Cap-and-Trade Basics

Trading Allows Regulated Entities to Choose Compliance Options

Pollution Stacks

The cap-and-trade system establishes a carbon cost associated with emitting greenhouse gases (GHGs) through a carbon market.

Regulated entities will look for less-polluting and more efficient ways to use energy and produce products or pay for the price of carbon allowances in the carbon market.  Regulating by a market-based compliance mechanism such as the California cap-and-trade program (program) will initiate a signal to regulated entities to invest in less-polluting technologies or suffer increased costs to do business.  As designed, the program let’s the emitter choose the pathway to comply with the regulation to reduce GHGs at the cheapest cost.  Businesses will need to seek out the most cost effective ways to modify their operations to use and produce energy more efficiently to reduce GHGs.

Why trading?

The trading mechanism allows entities to buy and sell their allowances or purchase offsets credits on an open market, giving them a clear incentive to operate as efficiently as possible.  Entities that can reduce GHGs and no longer need their allowances will be rewarded by being able to sell them, whereas entities that find themselves unable to increase energy and fuel efficiency will have to buy additional allowances or obtain "offset credits" to account for the additional GHGs.  Offsets are actions, such as the planting of trees that absorb GHGs, or the destruction of ozone depleting substances.  Trading and banking of carbon allowances allow entities to choose compliance options and minimizes costs through compliance flexibility.  Selling unused allowances creates an incentive to operate cleanly. The carbon market creates financial incentives to help businesses to invest in clean technologies and establishes a market where those incentives can be freely traded while allowing for market forces to work at the job of curbing climate change.

How does it work?

For example, a business with electricity generation operations such as a utility could implement cleaner operations that emit less GHGs.  If this business reduces GHGs, then they can sell their allowances to other entities that have not reduced GHGs within a particular compliance period.  The carbon market allows entities to seek out less-polluting generation systems if it is less expensive to do it, whereas companies that find it difficult or expensive to reduce GHGs can buy allowances from other regulated entities in the carbon market to cover their GHGs.  The regulated entity will make a choice to invest in clean technologies to reduce GHGs, or buy excess allowances in an auction from other regulated entities to cover their reported GHGs.  Ultimately, the carbon market ensures that GHG reductions targets are met because the cap declines approximately 2 to 3 percent per year.  As result, fewer allowances are available to buy later in the program making it an incentive for early reductions of GHGs.

Why set a price on carbon?

By putting a price on GHGs it will keep the costs of implementation low and spur investment in California’s Clean Energy Future and intrinsically encouraging the development of a clean energy economy that promotes clean renewable sources of energy.  Essentially, an economy-wide price on carbon sends a clear signal that California is serious about powering the economy with clean, less-carbon intensive technologies.

We designed our program to carefully ensure that the initial price on carbon is strong enough to begin immediately sending the right signals without creating economic shockwaves.  The design of the allocation system, which is the means to distribute allowances during the startup of the program, relies on both free allocation and auction of allowances. The provisions for free allocation are designed to encourage greater efficiency of production, which means that there are simply no incentives for regulated entities to increase GHGs as a means to receive more allowances.

California’s carbon market will set a price on carbon that has been estimated to be between $15 to $30 per one allowance (or one metric ton of carbon dioxide equivalent).



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