The Financial Market Solution to Carbon Emissions

John Parsons

While health care remains the hot topic on Capitol Hill, another piece of legislation is poised to gain similar attention.  Regulating carbon emissions to address the threat of global warning is a top priority of the Obama administration, and its favored approach is to create a “cap-and-trade” market.

A cap-and-trade market allows carbon emitters to buy and sell allowances – the right to emit carbon dioxide (CO2) – on an open exchange.  The framework for this market has already been laid out in the Waxman-Markey Cap & Trade Bill (H.R. 2454), which passed the House on June 26 and now awaits Senate review.

John Parsons, a Senior Lecturer at the MIT Sloan School of Management and Executive Director of MIT’s Center for Energy and Environmental Policy Research, spoke about the proposed legislation to a group of analysts in Boston last week.

Parsons believes cap-and-trade is the best approach to addressing carbon emissions.  He described two other successful attempts at regulating emissions through a cap-and-trade approach: the US has had a sulfur dioxide (SO2) market since 1995 and the European Union has had a CO2 market since 2005.

Success is far from guaranteed, however, and Parsons also spoke about a number of problems posed by the Waxman-Markey bill.

How it works

The goal of the cap-and-trade system under the Waxman-Markey bill is to regulate CO2 along with a number of other gasses, including methane, nitrous oxide, and hydrofluorocarbons (HFCs), which are used in refrigerators and air conditioners.  But the main target is the 6 million tons of CO2 that US industry produces annually (as of 2005); the other gases combined contribute about 1 million CO2-equivalent tons to global-warming pollution.

The Waxman-Markey bill aims to reduce CO2 emissions to 17% of 2005 levels by 2050.

Coal- and natural gas-burning electrical utilities, which produce 39% of US CO2 emissions, are the primary target of the legislation.  Caps on those companies would be phased into the program beginning in 2012, along with automobiles, the second-largest target at 31% of emissions.  Industries such as steel production would be included in 2014 and natural gas distributors in 2016.

The graph below illustrates how the cap-and-trade program will reduce emissions: Cap and Trade

The horizontal line at 7 million tons represents the 2005 level of CO2 and other emissions.  The blue region represents the decline in CO2 emissions achieved through the program, and those “savings” are represented by the red region.

Certain emissions, such as those produced by agriculture and forestry, are excluded from the legislation. They are represented by the yellow region.