1. The document introduces cap-and-trade as a market-based policy approach to reducing greenhouse gas emissions by establishing a limit on emissions that declines over time, and allowing pollution permits that can be traded. 2. It uses a game of musical chairs as an analogy to illustrate key concepts of cap-and-trade such as trading permits, market price determination, incentives to reduce emissions, and challenges around leakage, offsets, and policy design choices. 3. Important considerations in cap-and-trade design include how to allocate initial permits, whether to use auctions or free allocation, and how to spend revenues to address equity and transition support.

1. An Introduction to Cap-and-Trade Climate Policy Holmes Hummel, PhD hummelhh@mindspring.com November 21, 2007 Using Musical Chairs: An Illustration of Managed Scarcity

12. Would anyone be willing to trade their chair for $30 ?

13. Sure! For that price, I can finance an efficiency upgrade, eliminating my need for a pollution permit.

16. Using Market Incentives If I could I build wind farms to replace my coal power plants, then I could sell permits… 2009

17. Using Market Incentives Hey, I made a profit by reducing my fossil fuel use and avoiding carbon emission costs! 2010

20. Achieving Reduction Targets Who will be the last greenhouse gas polluters left in the game? 2050

24. Achieving Reduction Targets $90 $90 $90 How high can the price go? As high as it takes to motivate one of us to stand up. 2020 SELL PRICE:

27. The Problem of “Leakage” At higher carbon prices, I’ll need to close my cement plant – or move it to another country... $90 $90 $90 2050 SELL PRICE:

28. The Problem of “Leakage” $90 $90 $90 “ Leakage” occurs when polluters move to avoid regulation – which is why an international agreement is so important . SELL PRICE:

29. The Problem of “Leakage” “ Leakage” occurs when polluters move to avoid regulation – which is why an international agreement is so important . Otherwise, a national climate policy may drive jobs away and still not reduce global emissions. $90 $90 $90 SELL PRICE:

30. The Problem of “Offsets” $20 $20 $20 Opposite to leakage, a player may find a business sector that isn’t covered by the policy … but has a lower cost opportunity to reduce emissions. $15 Reducing methane from hog farms SELL PRICE:

31. The Problem of “Offsets” Because all tons of carbon emissions affect the atmosphere the same, this offset could be accepted as equivalent to a permit . $20 $20 $20 $20 No one would have used this chair unless I went out and bought it – and it’s just as good as any other! SELL PRICE:

32. The Problem of “Offsets” $20 $20 $20 However, it can be difficult to verify that the player’s investment was responsible for those reductions – and that they actually happened. Therefore, standards for offsets must be high to ensure the carbon reductions are real – and not “hot air.” $20 SELL PRICE:

33. The Problem of “Offsets” $20 $20 $20 China, India, and other countries have some very low cost opportunities to reduce emissions. However, the U.S. Congress did not ratify the Kyoto Protocol that makes use of the Clean Development Mechanism for offsets. $20 SELL PRICE:

34. The Problem of a “Safety Valve” $20 $20 $20 Some companies want market-based policies, but not market risk. SELL PRICE:

35. The Problem of a “Safety Valve” $20 $20 $20 Some companies want market-based policies, but not market risk. My business cannot cope with the possibility that carbon prices might exceed $20/mtCO 2 ! SELL PRICE:

36. The Problem of a “Safety Valve” $20 $20 $20 Some companies want market-based policies, but not market risk. A “safety valve” would put a cap on the carbon price rather than on the emissions, allowing firms to protect their investments by buying unlimited pollution permits at a guaranteed maximum price. SELL PRICE:

37. The Problem of a “Safety Valve” $20 $20 $20 Some companies want market-based policies, but not market risk. A “safety valve” would put a cap on the carbon price rather than on the emissions, allowing firms to protect their investments by buying unlimited pollution permits at a guaranteed maximum price. $20 $20 $20 SELL PRICE:

38. The Problem of a “Safety Valve” However, a “safety valve” would effectively violate the cap on emissions, and convert the policy to a stable tax . Anyone can burn as much coal as they’d like if they can pay the fee. $20 $20 $20 $20 $20 $20 $20 $20 SELL PRICE:

39. The Problem of a “Safety Valve” With a “safety valve” on the price of carbon, the market drivers are weaker, making command & control policies even more important. Building codes, fuel economy standards, renewable portfolio standards, tax laws, and other legal requirements are essential – as they are today. $20 $20 $20 $20 $20 $20 $20 $20 SELL PRICE:

40. Banking $90 $90 $90 $90 Players who receive more permits than they need would like to “bank” them. By saving a spare permit, the player can to pollute that amount in a future year or to sell that permission to someone else in the future. SELL PRICE: 2020 2015 2016 2017

41. Banking $90 $90 $90 $20 I’m glad I reduced emissions and saved permits in earlier years – because now they are worth much more! SELL PRICE: 2020 2015 2016 2017

42. Borrowing Similarly, some people who lack sufficient permits to cover their pollution would like to “borrow” them from the permits they expect to receive in the future. $90 $90 $90 $90 I can’t afford this market. I’d rather borrow from the future and hope that technology and business opportunities get better… SELL PRICE: 2020

43. Borrowing $90 $90 $90 $90 Didn’t Social Security and the national debt get into trouble that way?? SELL PRICE: 2020 on credit, due 2025

49. Auctioning Permits vs Allocating for Free $0 $0 $0 $0 $20 $20 $0 BUY: Auctioned permits Free permits Why is this a cause for concern? 2. Unearned windfall profits: In a carbon market, firms that buy permits in an auction will try to pass costs to customers, and others receiving a permit for free can sell their permits at that same price.

50. Auctioning Permits vs Allocating for Free $0 $0 $0 $0 $20 $20 $0 BUY: SELL: $20 $20 $20 $20 $20 $20 $20 Unearned windfall profits Cost passed to consumers Why is this a cause for concern? 2. Unearned windfall profits: In a carbon market, firms that buy permits in an auction will try to pass costs to customers, and others receiving a permit for free can sell their permits at that same price.