Cost Containment for Cap-and-Trade: Designing Effective Compliance Flexibility Mechanisms

September 17, 2009

This paper is part of a series of studies on the policy design issues for cap-and-trade. As part of the Energy Security Initiative Policy Brief Series, this paper focuses on cost containment policy.


A viable long-run solution to the global climate
problem will require a sustained political
effort to confront and ultimately resolve two
top-tier policy issues. First, those with the greatest
stake in the outcome – the major economies, leading
carbon emitters and most vulnerable nations – must broadly agree on a consensus definition
of “dangerous anthropogenic interference” with
the climate system and a method for translating
such impact thresholds into global temperature,
concentration and emissions goals. Second, upon
agreeing on such an objective, these stakeholders
must then confront the more daunting challenge
of equitably distributing the total abatement burden
in order to arrive at a well-coordinated, technologically
feasible and politically sustainable set
of national emissions reduction pathways.

A related paper discusses the challenges associated with the determination of global and national emissions reduction trajectories (Mignone, 2009). Here we imagine that an appropriate US emissions reduction blueprint has already been selected from the space of available alternatives and focus more narrowly on the set of design considerations that could enhance the overall performance of the resulting regulatory program. We start from the premise that cap-and-trade will be the primary policy vehicle through which any proposed emissions reduction schedule will be realized.

In the larger taxonomy of regulatory solutions, cap-and-trade is the logical alternative to a carbon tax, which has had relatively fewer proponents in the U.S. legislative context. While either instrument can be used to motivate emissions reductions, and while both fundamentally rely on price signals to alter future investment behavior, the choice of cap-and-trade reflects a judgment about the practical and political merits of directly regulating emissions quantities. Substantively, cap-and-trade provides greater certainty about the quantity of emissions abatement at the expense of some certainty in the resulting price of emissions allowances.

In light of this tradeoff, advocates of cap-andtrade must address concerns about price and cost uncertainty in order to secure broad political support for the effort and to build a policy framework that is both cost-effective and durable over the long periods of time demanded by the climate system. Near-term uncertainty in prices – or more specifically, price volatility – is an unavoidable feature of real commodity markets, but one that is likely to be problematic in the carbon abatement context only if it is extreme enough to jeopardize the clarity of the underlying investment price signal. Maintenance of this signal is, after all, the primary motivation for establishing a carbon market.

In this paper, we focus on a key element of the response to such price uncertainty, namely the suite of compliance flexibility mechanisms that could be incorporated into the fabric of policy itself. We suggest that carefully designed temporal flexibility instruments, such as banking and borrowing, combined with a limited centralized authority to make subtle market adjustments, could eliminate most price volatility resulting from short-term economic dislocations.[1] When it comes to longer-term uncertainty and the possibility that sustained high prices and costs will threaten the durability of the policy itself, we suggest that a carefully-designed upper bound on the carbon price could reduce these threats without materially increasing the risk to the overall environmental integrity of the program.

This paper proceeds as follows: Section 2 discusses key market performance objectives relevant to the design of policy. Section 3 considers firm-level temporal flexibility mechanisms, and Section 4 examines centralized adjustment mechanisms. Section 5 discusses more explicit measures to control prices and costs, and Section 6 summarizes the major issues and discusses the ways in which policies could be combined successfully in the context of a real carbon trading regime.

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[1] Of course, there are likely to be other sources of volatility in the market. Price risk from such volatility could be addressed using other common hedging tools, like futures and options contracts. For a discussion of such hedging instruments and the implications for the development and regulation of the future carbon derivatives market, see Pirrong (2009).