy

*Blue highlight denotes RGGI state

38

To grasp the relevancy of this national emissions trading system, it is first

necessary to understand the full breadth of reductions possible due to a well-regulated

federal cap-and-trade program. A quantitative analysis of the energy-related carbon

dioxide emissions produced by each of the fifty states from 2009-2011 details the

potential extensive environmental benefits of FGGI. Under normal circumstances, the

fifty states averaged a 0.9% reduction in emissions from 2009-2011. Yet, by analyzing a

2009 2010 2011 Percent Absolute

Historical 5,310 5,494 5,360 -0.9% -50.0

2.50% 5,309 5,176.3 5,046.9 -5.2% -262.1

2.75% 5,309 5,163.0 5,021.0 -5.7% -288.0

3.00% 5,309 5,149.7 4,995.2 -6.3% -313.8

Change

(2009-2011)

4,750

4,850

4,950

5,050

5,150

5,250

5,350

5,450

5,550

2009 2010 2011

Energy-Related C02 Emission Reducitons in a National Cap-and-Trade Market

Historical

2.50%

2.75%

3%

39

range of reduction rates between 2.5% and 3%, the states could achieve anywhere

between 5.2-6.3% overall reduction in the carbon sector alone. When applied across

various industry verticals, the benefits of cap-and-trade economic policy are truly far-

reaching.

40

VIII. Conclusion

Carbon is the foremost essential building block to life on Earth; however, as a

greenhouse gas, carbon dioxide and other compounds can cause detrimental changes to

our climate. Partly due to major greenhouse emitters such as Europe, China, and the

United States, the planet is experiencing global climate change, and it will not stabilize

until human activity is met with human intervention.

Market-based solutions are the most effective way to intervene and address the

United States’ greenhouse gas dilemma, rather than alternative strategies that have been

used in the past such as decreasing our overall consumption of carbon-based fuels or

increased use of carbon-free energy. This research report asserts that the most efficient

solution involves introducing not a regional ETS but rather a national cap-and-trade

program, denoted by the Federal Greenhouse Gas Initiative (FGGI). Its overall

effectiveness is due to the capitalistic nature of the system. That is, that firms in all states

are incentivized to innovate and find new ways to reduce outputs of GHGs.

Economically, such a reduction not only prevents a firm from absorbing a host of fines

from regulators, but it also offers the opportunity to trade away their extra allowances for

profit. Over time, as the program shapes the way in which firms conduct efficient

business across the entire nation, a decrease in greenhouse gas emissions can be

observed.

Two questions arise regarding a national cap-and-trade program in the United

States such as the FGGI: its plausibility and its effectiveness. China’s efforts in

developing its own national ETS address questions of plausibility. As outlined earlier,

China developed pilot market-based programs in seven provinces; however, when

41

evaluated, the programs exhibited a few core issues, mainly being that they failed to

create a cohesive and continuous system with complete legal obligations and strong

regulatory fortitude in addition to a lack of liquidity in the trading market. As a result,

China announced last year that it would explore moving to a national emissions trading

system, and just over two months ago the nation announced a fifteen-year development

timeline for the new, improved ETS.

In addition to the plausibility of a national cap-and-trade program in the United

States, questions of the FGGI’s effectiveness also come to mind. Critics argue that short-

lived initiatives such as the Chicago Climate Exchange, which reached trading volumes

of zero in 2010, prove the ineffectiveness of an ETS in the U.S. However, the CCX

presented two major flaws: that participation was not mandatory and that there lacked

regulation on the gradual decrease of emission allowances. The two flaws caused a sharp

drop in prices and eventually a discontinuation of emissions trading on the exchange.

Other efforts in the United States, such as the Regional Greenhouse Gas Initiative

(RGGI) and Acid Rain Program prove that emissions trading systems are effective if

facilitated by a strict regulating body with the capability of gradually decreasing

emissions caps and enforcing penalties to those entities that do not comply.

The proposed Federal Greenhouse Gas Initiative (FGGI) will marry the regulatory

successes of the RGGI and Acid Rain Program with the free-market innovation of the

CCX. As a federal program, the FGGI will set a cap on all greenhouse gas emissions

allowed in each of the 50 states and have the ability to administer strict fines on entities

that do not operate within their emission allowances. Further, it will have the power to

gradually decrease emissions allowances each year by 6/7 of U.S. GDP (y/y), allowing

42

firms to secure economic efficiency without regulation-induced debilitation. The

initiative will be entirely self-sufficient, as it will have the capacity to fund itself, as well

as increase consumer benefit programs, through capital raised in auctions.

The proposed FGGI is a market-based solution that is both plausible and effective.

China’s efforts in establishing a national emissions trading system of its own is evidence

that a national-scale program is plausible in the U.S. Further, the success of regional

emissions trading markets in the U.S. is evidence that a national cap-and-trade program is

not only plausible but also presumably effective in efficiently reducing greenhouse gas

emissions in the United States. But perhaps just as important as the proposal’s plausibility

and effectiveness is that this particular cap-and-trade program will usher a new era of

environmental conservation policy that is cognizant of the quest for economic prosperity.

It aims to solve the greenhouse gas dilemma by instilling the values of American

capitalism and innovation, and sets a standard by displaying that a reduction in

greenhouse gas emissions can be synonymous with the motivation for national economic

efficiency.

43

IX. Acknowledgements

Thank you to Professors R. S. Berry and G. Tolley as well as Teaching Assistants

Jing Wu and JaeYoon Lee for a wonderful quarter.

44

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