Tools of the Trade


A Guide to Designing and


Operating a Cap and Trade


Program for Pollution Control

Tools of the Trade:


A Guide To Designing and


Operating a Cap and Trade


Program For Pollution Control


United States Environmental Protection Agency 

Office of Air and Radiation 

EPA430-B-03-002 

www.epa.gov/airmarkets 

June 2003 
Table of Contents 

Acknowlegments ............................................................................................................................................................................................................ii


Chapter 1: Introduction ............................................................................................................................................................................................1-1


Introduction ........................................................................................................................................................................1-1


Purpose ................................................................................................................................................................................1-1


Structure ..............................................................................................................................................................................1-1


Cap and Trade ....................................................................................................................................................................1-2


Chapter 2: Is Cap and Trade the Right Tool?......................................................................................................................................................2-1


Introduction ........................................................................................................................................................................2-1


General Assessment Issues ................................................................................................................................................2-1


Comparison of Cap and Trade and Other Policy Options ..............................................................................................2-5


Chapter 3: Developing a Cap and Trade Program ..........................................................................................................................................3-1


Introduction ........................................................................................................................................................................3-1


Guiding Principles ..............................................................................................................................................................3-1


Establishing Legal Authority ............................................................................................................................................3-2


Creating an Emission Inventory ........................................................................................................................................3-3


Program Design Elements ................................................................................................................................................3-4


Other Design Considerations ..........................................................................................................................................3-25


Chapter 4: How to Implement and Operate a Cap and Trade Program ................................................................................................4-1


Introduction ........................................................................................................................................................................4-1


Integrated Information Systems ........................................................................................................................................4-1


Auditing and Verification ..................................................................................................................................................4-4


Technical Support for Regulated Sources ........................................................................................................................4-5


Administrative Costs Associated with Cap and Trade ....................................................................................................4-6


Chapter 5: Assessment and Communications..................................................................................................................................................5-1


Introduction ........................................................................................................................................................................5-1


Communicating Status and Results ..................................................................................................................................5-1


Communication Issues Unique to Emission Trading Programs ....................................................................................5-2


Modes of Communication..................................................................................................................................................5-5


Continued Assessment ......................................................................................................................................................5-5


Glossary of Terms..........................................................................................................................................................................................Glossary-1 

Acronyms......................................................................................................................................................................................................Acronyms-1 

References..................................................................................................................................................................................................References-1 

Appendix A: The Optimal Level of Pollution ....................................................................................................................................................A-1


The Economics of Emission Trading ..............................................................................................................................A-2


Appendix B: Example Assessment of the Potential For Cap and Trade ..................................................................................................B-1


ii Table of Contents 
Acknowledgments 

T

he U.S. Environmental Protection Agency (EPA) would like to acknowledge the many individual contributors to this document, without whose efforts this guidebook would not be complete. Although the complete list of experts who have provided technical and editorial support is too long to list here, we would like 

to thank some key contributors and reviewers who have played a significant role in developing this guidebook. 

In particular, we wish to acknowledge the efforts of the staff of the Clean Air Markets Division (CAMD) of 

the U.S. EPA – the division responsible for operating the U.S. SO2 Allowance and Ozone Transport Commission 

(OTC) NOx Budget Trading Programs. Many staff contributed to this guidebook, including Rona Birnbaum, 

Kevin Culligan, Katia Karousakis, Stephanie Grumet, Richard Haeuber, Melanie LaCount, Sasha Mackler, 

Brian McLean, Beth Murray, Sam Napolitano, and Sharon Saile. Special mention is due to Jennifer Macedonia 

and Mary Shellabarger who did much of the planning and development of this guidebook. Joe Kruger and 

Jeremy Schreifels compiled and edited the completed document. 

This guidebook benefited immensely from the comments and suggestions of a panel of external reviewers, 

including Dallas Burtraw, Resources for the Future; Andrzej Blachowicz, Center for Clean Air Policy; Tomas 

Chmelik, Czech Ministry of Environment; A. Denny Ellerman, Massachusetts Institute of Technology; Erik 

Haites, Margaree Consultants; Blas Pérez Henríquez, University of California-Berkeley; Stan Kolar, Center for Clean 

Air Policy; Nancy Seidman, Massachusetts Department of Environmental Protection; Jintian Yang, Chinese 

Research Academy of Environmental Sciences; and Peter Zapfel, European Commission. We would like to 

thank each of them for their insightful comments and suggestions. 

We would also like to thank the staff at ERG for graphics and production support. 

iii Acknowledgements 
1 

Introduction


Introduction 

T

o ensure a cleaner, healthier environment, governments are increasingly using market-based 

pollution control approaches, such as emission 

trading, to reduce harmful emissions. The theory of 

emission trading and the potential benefits of marketbased incentives relative to more traditional environmental policy approaches are well established in 

economic and policy literature. Until recently, however, 

practical applications of emission trading programs 

have been relatively limited. In 1990, the United States 

enacted legislation to implement a comprehensive 

national sulfur dioxide (SO2) program using a form of 

emissions trading called “cap and trade.” The U.S. 

SO2 cap and trade program has proven to be highly 

effective from both an environmental and an economic 

standpoint. The success of this program and others 

that followed has spurred interest from policymakers, 

regulating authorities, and business and environmental 

organizations. Today, emission trading mechanisms are 

increasingly considered and used worldwide for the 

cost-effective management of national, regional, and 

global environmental problems, including acid rain, 

ground-level ozone, and climate change. 

Purpose

This guidebook is intended as a reference for policymakers and regulators considering cap and trade as a 

policy tool to control pollution. It is intended to be 

sufficiently generic to apply to various pollutants and 

environmental concerns; however, it emphasizes cap 

and trade to control emissions produced from stationary source combustion. In the United States, SO2 and 

NOx are controlled with cap and trade programs. 

These programs provide many illustrative examples 

that are described within this text. 

Structure 

This guidebook is organized as follows: 

•	 The introduction explains the policy tool known 

as cap and trade. 

•	 Chapter 2 provides guidance on how to determine if cap and trade is the right solution for a 

particular problem and describes how it varies 

from other policy options, including other forms 

of emission trading. 

1-1 Introduction 
•	 Chapter 3 explains the process for developing a 

cap and trade program. 

•	 Chapter 4 explains how to implement and operate a cap and trade program. 

•	 Chapter 5 discusses how to assess the results of a 

cap and trade program and communicate them to 

the public. 

•	 Glossary of Terms and Acronyms contains definitions of the terms and abbreviations used 

throughout this guidebook. 

•	 References contains a list of articles and papers 

cited in this guidebook. 

• The Appendices contain additional technical 

and reference information. 

Specific examples are provided throughout the text. 

These examples draw on the experience from cap and 

trade programs, including the U.S. SO2 Allowance 

Trading Program (also known as the Acid Rain 

Program), the Regional Clean Air Incentives Market 

(RECLAIM) in Southern California, the Ozone 

Transport Commission (OTC) Regional NOx Trading 

Program in the Northeastern United States, and the 

United Kingdom’s emission trading program for carbon dioxide (CO2). These examples were selected to 

illustrate various aspects of cap and trade and are not 

intended to endorse controls on a specific pollutant. 

Cap and Trade 

Cap and trade is a market-based policy tool for environmental protection. A cap and trade program establishes 

an aggregate emission cap that specifies the maximum 

quantity of emissions authorized from sources included 

in the program. The regulating authority of a cap and 

trade program creates individual authorizations 

(“allowances”) to emit a specific quantity (e.g., 1 ton) 

of a pollutant. The total number of allowances equals 

the level of the cap. To be in compliance, each emission source must surrender allowances equal to its actual emissions. It may buy or sell (trade) them with other 

emissions sources or market participants. Each emission 

source can design its own compliance strategy – emission reductions and allowance purchases or sales – to 

minimize its compliance cost. And it can adjust its 

compliance strategy in response to changes in technology or market conditions without requiring government 

review and approval. 

How a Cap and Trade Program Works 

1. The regulating authority sets a cap on total 

mass emissions for a group of sources for a 

fixed compliance period (e.g., 1 year). 

2. The regulating authority divides the cap into 

allowances, each representing an authorization to emit a specific quantity of pollutant 

(e.g., 1 ton of SO2). 

3. The regulating authority distributes 

allowances. 

4. For the compliance period, each source measures and reports all of its emissions. 

5. At the end of the compliance period, each 

source must surrender allowances to cover the 

quantity of the pollutant it emitted. 

If a source does not hold sufficient allowances to 

cover its emissions, the regulating authority imposes 

penalties. 

Environmental Certainty 

Cap and trade programs offer a number of advantages 

over more traditional approaches to environmental regulation. First and foremost, cap and trade programs can 

provide a greater level of environmental certainty than 

other environmental policy options. The cap, which is 

set by policymakers, the regulating authority, or another governing body, represents a maximum amount of 

allowable emissions that sources can emit. Penalties 

that exceed the costs of compliance and consistent, 

effective enforcement deter sources from emitting 

beyond the cap level. In contrast, traditional policy 

approaches such as command-and-control regulation 

generally do not establish absolute limits on allowable 

emissions but rather rely on emission rates that can 

allow emissions to rise as utilization rises. 

With cap and trade programs, even new emission 

sources may not increase the limits on emissions. The 

regulating authority may require new entrants to purchase or receive allocated allowances from the total 

allowable emissions set by the cap (see Chapter 3 for a 

description of different ways that new entrants may be 

treated). Thus, the emissions target is maintained and 

the price of an allowance can adjust to reflect the 

increased demand for allowances. 

A cap and trade program may also encourage 

sources to pursue earlier reductions of emissions than 

would have otherwise occurred, which can result in 

1-2 Introduction 
the earlier achievement of environmental and human 

health benefits. This is a result of two primary drivers: 

first, the cap and associated allowance market creates 

a monetary value for allowances, providing sources 

with a tangible incentive to decrease emissions. 

Second, a cap and trade program can incorporate the 

flexibility of banking (see Chapter 4) to provide 

sources with an additional incentive to reduce emissions earlier than required. Banking allows sources to 

carry over unused allowances for use in a later compliance period when there might be more restrictive 

requirements or higher expected costs to reduce emissions. Essentially, banking gives sources some flexibility in the timing of emission reductions (i.e., temporal 

flexibility). This is in addition to flexibility given to 

sources in the location at which they make emission 

reductions (i.e., spatial flexibility). 

Another environmental advantage of cap and trade 

is improved accountability. Participating sources must 

fully account for every ton of emissions by following 

protocols to ensure completeness, accuracy, and consistency of emission measurement. This system contrasts with most environmental programs that base 

compliance on periodic inspections and assumptions 

that equipment is functioning and the source is in 

compliance between inspections. 

Accurate measurement of emissions and timely 

reporting are critical to the success of a cap and trade 

program and the integrity of the cap. After emissions 

data and allowance transaction information are reported, 

Figure 1. Cost Minimization With Trading 

the regulating authority can provide detailed or summary information to the public (e.g., on the Internet). This 

transparency, or access to information, can provide confidence in the effectiveness of the program. 

Minimizing Control Costs 

In addition to the environmental benefits of adopting 

a cap and trade program, significant economic benefits 

also support the use of such a mechanism. Cap and 

trade programs provide sources with flexibility in how 

they achieve their emission target, which is uncommon 

under traditional environmental policy approaches. 

The cap establishes the emission level for emission 

sources; the sources, however, are provided with the 

flexibility of choosing how they want to abate their 

emissions. Each source can choose to invest in abatement equipment or energy efficiency measures, to 

switch to fuel sources with no or reduced emissions, or 

to shutdown or reduce output from higher emitting 

sources. The regulating authority does not need to 

approve each source’s compliance choices because the 

cap, accompanied by emission measurement and 

reporting requirements, enable the regulating authority to focus on assessing compliance results (i.e., ensuring that each source has at least one allowance for each 

unit of pollution emitted). Cap and trade programs 

also allow sources to trade allowances, providing an 

additional option for complying with the emissions target. Sources that have high marginal abatement costs 

(i.e., the cost of reducing the next unit of emissions) 

can purchase additional 

allowances from sources that 

have low marginal abatement 

Initial Emissions 

Allowable limit 

(cap) 

Abatement Cost: $100/ton 

Reduction: 5 tons 

Abatement Cost: $80/ton 

Reduction: 7 tons 

Abatement Cost: $120/ton 

Reduction: 3 tons 

Potential transfer of 2 allowances for $80-$120 each 

3 tons 5 tons 

7 tons 

10 tons 10 tons 10 tons 

costs. In this way, both buyers 

and sellers of allowances can 

benefit. Sources with low costs 

can reduce their emissions 

below their allowance holdings 

and earn revenues from selling 

their excess allowances – a 

reward for better environmental 

performance. Sources with high 

costs can purchase additional 

allowances at a price that is 

lower than the cost to reduce a 

unit of pollution at their facility 

(see Figure 1). This outcome is 

consistent with the “polluter 

pays” principle. 

1-3 Introduction 
A well designed cap and trade program can also 

provide continuous incentives for innovation in emission abatement. Because of the value attached to 

allowances. The value creates an economic incentive 

to invest in research and development for emission 

abatement options that can further reduce the costs of 

attaining compliance. 

Finally, the cost-minimizing feature of cap and trade 

has long-term environmental benefits. Driving down 

the cost of reducing a unit of pollution means that policymakers and regulating authorities can set targets that 

reduce more pollution at the same cost to society. This 

system makes it economically and politically feasible to 

achieve greater environmental improvement. 

1-4 Introduction 
2 

Is Cap and Trade 

the Right Tool? 

Introduction 

Cap and trade can be an effective tool to address 

air pollution. However, it is not appropriate in all 

situations or for all environmental problems. 

Policymakers should consider a number of important 

issues before deciding whether cap and trade is appropriate. Prior to developing a cap and trade program, 

policymakers and other experts should determine 

whether the nature of the environmental problem, as 

well as the institutional capacity and political situation, 

is conducive to the successful establishment of such a 

program (Benkovic and Kruger, 2001). 

This section begins with a brief discussion of some 

of the general issues that must be assessed for any 

type of emission reduction program. Next, the section 

examines whether cap and trade can address a particular environmental problem. Finally, it compares cap 

and trade to other types of policies including different 

forms of emission trading. 

General Assessment 

Issues 

Before making a decision about an emission reduction 

program, policymakers should assess a number of science, technology, and other issues. For example, regardless of the type of program chosen, policymakers must 

understand the nature of the environmental or health 

problem of concern, the pathways of exposure, the location and magnitude of the sources that contribute to the 

problem, and the emission reductions necessary to 

address the problem. Similarly, policymakers should 

have answers to technical and economic questions such 

as the cost, availability, and performance of control technologies. Although a full discussion of these questions 

is beyond the scope of this manual, Appendix B summarizes how some of these questions were addressed 

under the U.S. SO2 Allowance Trading Program. 

Once policymakers have a thorough understanding 

of these issues and questions, they can determine 

whether cap and trade is an appropriate tool to address 

the problem. The following sections outline some of 

the key considerations used to determine whether cap 

and trade will be an effective program for a particular 

situation. 

2-1 Is Cap and Trade the Right Tool? 
Is Flexibility Appropriate? 

Cap and trade is premised on the notion that regulators do not need to direct the type or location of specific emission reductions within a region. Instead, 

these programs set an overall target and let “the market” determine where to make the most cost-effective 

reductions. In some cases, however, it does matter 

where an emission reduction is made. For example, 

some toxic emissions may have primarily local health 

impacts in the area immediately surrounding a facility. 

Allowing such a facility to buy allowances from other 

similar facilities in the area may not fully address the 

risks caused by its emissions. It may make a situation 

worse by causing a “hotspot” if the cap does not 

require sufficient reductions to minimize or prevent 

local impacts. In such a case, it may be necessary, from 

a public health standpoint, to impose source-specific 

controls and limit the flexibility inherent in an emission trading program. 

In general, the more a pollutant is uniformly dispersed over a larger geographic area, the more appropriate it is for the use of cap and trade. 

Even when the location of emissions does matter, 

cap and trade may be effective if the environmental 

goal can be met through emission reductions in a general region. For example, a cap and trade program can 

reduce total loadings of a pollutant into the atmosphere, particularly if these pollutants are emitted by 

many sources and transported over a large geographic 

region. This was the case in the United States with 

the SO2 Allowance Trading Program, which is intended 

to reduce acid deposition in the Eastern United States 

and Canada. Similarly, cap and trade programs can 

address ambient air quality problems by reducing 

background levels of pollution that contribute to 

adverse air quality. For example, if there are prevailing 

winds, it may be necessary to include emission sources 

upwind of the polluted area that could prevent downwind areas from meeting their ambient air quality 

standards. The NOx cap and trade programs in the 

Northeastern United States were designed to reduce 

long-range transport of NOx emissions that lead to the 

formation of ground-level ozone. 

Before designing cap and trade programs to address 

emissions that are not uniformly mixed, it is necessary 

to conduct an assessment of the possibility of 

hotspots. Chapter 3 contains a discussion about ways 

to assess the potential for hotspots and how to develop 

policies to avoid them if necessary. In such cases regulating authorities may need to limit emissions at specific sources or limit trading to ensure that the program does not create hotspots and that it achieves the 

environmental objectives. It should be noted, however, that if a program requires too many trading restrictions to avoid hotspots, a more conventional regulatory 

approach to address the problem might be preferable. 

Do Sources Have Different 

Control Costs? 

Cap and trade programs make the most sense when 

emission sources have different costs for reducing 

emissions (Newell and Stavins, 1997). These cost differences may result from the age of the facilities, availability of technology, location, fuel use, and other 

factors. In the U.S. SO2 Allowance Trading Program, 

there was considerable diversity in emission reduction 

costs because of differences in the age of power plants 

and the proximity to low sulfur coal supplies (Stavins, 

1998). Where costs are different, there is “room for a 

deal,” because sources with high marginal abatement 

costs have an incentive to buy allowances from sources 

with low marginal abatement costs. Conversely, if 

affected sources tend to be relatively homogenous, 

their marginal abatement costs may be approximately 

equal and there is little incentive for trading. In this 

case, a cap and trade program is not likely to yield a 

significantly more cost-effective outcome than more 

traditional types of regulation. Table 1 is a compilation 

of SO2 marginal control costs for sources in Taiyuan, 

China. The data were used to assess the feasibility of 

using cap and trade to reduce SO2 emissions. This 

type of analysis is critical to determining the merits of 

using cap and trade as a policy instrument. 

Are There Sufficient Sources? 

In general, cap and trade programs should include 

enough sources to create an active market for 

allowances. If there are too few sources, there may be 

few opportunities for trading. In addition, even if there 

are cost-effective trading opportunities in a program 

with few sources, a market with few transactions could 

make potential sellers reluctant to part with their 

excess allowances. These potential sellers could be 

concerned that if business conditions change and they 

need more allowances in the future, they will have difficulty purchasing them. They may instead hoard 

excess allowances even though it might not appear to 

2-2 Is Cap and Trade the Right Tool? 
Table 1: Cost-Effectiveness of SO2 Control Measures in 

Taiyuan, China 

Control Source Cost/ton 

(US$) 

Treat post-combustion gas Taiyuan District Heating $60 

Flue gas desulfurization (FGD) Eastern Mountain Power Plant $80 

Lower sulfur coal (~1.3%) Taiyuan #1 and #2 Power Plants, 

Taiyuan Iron & Steel $100 

FGD (simplified) Taiyuan #1 Power Plant * $240 

Limestone fuel additive Coal Gasification Plant $130 

* In addition to unspecified costs paid through a grant from the government of Japan. 

Source: RFF, 2001 

they must follow national policies but are given considerable 

autonomy in implementation.2 

To the extent that the region of 

a cap and trade program covers 

more than one jurisdiction, the 

authorities should maintain 

some consistency in key design 

elements of the program. To 

ensure that the allowances are 

consistent and fungible across 

jurisdictions, cap and trade programs require common design 

elements, including standards 

for determining applicability, 

emissions measurement and 

reporting, recordkeeping, 

enforcement, and penalties for 

be in their economic interest to do so. Additionally, 

with fewer sources, there may be a concern that larger 

sources may exert market power and withhold 

allowances from the market to drive up prices of 

allowances. 

There is a tradeoff, however, in that the more numerous the sources, the more complex and costly the cap 

and trade program may be to establish and operate. For 

example, a cap and trade program for vehicles could be 

administratively costly if there was a need to measure 

and report emissions and enforce compliance at the 

vehicle level.1 Technological advances, however, are 

making it possible to cost-effectively expand participation in cap and trade programs (e.g., computerized data 

tracking systems, improved emission measurement technology (Kruger, et al., 2000)). 

Is there Adequate Authority? 

Another important question government officials must 

consider is whether the relevant government entity has 

sufficient jurisdiction over the geographic area where 

they would implement the cap and trade program. In 

many countries, regional or local authorities are responsible for implementing environmental programs. Often, 

non-compliance (Kinner, 2002). 

Thus, program designers should answer the following 

questions: 

•	 Will provinces and municipalities be responsive 

to directives, such as monitoring requirements, 

imposed by the national government or would 

they cooperate to form a collective effort to 

develop such requirements? 

•	 Does the central government, or coalition of 

local governments, have the capacity to enforce 

compliance provisions and penalties throughout 

the entire trading region? 

Other design elements, such as allocation methodologies for assigning the initial distribution for 

allowances, might be left to the provinces or municipalities since the allocation methods have little environmental impact. 3 

Are there Adequate Political 

and Market Institutions? 

For the trading component of a cap and trade program 

to work, a country must have some of the same institutions and incentives in place as those required for any 

type of market to function. These include: 

1	 Other environmental policy tools, or alternatively, the compliance obligation and allowance allocation at the vehicle manufacturer, fuel refiner or 

distributor level, may be more appropriate in this case. 

2	 For example, China’s provincial Environmental Protection Boards have the main responsibility for running air quality and other environmental 

programs. Similarly, in Slovakia there are 79 local districts that implement environmental and other programs. 

3	 Allowing different provinces or municipalities to have different allocation schemes may have distributional economic impacts, such as favoring 

firms within an industrial sector in one region of a country over another. This result could have economic efficiency effects if product markets 

are not perfectly competitive. 

2-3 Is Cap and Trade the Right Tool? 
•	 A developed system of private contracts and 

property rights (see Chapter 3 for discussion of 

property rights issues associated with emission 

trading). 

•	 A private sector that makes business decisions 

based on the desire to lower costs and raise profits. 

•	 A government culture that will allow private businesses to make decisions about “how” to achieve 

objectives with a minimum of intervention. 

As with all environmental programs, a cap and trade 

program requires adequate enforcement to ensure that 

emission objectives are met. In addition, for an 

allowance market to develop, market participants must 

be confident that sources will measure and report 

emissions correctly, the regulating authority will verify 

compliance, and, if there is non-compliance, the regulating authority will assess sufficient financial penalties. Thus, cap and trade programs will have greatest 

success in countries where rule of law is respected and 

enforcement is consistent, impartial, transparent, and 

independent of political considerations (EDf and 

RSHE, 2000). In addition, once regulations are implemented, they should be changed only through transparent and fair procedures. Participants should clearly 

understand from the beginning how the program 

works and how regulating authorities will measure and 

enforce compliance. Interest in a trading program will 

diminish significantly if firms believe that rules are 

unfair, arbitrary, or unpredictable. 

Even if a country does not yet have all of the attributes described above, it may still be beneficial to 

develop the infrastructure necessary for a cap and 

trade program in advance of more comprehensive economic changes (Ellerman, 2002). As centrally planned 

economies make the transition to become more market oriented, they may also transform their environmental programs to become more efficient. Even if 

conditions are not yet ripe for trading, the structure of 

a cap and trade program may improve environmental 

performance. In particular, the emphasis on careful 

mass-based emission measurement and accounting 

may improve environmental accountability of sources. 

For example, recent experiments in Slovakia (CCAP, 

2001) and Chile (Montero, et al., 2000) have indicated 

that the allocation process associated with cap and 

trade has served as an incentive for more complete 

and accurate emission inventories. 

Are Measurement Capabilities 

Sufficiently Accurate and 

Consistent? 

In considering whether cap and trade is an appropriate 

tool to address an environmental problem, policymakers should consider whether sources covered by the 

program can measure emissions with sufficient accuracy and consistency to support the cap and trade policy 

tool. (For a discussion of emission measurement priorities and issues for a cap and trade program, see 

Chapter 3.) 

Unlike many types of environmental regulation 

where regulating authorities judge compliance by 

adherence to detailed technology or process specifications, cap and trade programs require a purely performance-based test for compliance. Ultimately, measured 

emissions dictate how many allowances a source must 

surrender at the end of the compliance period. Thus, 

the measured emissions dictate how many extra 

allowances a source may be able to sell or how many 

additional allowances a source may need to buy. If one 

source uses a less accurate emission measurement 

method than another, and consequently underestimates its actual emissions, it could surrender fewer 

allowances than necessary to offset its emissions. If 

this scenario occurred, the emission goal (or cap) 

would not be met. In addition, facilities with opportunities to reduce emissions beyond required levels 

would lose some of the economic incentive, because 

the underreporting sources need fewer allowances for 

compliance and will therefore either increase the supply or decrease demand for allowances. 

2-4 Is Cap and Trade the Right Tool? 
Comparison of Cap 

and Trade and Other 

Policy Options

A number of different policy tools can be used to 

address environmental concerns. These include: 

•	 Economic-incentive approaches, such as environmental taxes and emission trading. 

•	 Command-and-control approaches, such as technology mandates or emissions rate standards. 

• Non-regulatory approaches, such as voluntary 

agreements and eco-labeling. 

Ultimately, the policymaker’s objective should be 

to achieve the optimal level of pollution control to 

adequately protect human health and the environment at a minimum cost to society. 

Market-Based Approaches vs. 

Command-and-Control 

Regulation 

For many air pollution problems, command-and-control (or direct regulation) may be the best course. For 

example, where regulating authorities can identify a 

specific facility as the source of a public health problem, limiting its emissions may be the simplest and 

most effective solution. Also, in the transportation sector where fuel characteristics can have a direct impact 

on the effectiveness of engine technology, it may be 

best to directly specify fuel parameters, such as sulfur 

content, to permit firms to design engines in the most 

cost-effective way to reduce harmful emissions of particulates or other pollutants such as NOx, hydrocarbons, and carbon monoxide. 

Command-and-control regulations often work best 

when: 

•	 Emission reduction experience is limited and 

expertise is concentrated among regulators. 

•	 Solutions are clear or there are few options for 

reducing emissions. 

• Monitoring total mass emissions is not feasible. 

•	 Emissions have serious local health impacts, and 

trading might make such hotspots worse. 

•	 Emissions are toxic, and the desired emissions 

level might be zero. 

With command-and-control, the regulating authority typically establishes a requirement to install a specific type of emission reduction technology. Although 

sources may achieve a certain level of emissions per 

unit of heat input or product output using the technology, increased utilization and new emissions 

sources can threaten the ability to achieve and maintain an emissions target. Older sources that have been 

exempted or “grandfathered” from strict emissions 

controls might also threaten the ability to achieve and 

maintain an emission target. This threat can affect the 

ability to achieve an environmental and/or human 

health goal. 

For some environmental problems, however, specific requirements may cost more than flexible policy 

approaches and inhibit innovation. These types of 

environmental problems may work well for a transitional application of incentive-based approaches or 

economic instruments, such as taxes or a cap and 

trade program. Such programs may be preferred to 

encourage more economically efficient solutions. If 

properly designed, economic incentives can harness 

market forces to work toward environmental improvement. By internalizing pollution control costs they can 

make pollution reduction in the economic interest of 

the firm and promote innovation. 

It is also possible and, in some instances, beneficial 

to use a hybrid approach where command-and-control 

policies are implemented side-by-side with a cap and 

trade program. Command-and-control policies, if not 

overly restrictive, can establish a backstop or safety net 

to adequately protect human health and the environment (see Chapter 3).4 

Cap and Trade vs. 

Environmental Taxes 

Environmental taxes are another significant marketbased instrument for reducing pollution. The major 

difference between cap and trade and environmental 

taxes is that cap and trade imposes an absolute restriction on the quantity of emissions allowed (i.e., the cap) 

and allows the price of emissions to adjust to the marginal abatement cost (i.e., the cost of controlling a unit 

of emissions). An environmental tax sets a price for a 

ton of emissions and allows the quantity of emissions 

4 For a discussion of integrating cap and trade with other instruments, see Schreifels, 2000 and Ellerman, 2002. 

2-5 Is Cap and Trade the Right Tool? 
Figure 2. Economically Efficient Control of Pollution 

Cost per Unit of Pollution 

Marginal 

Social Benefit 

Quantity of Pollution Reduced 

Actual Marginal 

Abatement Cost 

CAP AND TRADE TAX 

Expected Marginal 

Abatement Cost 

P* 

Q trade 

Cost per Unit of Pollution 

Marginal 

Social Benefit 

Quantity of Pollution Reduced 

Actual Marginal 

Abatement Cost 

Expected Marginal 

Abatement Cost 

P* 

Q tax 

Theoretically, environmental taxes or cap and trade will provide the same level of environmental protection. However, if policymakers have 

incomplete or imperfect information about costs and benefits, researchers create new control technologies, or unforeseen developments arise, 

cap and trade provides certainty that the level of emissions will not increase beyond the emission cap. However, there are no assurances about 

the cost of the program. An environmental tax does not provide certainty about emissions, but it does establish a limit on the cost of the program to ensure that the price of emitting a unit of pollution does not exceed the tax level. In the second graph, the actual marginal abatement 

cost is higher than expected leading to fewer emission reductions (i.e., higher emissions) for the tax program. If the actual marginal abatement 

cost were lower than anticipated, the emission reductions for the environmental tax program would be greater than for the cap and trade program (and costs would be higher.) 

to adjust to the level at which marginal abatement cost 

is equal to the level of the tax (See Figure 2). 

Environmental Certainty 

There is extensive discussion in economics literature 

about the relative merits of cap and trade and environmental taxes.5 In situations where greater environmental 

certainty is needed, cap and trade programs are preferable because the cap sets an emission goal that sources 

must meet. With taxes, the regulating authority must 

establish a tax per unit of emissions. However, due to 

imperfect information (e.g., regarding marginal abatement costs and price sensitivities) and technological 

changes, setting the tax at the level required to attain the 

emission target becomes difficult and uncertain.6 

Moreover, under a regime of environmental taxes, new 

entrants into the polluting activity will lead to increased 

emissions. With cap and trade, regulating authorities can 

require new entrants to purchase allowances directly 

from the market or the regulating authority can provide 

allowances from set-asides that are within the cap. Thus, 

the emission goal can be maintained. 

Price Certainty 

In situations where price certainty is needed, tax programs are preferable because the tax per unit of emissions limits the cost to firms. For example, where the 

costs of achieving a level of emission reductions are 

uncertain, policymakers may decide to set an emissions tax rather than taking a chance that an allowance 

price will rise to a level that is economically or politically unsustainable. 7 

5 For a discussion of the economic considerations for choosing between taxes versus emissions trading, see Baumol and Oates, 1988. 

6	 A recent study of environmental taxes in Europe showed that these programs have failed to achieve the expected level of emission reductions 

(OECD, 2001). 

7	 A third type of economic instrument is essentially a hybrid of a tax and a cap and trade program. This mechanism, sometimes known as a “safety 

valve” or a “price cap” is a cap and trade program with a maximum price per ton. If the market price per ton rises above the maximum price, 

regulated sources can buy additional tons at the maximum price. In such a situation, the emission cap is exceeded, but the price per ton does 

not rise above the maximum level (Pizer, 1997). 

2-6 Is Cap and Trade the Right Tool? 
Administrative Costs 

Administrative costs are similar for both environmental 

taxes and cap and trade. Each approach requires 

sources to keep records of fuel consumption or emissions and to report this information to the regulating 

authority. The regulating authority’s administrative 

costs include processing this information, reviewing it 

for completeness and accuracy, and recording it. The 

regulating authority could also conduct detailed audits 

of selected submissions. 

With both instruments the regulating authority 

must decide the rigor of emission measurement and 

reporting requirements. For example, Sweden’s NOx 

tax and the U.S. SO2 Allowance Trading Program 

require the use of continuous emission monitors 

(Blackman and Harrington, 1999). Similarly, the regulatory authority’s review of data can be more or less 

rigorous depending on the level of review necessary. 

Under the U.S. SO2 Allowance Trading Program, emission data review is rigorous. Although it is highly automated, more than 75 percent of staff resources at the 

federal and state level are associated with the measurement, processing, and tracking of emissions data 

(see Chapter 4 for a more detailed discussion of 

administrative costs). 

Under a cap and trade program, a small amount of 

additional resources are necessary to process 

allowance transfers and reconcile emissions and 

allowances at the end of a compliance period. A tax 

program will require resources to collect and manage 

tax receipts. Some fiscal institutions, however, may 

already have the resources in place to collect and manage receipts from other tax schemes. 

Political Considerations 

Some regions have a history of implementing environmental tax programs. In these regions environmental 

taxes may be easier to implement because they are 

already understood and accepted and much of the 

infrastructure may already exist. In other regions, there 

may be political reasons to opt for a cap and trade program. Emission sources may prefer a system in which 

allowances are allocated without charge rather than a 

system of environmental taxes in which a source has to 

pay for emissions. The initial allocation of allowances 

reflects a transfer to sources of an asset that is scarce 

and therefore has economic value. Recognizing this, 

sources are often more supportive of this market-based 

incentive program than they are of environmental 

taxes. In some circumstances, policymakers might use 

both policies, environmental taxes and cap and trade.8 

A low tax can generate revenue for the regulating 

authority while still offering emission sources the benefits of a cap and trade program. Alternatively, the regulating authority could generate revenue with a cap 

and trade program by distributing some or all 

allowances through an auction. 

Other Forms of Emission 

Trading 

This section examines two additional forms of emission trading – project-based trading and rate-based 

trading – and compares them to the cap and trade 

approach in terms of potential to limit total emissions, 

ability to achieve cost minimization, administrative 

overhead, and transaction costs. 

Cap and Trade vs. Project-Based Trading 

Potential to Limit Total Emissions 

Project-based trading, otherwise known as credit trading or offset trading, is generally not used as a standalone program. It can be used to offer emission sources 

the flexibility to seek lower cost emission offsets from 

sectors outside a regulatory program. Historically in the 

United States, these types of credits or offsets have 

been used to meet rate-based emissions limits for conventional pollutants. More recently, there has been considerable international interest in using project-based 

trading as a complement to cap and trade to meet voluntary or mandatory greenhouse gas emission targets. 

Emission offsets, or credits, are typically calculated 

by comparing actual emissions against a baseline. The 

baseline is an estimate of what emissions would be in 

a hypothetical situation (e.g., if the project had not 

been created). Determining the baseline is often the 

biggest challenge with project-based trading. 

Designing effective protocols to verify offsets is difficult because it requires making a determination about 

whether the emission reductions from an offset project would have occurred anyway. This type of test is 

known as “additionality.” If emission reductions from 

a project are not “additional,” there is a risk that these 

reductions could dilute an emissions goal and lead to 

8 For a discussion of integrating cap and trade and environmental taxes, see Ellerman, 2002. 

2-7 Is Cap and Trade the Right Tool? 
increased emissions compared to a case in which no 

offsets are allowed. 

A similar concern in some situations is “paper credits.” These are created when a source uses its legal 

allowable level of emissions (e.g., its maximum potential to emit) as its baseline rather than what emissions 

would have been in the absence of the project. These 

paper credits are the difference between what a source 

is allowed to emit and what a source actually emits. 

These credits increase allowable emissions without 

generating any real emission reductions.9 

Two issues must be addressed for project-based 

trading–the effect on total emissions from “non-additional” offsets and “leakage,” which is an increase in 

emissions or decrease in sequestration caused by the 

project but not accounted for in the emission baseline 

for that project activity.

10 The underlying concept is 

that a particular project can produce offsetting effects 

that fully or partially negate the benefits of the project. For example, a project that protects a forest tract 

slated for deforestation may simply accelerate logging 

of the next most suitable location. 

Projects that temporarily sequester emissions (e.g., 

forestry projects that sequester carbon dioxide) also 

raise issues of “permanence.” If the emission reductions 

from the project are used to offset other emissions, and 

the project subsequently releases the sequestered emissions, not only is the environmental benefit lost, but the 

credits may allow emissions to increase. 

Cost Minimization 

As with cap and trade, project-based trading can 

reduce the economic costs of achieving an emission 

goal by adding flexibility for sources to develop appropriate compliance strategies. For example, a polluting 

facility may invest in an offsite emission abatement 

project to earn emission reduction credits. If approved, 

these credits may be used to offset emissions from the 

facility. 

Administrative Involvement and Transaction Costs 

A key difference between cap and trade and projectbased trading is the way that emission reductions are 

verified and the implications for administrative involvement. A cap and trade program requires preliminary 

analysis to establish an emission cap for regulated 

sources. Depending on the method of allowance distribution (see Chapter 3), additional work may be 

required to allocate emission allowances to the regulated sources. Due to the emission cap and measurement 

requirements, there is no need for the regulating 

authority to review each emission reduction activity or 

to calculate an emission baseline for each activity. 

Instead, each regulated source measures and reports its 

total emissions, and the regulating authority focuses on 

ensuring emissions are measured accurately and an 

allowance is turned in for each unit of emissions. 

In contrast, project-based trading often requires that 

project participants develop a project specific emission 

baseline for review by the regulating authority or other 

authorized experts.11 Review of such baselines can be 

contentious and resource intensive because it is 

extremely difficult to define with certainty what 

would have happened in the absence of a project. 

To reduce administrative and transaction costs and 

address additionality concerns, the regulating authority may establish multi-project baselines. Multi-project 

baselines use performance standards or benchmarks 

for a type of project. If the project results in emission 

rates lower than the standard, the project automatically receives credit equal to the difference between the 

baseline and the actual emissions (Sathaye, et al., 

2001). Standardizing baseline methodologies in 

advance can significantly reduce administrative costs 

and reduce the subjectivity inherent in the review of a 

project baseline. They may not, however, always be a 

perfect test for whether emissions are below the levels 

that would have occurred otherwise. Also, multi-project baselines may be difficult to develop for some 

types of projects. 

Project-based trading can reduce the costs of 

attaining an emission goal, but the administrative and 

transaction costs per unit of emission reduction are 

often higher than cap and trade programs; there is 

greater uncertainty and risk associated with an offset 

than an allowance (e.g., due to baseline, permanence, 

and leakage issues); and extensive involvement and 

oversight by the regulating authority are required to 

ensure environmental integrity. These transaction 

9 Paper credits can also affect rate-based trading programs. 

10	 Leakage can also occur in cap and trade programs that do not include all sources contributing to the environmental problem. Sources in the program may shift production to other sources not participating in the program, thereby negating some of the emission reductions. 

11	 Adequate safeguards for using an outside expert for verification include: sufficient direction and oversight from the regulating authority; accreditation of competency; and protection from conflicts of interest. 

2-8 Is Cap and Trade the Right Tool? 
complexities vary depending upon project type. 

Project-based trading can be an effective way to introduce some sectors to market-based incentive programs. In addition, it can be effective for sectors in 

which it is easier to measure an emission reduction 

(e.g., the quantity of gas captured from a landfill 

methane recovery project) than total mass emissions. 

Cap and Trade vs. Rate-Based Trading 

Under a rate-based trading approach, the regulating 

authority determines a performance standard (e.g., an 

amount of emissions allowed per unit of output) for a 

sector (e.g., tons of a pollutant per kWh of electricity 

generated). Sources with emission rates below the 

performance standard can earn credits12, whereas 

sources with emission rates above the standard must 

obtain credits for their excess emissions to remain in 

compliance. 

Sources with low cost opportunities to improve their 

emissions rate have an incentive to operate at rates 

below the performance standard. They can then sell 

the resulting credits to sources that have higher costs 

to attain the performance standard. Rate-based trading 

programs have been used in the United States to 

phase out lead in gasoline and control mobile source 

emissions. 

One consideration when evaluating rate-based trading is that if the activity level increases at a rate faster 

than the emission rate declines, sources can earn credits while total emissions increase. 

Potential to Limit Total Emissions 

Perhaps the most important measure of a regulatory 

approach is whether it can produce the desired environmental improvement. Emission caps set the total 

emission level, in effect, constructing a program from 

the environmental goal back to the sources. In contrast, rate-based trading attempts to establish an emission rate standard for each source that will, in 

aggregate, produce the desired environmental improvement. However, under a rate-based program, emissions 

and the pollution load on the environment can 

increase if sources increase their utilization or if new 

sources are built. 

This situation raises a distinction between cap and 

trade programs and rate-based programs regarding 

industrial growth. Both types of programs accommodate growth. The responsibility for addressing growth, 

however, falls upon the sources in a cap and trade program while it falls on the regulating authority in a 

rate-based program. More specifically, under a cap, 

sources must determine how to operate new facilities 

or increase utilization of existing facilities and still 

comply with the emission cap. This approach encourages industry to innovate and find lower-cost 

approaches to reducing emissions. In the U.S. SO2 

Allowance Trading Program electricity production and 

economic growth increased while SO2 emissions 

decreased significantly (see Figure 3). In a rate-based 

program, as with an environmental tax program, the 

regulating authority must periodically impose new rate 

standards to achieve and maintain an emission target 

and prevent (or correct for) additional emissions that 

may result from increased production. This cycle of 

revising regulatory programs can create a less certain 

regulatory environment for sources to conduct compliance and business planning. 

Cost Minimization 

As with cap and trade, the fact that sources can trade 

their credits under the rate-based approach implies that 

the performance standard could be achieved at a lower 

economic cost. This is because sources with high marginal abatement costs will choose to purchase credits 

from firms with lower marginal abatement costs. 

Administrative Involvement and Transaction Costs 

Under a rate-based system, the regulating authority 

converts each source’s emission rate and activity level 

to credits. Because the regulating authority must collect activity level data, the data requirements may be 

greater for rate-based trading. Such data may also 

include commercially sensitive data that could be difficult to obtain. This information, however, may be useful for other types of trading programs as well. The 

regulating authority can use the information to verify 

measured emissions. 

Like cap and trade, rate-based approaches do not 

necessarily require that the regulating authority 

approve each trade (in contrast to the project-based 

trading described earlier). Because some additional 

steps for government approval may be required, the 

level of administrative involvement and costs could be 

12	 For electric power sources, the credits earned would be equal to the difference between the performance standard and the source’s emission rate 

multiplied by the source’s current heat input or generation. 

2-9 Is Cap and Trade the Right Tool? 
Figure 3. Decoupling Economic Growth and Environmental Protection 

60 

Gross Domestic 

Product 

40 

20 

0 

-20 U.S. SO2 Allowance Trading 

Program SO2 Emissions 

-40 

YEAR 

the same or slightly greater than those of a cap and 

project-based programs usually do not require net
 trade program. 

emission reductions, they are not effective as stand-


Summary of Other Forms of Emission alone programs. However, a well designed project-


Trading based trading program may complement a


Each of the three forms of emission trading is approcommand-and-control program that establishes emis­


priate in certain situations. When achieving and main- sion or concentration limits. It may also complement a


taining an absolute emission goal is important, a cap cap and trade program in sectors for which accurate


and trade program can provide more certainty about emission measurement of entities or activities may not


total emissions. Administrative and transaction costs be as well developed. 


for cap and trade programs are often lower than for 

Rate-based trading can be an effective way to pro-


project-based trading, which is burdened by higher mote efficiency if circumstances do not require an


uncertainty and risk and the need for extensive regu- absolute cap on emissions. The administrative and


lating authority involvement. transaction costs for rate-based trading programs are


Project-based trading programs have historically 

likely to be the same or similar to cap and trade. (See


evolved from the introduction of limited flexibility in Table 2 for a summary of the forms of emission trading.)


traditional command-and-control programs. Because
 PERCENT CHANGES SINCE 1980 

Table 2: Three Forms of Emissions Trading Compared 

Limit Total Cost Administrative & 

Emissions Minimization Transaction Costs 

Cap and Trade High Yes Low 

Project-based Trading Low to Medium Yes High 

Rate-based Trading Medium Yes Low to Medium 

2-10 Is Cap and Trade the Right Tool? 
Early Emissions Trading in the United States 

Cap and trade in the United States evolved to improve upon earlier experiences that were expensive, resourceintensive and burdened with subjective review procedures, which resulted in limited environmental benefits. The 

U.S. EPA and state-level environmental agencies have used several different forms of emission trading with varying 

degrees of environmental and economic effectiveness. Although many of the early achievements were modest, 

the early efforts in emission trading are important because they provided a foundation and valuable practical 

experience for the development of more effective emission trading programs (e.g., the U.S. SO2 Allowance Trading 

Program). 

Offset Program 

EPA first applied the concept of marketable emission permits in the mid-1970s as a means for new sources of 

emissions to locate in areas with poor air quality without causing additional air quality problems. New sources and 

existing sources that wanted to expand their facilities were required to “offset” their emissions by acquiring emission reductions from other sources. In this program, offsets are generated when a source reduces actual emissions 

below their permitted level and applies to a state agency for certification of the reduction. For a source to receive 

an offset, the state must determine that the reduction is: (1) surplus in the sense of not being required by current 

regulations; (2) enforceable; (3) permanent; and (4) quantifiable. Offsets are normally denominated by the quantity 

of pollutant in tons released over 1 year (tons/year). The most common method of generating offsets is closing the 

source or reducing its output. However, sources can also earn offsets by modifying production processes or 

installing pollution control equipment. 

Bubble Policy 

The bubble policy is another approach 

that served as a foundation for later 

trading policies. Established in 1979, 

the bubble policy allowed sources to 

meet emission limits by applying a 

single aggregate emission limit to 

multiple sources within a facility rather 

than applying individual control 

equipment or emission rate requirements at each emission source. The 

term “bubble” is used to invoke an 

image of a bubble over a facility (such 

as a refinery or a steel mill) with several emission sources. A facility or group 

of facilities can aggregate emissions 

and use a mix of controls that is different from those mandated by regulations, as long as total emissions within 

the bubble are equal to or less than 

the cumulative limit for all sources 

within the bubble (see Figure 4). 

By design, bubbles are intended to 

be neutral in terms of environmental Emission Limit: 10 tons 

3 tons 

6 tons 

1 ton 

Figure 4. Bubble Policy 

2-11 Is Cap and Trade the Right Tool? 
impact. However, bubble proposals must undergo individual review and approval, which, over the years, has been 

streamlined but is still rather burdensome. Consequently, the bubble provision has been used in less than 100 

cases in the United States over the last 20 years. 

Evaluation of Early Emissions Trading Activities 

Several factors limited the appeal of these early trading approaches. The trading mechanisms were meant to modify or enhance existing air pollution control programs that did not themselves address total emissions. Therefore, 

the trading mechanisms were not effective at controlling overall emission growth. To ensure that air quality did 

not deteriorate, expensive air quality modeling was often required before regulators accepted proposed trades. 

Deposits to emission banks (credits generated for some later, yet-to-be-determined use) were typically “taxed” by 

the air quality management authority to meet state air quality requirements or to generate a surplus that the area 

could use, for instance, to attract new firms. Offset ratios (i.e., requiring more than 1 ton of emission reductions to 

offset 1 new ton of emissions) used to counter some of the uncertainties from a trade further depressed credit 

value. Finally, the administrative oversight to protect against the creation of “paper credits” and “anyway tons” 

turned out to be resource-intensive. 

In a 2001 study on project-based trading systems, the Environmental Law Institute (ELI) concluded that such 

programs in the United States “have generally failed to generate considerable trades and retrospective reviews 

have tended to blame their shortcomings on high transaction costs, uncertainty and risk in obtaining needed government approvals, as well as lack of clear legal authority and clearly specified objectives” (ELI, 2001). 

2-12 Is Cap and Trade the Right Tool? 
3 

Developing a Cap 

and Trade Program 

Introduction 

P

rior to implementing a cap and trade program, 

policymakers should examine various design 

options, decide which features to employ, and 

ensure that there is adequate legal authority. Key decisions include determining which sources to include in 

the program (i.e., applicability), the level of the emission reduction or limitation (i.e., cap), and the timing 

when reductions will be required. In addition, policymakers should determine requirements for measuring 

and reporting emissions, methods of distributing 

allowances, rules governing allowance use, compliance 

and enforcement provisions, and provisions for integrating cap and trade with existing policies. Before 

design work can proceed, it is critical to have information on the potentially affected sources, such as their 

emissions, utilization, and control options. All of these 

issues are discussed in this chapter. 

Guiding Principles

Several overarching principles can guide the development of a cap and trade program. Adhering to these 

principles—simplicity, accountability, transparency, 

predictability, and consistency—can promote environmental compliance and efficient markets. 

Simplicity 

Simplicity is an important goal when designing an 

effective cap and trade program. Program operation for 

both emission sources and regulating authorities can 

be less costly and time-consuming if the rules are not 

overly complex or burdensome. Markets function better when the rules are simple and easily understood by 

all participants. Moreover, the environment is more 

likely to be protected when rules are clear and easily 

enforced. In contrast, complexity often requires more 

decisions, debate, and information collection. This situation, in turn, can create uncertainty and unnecessary 

burden that may lead to delays, opportunities foregone, and ultimately higher costs. In some countries, 

complexity may also make it more likely that there will 

be litigation over contentious issues. 

Another aspect of simplicity that will increase the 

economic effectiveness of a cap and trade program is 

the fungibility of allowances (i.e., an allowance is a standardized unit of trade that is interchangeable with other 

allowances). Fungibility is highly desirable to minimize 

transaction costs in the program and to maximize the 

3-1 Developing a Cap and Trade Program 
Setting the mass-based emission cap:

Implementation dates:

Sources covered:

Distributing tradable allowances:

efficiency of the cap and trade program to lower costs. 

Simplicity is enhanced by avoiding the creation of different categories of allowances with different attributes, 

unless it is absolutely necessary to maintain the environmental integrity of the system. For example, discounting the use of certain types of allowances based on 

their geographic origin or on their ability to be banked 

complicates transactions and reduces the cost effectiveness of allowance trading and may not have significant 

environmental benefits. 

More broadly, the principle of simplicity can be 

applied to all elements of the program, including: 

•	 Applicability thresholds (determining which 

facilities are affected) 

• Allocation formulas 

• Trading rules and/or restrictions 

• Measurement options and rules 

• Reporting requirements 

• Penalty assessment 

Accountability 

A cap and trade program must create a framework of 

oversight and enforcement that will hold participants 

accountable for their emissions and ensure compliance 

with the program’s requirements. The basis of 

accountability is the accurate measurement and verification of emissions and the rigorous and consistent 

enforcement of penalties for fraud or noncompliance. 

The regulating authority can facilitate accountability 

through clear and simple rules. 

Transparency 

Transparency refers to the full and open disclosure of 

relevant public and private decisions, such as establishing the rules and regulations for a trading program and 

determining if an emission source is in compliance. 

Transparency is important to a well-functioning cap 

and trade program, both in terms of its design and its 

operation. Transparency of the design process can promote public acceptance and confidence in the cap and 

trade program. 

Information transparency is also important to the 

effective operation of an emission trading program. 

Providing public access to source-level emission and 

allowance data promotes confidence in the program and 

provides an additional level of scrutiny to verify enforcement and encourage compliance. In some jurisdictions 

these data are classified as confidential and may require 

legal changes to make them publicly available. 

Advances in information technology and the 

Internet have made it possible to provide interested 

parties with timely and useful information about 

emissions, allowances, and program results. 

Predictability and Consistency 

Predictability and consistency in the design and application of program rules are important principles for an 

effective cap and trade program. They help create the 

right circumstances to encourage innovation and lower 

costs. With a cap and trade program, emission sources 

have an incentive to find better and lower-cost opportunities to reduce emissions. This incentive depends upon 

long-term, predictable, and consistent rules that affect 

the economic value of emission reductions. This 

arrangement does not mean, however, that rules cannot 

change in response to new information. Rather, it means 

that the framework must include the possibility for 

change and a clear explanation of the process for changing the rules. 

Establishing Legal 

Authority

As discussed earlier, there must be legal authority to 

establish a cap and trade program. Although policymakers can include many components in authorizing 

legislation, the basic components are listed below. 

Several of these components are discussed in more 

detail in this chapter and Chapter 4. 

•	 Setting the mass-based emission cap: If the cap 

is not set directly by policymakers, the regulating 

authority must have authority to limit the total 

quantity of pollution from the relevant sector(s) 

by establishing a cap on emissions. 

•	 Implementation dates: Sources must comply 

with the emission caps starting in a particular 

compliance period. 

•	 Sources covered: A complete control program 

must define which sectors are subject to program 

requirements and, within each sector, which 

emission sources are affected. For example, the 

scope of an electric generating sector cap and 

trade program could include all electric generating units or only electric generating units above 

a certain generation capacity. 

•	 Distributing tradable allowances: Traditional air 

quality permits authorize a certain amount of 

3-2 Developing a Cap and Trade Program 
Banking:

Trading procedures:

Emission monitoring and reporting:

Compliance:

Establishing and enforcing penalties for noncompliance:

Program applicability:

Allowance allocations:

Aggregate cap:

emissions and are non-transferable. Policymakers 

establishing a cap and trade program must provide for tradable permits, specifically that appropriate increments (e.g., allowances) are tradable 

among participants in the program. The regulating authority can allocate these authorizations, or 

allowances, to emit in a variety of ways, or auction them to the highest bidders. Policymakers 

should also explicitly state which regulating 

authority is responsible for issuing and distributing the allowances. 

•	 Banking: Policymakers might allow sources to 

use allowances issued in one period for compliance in subsequent periods. This arrangement is 

called banking. 

•	 Trading procedures: A cap and trade program 

needs consistent rules for conducting allowance 

transfers, as well as a system for tracking 

allowances. Policymakers should explicitly state 

which regulating authority is responsible for 

developing and enforcing trading procedures. 

•	 Emission monitoring and reporting: Accurate, 

comprehensive emission data are a cornerstone 

of a credible and effective cap and trade program. The regulating authority must have the 

authority to require standardized methodologies 

for emission measurement, collect emissions 

data to determine compliance, and publicize 

emission and allowance data to provide transparency and promote confidence in the program. 

•	 Compliance: Each affected emission source is 

required to hold at least one allowance in their 

account for each unit of emissions during the 

compliance period. Cap and trade programs must 

include provisions that authorize the regulating 

authority to reconcile the emissions of each 

source with the number of allowances they hold 

to determine compliance. 

•	 Establishing and enforcing penalties for noncompliance: The regulating authority must have 

the authority to impose and enforce sufficient 

penalties on emission sources that do not comply 

with the rules of the program. 

Legislation to provide legal authority can range 

from a few broad sentences to many detailed pages. 

The legislation may provide only general language 

authorizing the use of emission trading or it may 

explicitly state the rules and guidelines for a cap and 

trade program. 

In addition to establishing this new authority, a cap 

and trade program may require appropriate amendments to a country’s existing legislation. For example, 

fundamental legal issues (e.g., existing technology 

standards or taxes) may hinder the development of a 

cap and trade program if not properly addressed. Most 

countries will already have some regulations that are 

related to environmental performance. If existing regulations (or economic incentives) are simply in place 

to collect revenues for the government (e.g., environmental taxes set well below the marginal abatement 

cost), then a cap and trade program can likely be 

added. If there are technology standards, it may be 

necessary to make certain adjustments in existing legislation (e.g., replacing the technology standards with 

caps of equal or greater stringency, or allowing firms 

to opt out of them in favor of participating in the cap 

and trade program). For further discussion on cap and 

trade and potential conflicts in the existing legal 

structure, see Chapter 4. 

Creating an Emission 

Inventory

An important step in the development process for a 

cap and trade program is the creation of an adequate 

source-level emission inventory. The types of data and 

appropriate level of detail for the emission inventory 

will depend upon the intended use of the data. The 

emission inventory is likely to be useful in analyzing 

and making the following design decisions: 

•	 Program applicability: The regulating authority 

may use inventory data to make decisions about 

which sectors to include, where to apply the 

obligation to hold allowances (e.g., at the fuel 

distributor or the emission source), and what 

thresholds should be set to determine if a source 

is affected by or exempted from the program 

(e.g., production capacity). 

•	 Allowance allocations: The regulating authority 

may use inventory data to analyze the effects of 

different allocation options on emission sources 

and to decide on a method for distributing 

allowances. 

•	 Aggregate cap: The regulating authority will 

need the inventory data for the affected emission 

sources to analyze the potential costs and benefits of different emission caps, as well as to 

3-3 Developing a Cap and Trade Program 
Program design considerations:

Cost of data collection and availability of data:

Completeness:

Measurement Method:

assess the performance of the program once 

implemented. In some cases, the emission 

inventory is used to project future emissions, 

either using a sophisticated computer model or 

using simple assumptions about projected emission growth. 

Minimum data requirements for the emission inventory include: (1) individual emission source characteristics (e.g., size, location, name-plate capacity, process 

type, boiler type, fuel type); and (2) emission levels for 

individual sources based on output, fuel use, and/or 

emission data. These data requirements will vary 

depending upon: (a) the types of sources to be regulated under the cap and trade program; (b) the pollutant; 

(c) the choice of allowance distribution method; and 

(d) the method for setting the overall cap. 

Inventory Level of Detail 

For cap and trade programs that require emission 

sources to hold allowances, sources can be inventoried 

at five different levels of detail: (1) the company level

13; 

(2) the plant level, which denotes a plant or facility 

that could contain several emitting activities; (3) the 

point/stack level, where emissions exit to the ambient 

air from stacks, vents, or other points; (4) the 

process/segment level, representing the unit operations 

of specific source categories (e.g., a single boiler that 

burns both coal and gas would count as two segments); 

and (5) the unit level (e.g., each individual boiler)14. 

Although a full comparison of the different options 

is beyond the scope of this guidebook, the most significant factors in making this decision are: 

•	 Program design considerations: The level of 

detail needed for the emission inventory is often 

determined by program design considerations. 

For example, if the program applicability threshold is based on the size of a combustion unit, 

then an inventory created at the plant level will 

not provide sufficient detail; additional information at the unit level will be necessary. Similarly, 

allowance allocation formulas may require a certain level of inventory data. 

•	 Cost of data collection and availability of data: 

Some options may make it easier to collect necessary data. For example, fuel purchase records 

may be kept only at the plant level rather than 

for each individual unit. Although data can be 

apportioned when necessary, it may be more cost 

effective to collect data at more aggregated levels 

of detail, such as the plant level. 

•	 Completeness: Inventorying emissions at the 

unit level avoids many of the complications that 

may arise with other inventory levels (e.g., complex configurations of production units and 

stacks) and provides the most detailed information about the emission sources. However, this 

arrangement requires more data that may be 

more difficult to compile. 

•	 Measurement Method: It is important to consider whether the data gathered for the program 

development stage will need to match the level 

used to assess compliance once the program is in 

place. If so, the regulating authority should evaluate issues related to emission measurement for 

the various levels of detail. For example, if instack measurement such as continuous emission 

monitors (CEMs) is used for compliance with 

the program, a stack-level inventory would be an 

advantage because it would include all of the 

emissions from each stack. However, for alternative measurement methods (e.g., fuel-based mass 

balance approaches), using stack level data for 

compliance might complicate emission measurement, particularly if several units share fuel supplies but exhaust through different stacks. 

Program Design 

Elements 

In developing a cap and trade program, the regulating 

authority should consider a number of design elements. Each design decision affects other aspects of 

the program. Although these elements are discussed in 

a specific order, the interrelationships between all the 

design elements should be considered together when 

making program decisions. 

13	 Measuring emissions at the company level is very complicated and is not recommended for cap and trade programs. Issues such as partial ownership, mergers, and sales all effect the ability to accurately attribute emissions to a specific company. 

14	 In many cases, unit level may correspond to point/stack level, but it is possible for a unit to exhaust to multiple stacks or for multiple units to 

share a single stack. 

3-4 Developing a Cap and Trade Program 
Contribution to emissions:

Availability of cost-effective control options:

Ability to measure emissions:

Applicability 

After deciding that cap and trade is the preferred 

approach to reducing the emissions of a particular 

pollutant, policymakers must determine which emission sources to include in the cap and trade program. 

Ideally, all sources, sectors, and emissions would be 

included for full coverage and maximum environmental effectiveness and economic efficiency. However, 

measurement capabilities and costs, available control 

options, administrative burdens, political considerations, and other constraints may limit participation to 

a subset of emission sources. 

When determining the applicability of a cap and trade 

program, there are several important considerations: 

•	 Contribution to emissions: Included sources 

should represent a substantial portion of emissions in order to appropriately address the environmental issue of concern. To determine 

whether to include sources or sectors in a program, the regulating authority should perform an 

analysis using the existing emission inventory (as 

discussed in the previous section), as well as an 

analysis of how future growth will change the 

existing emission patterns. In this analysis, it is 

important for the regulating authority to acknowlFigure 5. Leakage 

edge and, if necessary, address emission sources 

that they cannot feasibly include, but that could 

receive shifts in production from emission sources 

constrained by the cap. Such shifts of production 

from affected sources to other non-affected 

sources (“leakage”) could undermine the environmental benefits of the cap (See Figure 5). 

Maximizing the coverage of emissions in a cap 

and trade program can optimize both the environmental effectiveness and the economic efficiency of the program. Conversely, the 

environmental effectiveness of a cap and trade 

program is diminished if a large percentage of 

emissions are outside the cap. Although the regulating authority can implement other policies 

for emissions outside the cap, the level of these 

emissions is not guaranteed. Also, because 

sources outside the cap do not benefit from the 

economic efficiency of the trading program, the 

policies to control their emissions may be relatively more costly. 

• Availability of cost-effective control options: 

Some sources included in the program should 

have a range of cost-effective abatement options 

to ensure the ability to achieve the reduction goal. 

Variation in abatement costs promotes competition among control 

options, stimulates 

innovative techUncapped sources Capped sources

Electricity 

Plants within capped area reduce pollution 

by decreasing production, but import power 

from ce outside of the cap. This source 

increases its production and pollution and 

sends electricity into the capped area, so 

there is no benefit to the environment. 

This is known as "leakage". 

a sour

nologies, and 

helps lower compliance costs. 

• Ability to measure emissions: As 

discussed further 

in this chapter, 

sources that participate in a cap 

and trade program 

must have the 

ability to account 

for their emissions 

accurately and 

consistently. 

Alternatively, a 

regulating authority may involve 

independent parties to measure 

3-5 Developing a Cap and Trade Program 
Number and size of sources:

Simplicity:

Equity:

Point of emissions (Direct emitters)15

:

Upstream (Potential emitters):

Hybrid:

and report emissions. If independent parties are 

involved, the regulating authority should have 

oversight, certification, and review procedures in 

place to promote accountability. Because each 

allowance has economic value, it is important to 

ensure that emissions (and thus allowances used) 

are quantified accurately and consistently. 

•	 Number and size of sources: The number and 

size of sources participating in the cap and trade 

program may affect the regulating authority’s 

ability to manage the program. The regulating 

authority must balance the desire to maximize 

the coverage of the program to increase the environmental effectiveness and efficiency against 

the ability to operate the program and enforce 

compliance. If sources responsible for a significant portion of the total emissions are not included in the program, the program may be less 

environmentally effective and less economically 

efficient. In addition, excluding some significant 

sources within an industrial sector can cause 

sources to shift activity to those sources outside 

the cap, thereby reducing the environmental 

effectiveness of the program. It might not, however, be necessary to include all small sources. 

Excluding some small sources may help keep the 

total number of sources to a level that is manageable for the administration of the program. 

•	 Simplicity: It is important to avoid overly complex applicability criteria. Complex criteria make 

it more difficult and costly for sources and for 

the regulating authority to determine which 

sources the program covers. Complex criteria also 

increase the likelihood of loopholes that allow 

significant sources in the same industrial sector 

to avoid inclusion in the program. To this end, 

the threshold(s) for determining source applicability should be based on source characteristics 

that remain constant, such as capacity or potential to emit, rather than characteristics that could 

vary from year to year, such as mass emissions or 

fuel use. This will ease administration of the 

program, provide greater certainty to sources, 

and avoid frequent changes in an individual 

source’s applicability status. 

•	 Equity: The regulating authority should give 

careful consideration to the economic competitiveness of businesses and the effect on markets 

that could result from including or excluding certain industries from a trading system. Fairness 

relative to emission reduction potential is another consideration for the regulating authority. 

Point of Obligation 

Closely related to the questions of which sources and 

sectors are covered in a cap and trade program is the 

question of where there is an obligation to hold 

allowances (See Figure 6). There is a growing literature 

discussing how this would apply to emissions that can 

be capped at several different points in an economy, 

including: 

•	 Point of emissions (Direct emitters)15

: A point of 

emission program focuses on direct emission 

sources (e.g., electricity generators and large 

industrial sources) where the pollutant(s) are 

released to the atmosphere. This approach works 

well if the production or combustion process 

affects emissions (e.g., NOx from industrial boilers) or there are available end-of-pipe controls 

(e.g., SO2 from electricity generators). The U.S. 

cap and trade programs obligate emission 

sources to hold allowances equal to their total 

mass emissions. 

•	 Upstream (Potential emitters): An upstream program focuses on any point prior to the emission 

source (e.g., fuel producers and processors such 

as coal mines or oil refineries). An upstream program does not have a direct cap on emissions. 

Rather, the cap is set on the emission potential 

inherent in the fuel. The restriction at the fuels 

level restrains supply and can cause fuel prices to 

increase relative to alternatives. This “price signal” encourages fuel consumers to reduce 

demand for the fuel, either by finding more 

cost-effective alternatives or creating new technologies that use the fuel more efficiently. In 

this way, it operates much like a pollution tax, 

but has the benefit of a cap on total emission 

potential (CCAP, 1998; Kopp, et al, 1999). 

•	 Hybrid: A hybrid approach could be used to cap 

some entities upstream and some entities at the 

point of emissions. For example, large emitters 

such as electricity generators might be capped at 

the point of emissions, while emissions from 

transportation might be capped upstream 

(CCAP, 2000, ELI, 1997). 

15	 In U.S. literature, this is often referred to as “downstream,” while obligations at any point after the emission source (e.g., commercial electricity 

consumers) are referred to as “indirect.” 

3-6 Developing a Cap and Trade Program 
Figure 6. Point of Obligation 

UPSTREAM 

(Fuel Producers) 

Fuel 

Extraction 

DOWNSTREAM 

(Indirect Emitters) 

Fuel Processing 

Major 

Emitting 

Sectors 

All Direct 

Emission Sources 

Point of Emissions 

(Fuel Consumers) 

All Indirect 

Emission Sources 

Analysts often compare upstream and point of 1999). For example, under an upstream system, 

emission approaches on several key program parame- an electricity generator would face higher fuel 

ters: prices if fuel producers were required to hold 

•	 In most countries, an upstream system could allowances. These higher fuel prices would 

capture the highest percentage of potential emis- encourage the generator to improve efficiency or 

sions. Upstream can be particularly effective switch to lower-emitting fuels in the same manwhen emissions are closely related to the fuel ner that the generator would be motivated to 

characteristics or end-of-pipe controls are not reduce emissions if it was required to hold 

readily available. In addition, an upstream allowances. However, a few analysts have argued 

approach may better address sectors in which that a point of emission approach provides a 

there are numerous small energy users with more direct signal to reduce emissions, because 

direct emissions. Advocates of the upstream the target is the emission source. According to 

approach also argue that it is economically effi- this view, an upstream system, which relies solecient because it would spread the efficiencies of ly on price signals, may not provide sufficient 

cap and trade across a larger segment of the incentive to find new technologies that reduce 

economy. emissions per unit of fuel or sequester emis­

•	 Most economists argue that upstream and point sions. In particular, an upstream system provides 

of emission approaches create identical incen- little incentive for emission sources to develop 

tives for reducing emissions from affected and employ post-combustion control technolosources’ energy use because energy consumers gies since this behavior would not be directly 

face higher costs from using fuels with greater rewarded (CCAP, 1998). On the other hand, 

emission potential in both cases (Kopp, et al., although it creates additional complexity, policy3-7 Developing a Cap and Trade Program 
makers can create incentives for post-combustion 

controls by awarding credits to downstream emission sources that reduce or sequester emissions. 

• An upstream system may include fewer sources, 

which would generally lower the administrative 

burden of a program. Although this is an important consideration, recent advances in the use of 

information technologies to manage cap and 

trade programs have allowed regulating authorities to handle greater numbers of emission 

sources without being overburdened (Kruger, et 

al., 2000). 

Some analysts argue that a hybrid system may be an 

acceptable compromise. These analysts contend that 

such a design would be desirable because it would provide similar coverage of emissions to an upstream system, while allowing the program design to focus on the 

types of emission sources that have been successfully 

included in past cap and trade programs (Mazurek, 

2002). Potential downsides to such an approach include 

a larger number of sources than an upstream program 

and added complexity from the need to avoid double 

counting emissions at both upstream and point of emissions sources. For example, policymakers may include 

natural gas-fired electric generators (point of emissions) 

and natural gas distributors (upstream) in a hybrid cap 

and trade program. The regulating authority would 

have to deduct fuel used by the included electric generators from the amount of natural gas distributed by 

upstream sources to ensure that emissions are not 

counted by both sectors. 

Opt-ins 

Some sectors may not meet the above criteria for inclusion in the cap and trade program but have individual 

sources that can meet the criteria. In such cases, it may 

be desirable to allow these sources to voluntarily “optin” to (participate in) the program. These sources 

receive an allowance allocation and are subject to the 

same requirements as sources under the cap. 

Theoretically, these sources will have cost-effective 

emission reduction opportunities that warrant the 

expense of meeting the monitoring and other requirements associated with the cap and trade program. If 

policymakers allow opt-ins, sources that choose to optin should be subject to all the terms of the program. It 

is imperative that any sources opting in employ a 

measurement protocol that is equivalent in consistency 

and accuracy to the methods used by the affected 

sources. This ensures that the reductions achieved are 

real, verifiable, and comparably valued. 

Although voluntary opt-in provisions may reduce 

costs to affected sources, they raise some of the same 

issues associated with project-based credits discussed 

in Chapter 2. Sources may decide to opt-in and take 

advantage of allowance allocations that are above what 

their emissions would have been if they were not participating in the cap and trade program. In some 

cases, they may opt-in and then take measures to 

reduce emissions that would have occurred anyway, 

regardless of participation in the program. Unless the 

regulating authority can make an allowance allocation 

at a level that equals “business as usual,” extra 

allowances will be introduced into the system and will 

undermine the environmental effectiveness of the cap 

and trade program. Research on the U.S. SO2 

Allowance Trading Program has shown that many of 

the sources that voluntarily joined the program under 

opt-in provisions16 were spurred by overly generous 

allowance allocation formulas. Opt-ins using these 

provisions achieved very few additional emission 

reductions (Ellerman, et al., 2000). 

Setting the Level of the Cap 

Setting the level of the emission cap is one of the most 

important decisions for policymakers and the regulating authority. In theory, the most economically efficient level for the emission cap is where marginal 

abatement costs are equal to marginal benefits from 

the reduced emissions (see Appendix A for further discussion). However, this level is often difficult to determine due to uncertain information. More generally, the 

cap should be set at a level that is expected to address 

the environmental and health problems of concern at 

an acceptable cost. 

As with other types of policies to reduce emissions, 

it is desirable to use atmospheric and ecological or 

health effects models to assess the impacts of different 

levels of emission reductions. Models range from those 

that describe links between one receptor area and one 

source, to others that describe complex regional-scale 

relationships. Models also can project a wide variety of 

16	 There were three provisions in the SO2 trading program that encouraged voluntary entry into the program. The Substitution and Compensating 

Generation provisions were used to bring Phase II units into the program during Phase I. The Industrial Opt-in provision was used to bring 

industrial boilers and small generating units into the program. 

3-8 Developing a Cap and Trade Program 
impacts throughout the region. Some models


address changes over short time periods, such Figure 7. Knee of Marginal Abatement Cost Curve


as episodes, while others focus on longer time


periods, and some attempt to do both.


Usually, models focus on one part of the over-


all assessment and should be linked to pro­


duce a truly integrated assessment. Emission


models develop emission data for input into


air quality models. The output of the air qual­


ity models is then translated into impacts


using a variety of models characterizing


human health and ecological welfare and


other effects. Ultimately, selection of the best


model framework or best set of models


Marginal Abatement Cost to Emission Sources 

Possible point of regulation 

balancing needed emission 

reduction and cost 

0 100 

C

OST OF REDUCTIONS 

depends on the question being asked. 

(USEPA, 2001) 

In practice, policymakers will determine 

the cap by considering a combination of science, economics, and political feasibility. One approach that 

policymakers sometimes use to determine the aggregate emission cap is finding the “knee in the cost 

curve” (i.e., the point before costs per unit of emission reduction begins to rise rapidly (see Figure 7)). 

Policymakers may also want to ensure that costs are 

within an acceptable range. To estimate costs and 

benefits, policymakers may use economic modeling to 

depict optimal control decisions. 

The decision of when to implement the cap is integral to the decision on the level of the cap. Policymakers may need to weigh the pros and cons of opting 

for a tighter cap with a later implementation date versus a less aggressive cap with an earlier implementation date. For example, it may not be feasible to set 

the cap at the optimal level for the initial stage of 

implementation. However, rather than delay implementation until a later date when the optimal level 

may be more achievable, it may be advantageous to 

begin the program as soon as possible to encourage 

advances in control technology and influence investment decisions. Under such a scenario, policymakers 

may establish a cap that declines over time to ultimately achieve the environmental goal. This is one of the 

advantages of allowing emission sources to bank excess 

allowances. It encourages early reductions, advances 

control technologies, and reduces the economic effect 

of the declining cap. For predictability, it is important 

that policymakers or the regulating authority define 

the decline in allowances in advance to provide sources 

sufficient time to adjust to new cap levels. 

EMISSION REDUCTION (PERCENT) 

The level of the cap will also depend on applicability decisions about which sources and sectors to 

include in the program. In the case where policymakers establish a national emission goal and develop a 

cap and trade program in conjunction with other regulatory tools, they must determine what portion of the 

goal should come from sources in the cap and trade 

program (the cap) and what portion from other sectors 

and sources. Ideally, a cap and trade program should 

include as many sectors as possible to maximize the 

cost savings from trading between sources with different marginal abatement costs. If it is not possible to 

include certain sectors under the cap and trade program, then alternative policy instruments may be used 

to reduce emissions in sectors outside the cap. Where 

possible, however, these instruments should be used 

to reduce emissions to levels where marginal abatement costs in the uncapped sector(s) are roughly 

equivalent to the marginal abatement costs in the sector(s) participating in the cap and trade program. 

Length of Compliance Period 

The length of the compliance period should be linked 

to the environmental problem and reflect operational 

considerations. If the environmental problem is continuous and long-term, as in the case of acid rain or climate change, the compliance periods should be 

continuous, covering all months of the year. If the 

problem is seasonal, as is the case with ground-level 

ozone in the Eastern United States, then the compliance period may be seasonal, such as the five-month 

compliance period each year used in the Ozone 

3-9 Developing a Cap and Trade Program 
Consistency:

Accuracy:

Transport Region (the District of Columbia and 12 

states in the Northeastern United States). 

The decision of whether to assess compliance quarterly, annually, or less frequently should also take into 

account the administrative burden imposed. A short 

compliance period puts a larger administrative burden 

on both the regulating authority and emission sources 

but allows for swifter action to correct a case of noncompliance. A longer compliance period allows more flexibility for the sources to achieve compliance and reduces 

the administrative burden for the regulating authority. 

By lengthening the period between compliance assessments, however, cases of noncompliance can persist for 

longer periods of time, possibly increasing the difficulty 

of correcting those problems. Most cap and trade programs determine compliance on an annual basis. 

Quantifying Emissions from 

Sources in the Program 

One of the most important features of a cap and trade 

program is that sources measure total mass emissions 

(as opposed to emission rate or concentration) as accurately and consistently as possible. Because the emisTable 3: Emissions Monitoring 

Priorities 

Purpose Priorities 

Cap and Trade • Complete and consistent 

accounting of total mass emissions 

• Accurate and consistent measurement among sources 

• Conservative emission estimates 

(not underestimated) 

Command-and­ • Accounting of emission rate or 

Control technology installation 

Project-based • Reasonably accurate estimate of 

Trading baseline (what emissions would 

have occurred in the absence of 

the project) 

• Accurate accounting of emission 

rate and activity level 

Research • Best available emission data, 

Inventory regardless of consistency among 

sources or sectors 

• Consistent emission measurement methodologies over time 

sion measurements are the “gold standard” underlying 

the traded allowances, it is important that a ton of 

emissions at one source is equal to a ton of emissions 

at any other source. This creates a level playing field 

for participants in the program and a strong foundation 

upon which a market can operate. 

The emissions monitoring priorities for a cap and 

trade program differ from other types of environmental regulations (see Table 3 for emission monitoring 

priorities of different types of programs). In considering potential emission measurement regimes for a cap 

and trade program, the following monitoring objectives may be useful as a guide: 

•	 Consistency: The regulating authority should 

create clear and consistent protocols for sources 

to determine emissions. This means employment 

of standard procedures and the use of sound 

engineering practices. This arrangement can be 

particularly challenging if the cap and trade program includes sources from a variety of industrial 

sectors. 

•	 Accuracy: For a cap and trade program, accurate 

measurement is more important than consistency 

over time. Policymakers should consider 

enhancements to measurement methods or using 

different methods if better approaches are available and practical. The monitoring program can 

also be designed to include performance standards that reward sources that achieve better 

accuracy than required. For example, for less 

accurate approaches, sources should use more 

conservative estimation methods that are not 

biased toward underestimating emissions. 

Ultimately, it is most important to avoid systematic underestimation of emissions. 

Considerations in Choosing a 

Measurement Approach 

Pollutant 

The pollutant to be measured, the conditions under 

which it is created, and the mode in which the emissions enter the atmosphere will affect the types of 

emission measurement techniques available. For example, measurement issues related to emissions of SO2, 

NOx , and CO2 from stationary source combustion will 

vary because emissions of SO2 and CO2 are directly 

linked to the combusted fuel, while emissions of NOx 

also depend on the combustion conditions. Therefore, 

3-10 Developing a Cap and Trade Program 
Typical Emissions Measurement Under the U.S. SO2 Allowance Trading Program 

In most cases, emission sources must continuously measure and record hourly emission concentrations of SO2, 

NOx , and CO2, as well as flow of exhaust gases with a continuous emission monitoring system (CEMS) (see Figure 

8). EPA has established provisions for initial equipment certification procedures, periodic quality assurance and 

quality control procedures, record keeping and reporting, and procedures for filling in missing data periods. Where 

possible, incentives are provided to improve and maintain the quality of the monitoring. For example, units must 

periodically undertake relative accuracy tests on their CEMS (which involves comparing the monitored emissions 

from the CEMS to monitored emissions from an independent or reference measure of emissions); if the CEMS 

receives a superior accuracy result, the frequency of future testing is reduced and the firm saves money. For a full 

discussion of monitoring performance standards and incentives for improving accuracy through quality assurance 

requirements, see Saile, 1995. 

Flow 

Monitor 

Gas Sampling 

Probe 

Gas 

Cylinders 

Flow Control Panel Data Acquisition and 

Handling System 

Pump Analyzers

Chiller 

Figure 8. A Continuous Emission Monitoring (CEM) System 

3-11 Developing a Cap and Trade Program 
an appropriate measurement method for CO2 , such as 

mass balance based on carbon content in the fuel will 

not be appropriate for NOx . Instead, accurate measurements of NOx emissions from stationary source 

combustion must be taken from exhaust gases. 

How Emissions Enter the Atmosphere 

How emissions enter the atmosphere can limit the 

choice of methodology. For example, continuously 

measuring actual emissions is an option only if emissions are vented through a stack or other contained 

area where measurement equipment can be located. In 

contrast, measuring fugitive emissions (i.e., emissions 

that escape directly into the atmosphere in a diffuse 

manner) may depend on estimation techniques based 

on inputs and defaults. 

Emissions Abatement Options 

The abatement options available for sources to reduce 

their emissions are also a factor in the choice of measurement method. It is important that the measurement 

method be able to accurately capture the reductions 

made. For example, measurement methodologies 

based on fuel inputs (e.g., mass balance) may be 

appropriate for sources that reduce emissions by 

switching or conserving fuels, but it would be much 

less appropriate for sources that use reduction technologies such as combustion modification or post-combustion control. In choosing a standard measurement 

approach, it is important to allow sources full flexibility 

of compliance/mitigation options. It is also important 

to consider potential technological innovations in mitigation approaches. Thus, it is useful to choose a 

method that can measure the reductions achieved 

through various reduction strategies or to specify multiple measurement options, some of which may be 

allowed only for certain mitigation options. 

Point of Obligation 

The point of obligation will influence where and how 

emissions, or their proxy, are measured. Similarly, 

measurement constraints will influence where and how 

the emissions are regulated. If the regulation is directed at upstream sources, such as fuel suppliers, it is not 

appropriate to measure combustion emissions using an 

in-stack monitor at the power plant where the fuel is 

burned. Instead, the fuel supplier’s compliance with 

the cap and trade program should be judged based on 

the amount and characteristic of each type of fuel sold, 

and the monitoring method would focus on determining the total amount of each type of fuel sold. 

Frequency of Measurement 

Although a cap and trade program requires a complete 

accounting of each unit of emissions, the minimum 

frequency of measuring emissions or the parameters 

used in calculating the quantity that is emitted will 

need to be determined (e.g., continuous emission 

monitoring, periodic monitoring, or the use of emission factors). The nature of the problem to be solved, 

the potential variability of the measured parameters, 

and the length of the compliance period will influence 

the appropriate frequency. For a cap and trade program 

aimed at solving a problem caused by a total accumulation of emissions in the atmosphere, such as acid rain, 

the frequency will be dictated by the ability to capture 

variations in emissions and contribute to an accurate 

estimate of total emissions. For an episodic problem, 

such as ground-level ozone, more importance will be 

placed on the frequency of measurement because 

aggregation of emission measurements must be at frequent enough intervals to investigate individual 

episodes. Furthermore, greater frequency of measurement is warranted when emissions, or the parameters 

used to calculate emissions, have the potential for high 

variability (e.g., for units that use fuels with varying 

characteristics or for units in which emissions can be 

affected by the way the unit or control devices on the 

unit are operated). Both the U.S. SO2 Allowance 

Trading Program and the OTC Regional NOx Trading 

Program in the Northeastern United States (which is 

aimed at addressing episodic ground-level ozone) 

require reporting of hourly emissions which are the 

average of at least four measurements taken each hour. 

Frequency of Reporting 

In addition to deciding upon the frequency of measurement, the regulating authority should consider how 

often to receive the data. The RECLAIM emission 

trading program in California uses computers to get 

the source measurement data reported to the regulating authority in real time. The U.S. SO2 Allowance 

Trading Program, which requires sources to record 

hourly data, requires sources to compile and send 

emission reports to EPA on a quarterly basis even 

though compliance is determined on an annual basis. 

Factors to consider when setting the frequency of 

reporting include: allowing enough staff time to review 

the data (e.g., not waiting until the end of the year to 

3-12 Developing a Cap and Trade Program 
Measuring Small, Clean Units in the 

U.S.SO2 Allowance Trading Program 

The U.S. SO2 Allowance Trading Program allows 

sources that operate very infrequently or are very 

small to use conservative estimations of emissions 

rather than install more expensive CEMS. The program provides limited alternatives for smaller emission sources, at which the cost of more accurate 

measurement is high relative to the emissions. These 

alternatives are designed to ensure that emissions 

are never underestimated. The program also allows 

large units that burn pipeline-quality natural gas to 

use fuel metering and default emissions rates to 

measure SO2 emissions because the characteristics 

of pipeline-quality natural gas are very consistent 

and the resulting SO2 emissions are very low. 

review all data at once); giving time to sources to correct any errors found during review; and providing 

timely, reviewed data summaries to the public. 

Cost and Feasibility 

Within a cap and trade program, there may be sources 

that emit small quantities of emissions because they 

are small, clean, or operated infrequently. Alternative 

and less costly methodologies may be appropriate for 

such sources due to the high cost of the standard 

methodology. It is important to the integrity of the 

trading system to ensure that less accurate methodologies are conservative in nature (i.e., the methods overestimate rather than underestimate emissions), as well as 

to keep the number of sources treated in this fashion 

relatively small. It is also important to keep in mind 

that the cost of accurate emission monitoring should be 

considered in light of the cost savings afforded by the 

cap and trade approach over traditional approaches to 

environmental protection. The added cost of accurate 

measurement may be a small percentage of the savings 

achieved by implementing a cap and trade program versus another form of regulation, and the resulting accuracy and confidence in the emission data may be well 

worth the expense (Ellerman, et al., 2000). 

Quality Assurance and Quality Control 

(QA/QC) 

Simply requiring the most accurate emission measurement methodology will not ensure an effective trading 

system. Effective implementation is critical. It is 

essential that the measurement techniques are standardized, commonly applied to program participants, 

implemented properly, and validated for individual 

applications. In addition, regardless of what measurement systems are used to quantify emissions, it is 

imperative that any system be subject to a welldefined and continuous quality assurance and quality 

control (QA/QC) program. These QA/QC programs 

should be based on national or international standards 

(e.g., International Standards Organization) and must 

be documented with records that can be audited. 

Missing Data Substitution 

It is essential to account for each unit of emissions 

from a source because cap and trade programs assess 

compliance by comparing the total emissions and the 

total number of allowances held. In real-life situations, 

however, monitored data may be unavailable because 

monitoring equipment occasionally functions improperly or is being tested or maintained. Therefore, there 

is a need for rules to provide a standard methodology 

for substituting for missing data periods. 

This standard methodology should provide incentives for regulated sources to keep records in good 

order, to keep measurement equipment well maintained, and to have procedures that ensure that faulty 

Quality Assurance Under the U.S. 

SO2 Allowance Trading Program 

The U.S. SO2 Allowance Trading Program requires 

sources to test each continuous emissions monitor 

(CEM) system in its installed location. The CEM is 

tested at least annually against an independent reference method prior to certifying the CEM for use. 

The independent reference method consists of 

inserting a calibrated probe into the exhaust stack 

and running a sample of exhaust gas through a calibrated analyzer to compare the reading with the 

installed CEM. A bias test determines if there is any 

systematic bias in the CEM readings relative to the 

reference method. If the CEM systematically underestimates emissions, the operator may either fix the 

monitor and retest it or calculate a bias adjustment 

factor (based on differences between the CEM reading and the reference method) that is applied to all 

reported data. 

3-13 Developing a Cap and Trade Program 
Data foundation:

Missing Data Substitution for the 

U.S.SO2 Allowance Trading Program 

Under the U.S. SO2 Allowance Trading Program, if a 

measurement device (e.g., continuous emission 

monitoring system or fuel flow meter) is not operating properly or if fuel sample analysis is not available 

for a particular hour, then the rules require that a 

substitute value be calculated by the source. The 

rules dictate the use of a substitute data algorithm—specified in the regulations—which represents a graduated response. Whether the substitute 

value is calculated as an average value or a conservative value depends on the percentage of time that 

the monitoring system has been able to produce 

and report a quality-assured value, as well as on the 

length of time that the data is missing. The substitute data calculation varies from a) the average of 

the hour before and the hour after the missing data 

period—for missing data periods of short duration; 

to b) a very conservative maximum potential value 

for long or frequent missing data periods. 

equipment will be replaced or repaired in a timely 

fashion. To accomplish this most simply, the rules 

could require a very conservative substitute value 

(e.g., a value that would result in the maximum potential emissions) to be used for any hours of missing 

data. Another option, which is more complex, would 

be to consider the frequency and length of the missing data periods in determining a substitute value. 

This way, an average or slightly conservative value is 

used for short and infrequent periods of missing data 

and a very conservative value is used for long or frequent missing data periods. 

Allowance Distribution 

The distribution of allowances may be one of the 

most difficult issues for policymakers when developing a cap and trade program. Distribution decisions 

have economic, equity, and political ramifications.17 

Cap and trade programs create a valuable asset for 

those who own or control the authorizations to emit. 

If emission sources receive allowances through a nocost allocation, they capture the gains from these valuable assets. Under an auction, the government captures the value of these assets in the form of increased 

revenues. Some analysts have argued that the revenues 

from allowance auctions can have economy-wide efficiency or equity benefits if they are distributed in 

certain ways (e.g., used to reduce distortionary taxes or 

distributed in lump sums to households or other 

groups.)18 

Different types of allocation formulas can create 

“winners” and “losers” among sources participating in 

a cap and trade program. It is important to note, however, that the method for distributing allowances will 

not affect the environmental integrity of the program 

if the program is properly enforced. 

The first major step in the allowance distribution 

process is to decide whether the allowances will be 

allocated at no cost to the emission sources (usually 

based on some form of operating data), sold by the 

regulating authority through an auction or a direct 

sale, or distributed by some combination of these systems. To date, existing cap and trade programs have 

allocated allowances at no cost to sources. 

Whatever allowance distribution method is selected, policymakers can include set-asides or pools of 

allowances from within the cap. Existing cap and 

trade programs utilize set-asides to provide allowances 

for new sources or to provide an incentive or compensation for certain types of behavior (e.g., early reductions, energy efficiency measures, or renewable 

energy generation). This section explains the incentives and decisions associated with allocations, auctions, and direct sales. 

Allocations 

If policymakers decide that allowances will be allocated free of charge, many different methods can be used 

to distribute the allowances. The regulating authority 

will need to consider the following issues: 

•	 Data foundation: In general terms, there are 

three different aspects of a unit’s operation that 

may be measured and used (individually or in 

combination with performance standards) as a 

basis for allocating allowances: mass emissions, 

fuel (or heat) input, and production output (e.g., 

17	 For a more detailed discussion of the equity, economic, and political ramifications of different distribution schemes, see Burtraw, et al., 2001 and 

Ellerman, et al., 2000. 

18	 For a more detailed discussion of the equity, economic, and political ramifications of different allowance distribution schemes, see Burtraw, et al., 

2001; Ellerman, et al., 2000; and Dinan and Rogers, 2002. 

3-14 Developing a Cap and Trade Program 
Reference period:

Allocation period:

The U.S. Experience with Allocations 

The U.S. SO2 Allowance Trading Program uses a combination of historic level of activity (heat input in 

million British thermal units (mmBtu) and an emissions standard, 1.2 pounds of SO2/mmBtu), as the 

primary basis of a permanent allocation. This 

ensures that the plants with the highest emission 

rates will be encouraged to reduce the most, while 

plants that already reduced emissions will need to 

do less (or nothing). The RECLAIM program also uses 

a combination of past activity levels and an emission 

standard for initial allocations. In both programs, 

total allocations are ratcheted down to match the 

program cap. Further, in both programs, new units 

must purchase allowances for compliance. In the 

case of the U.S. SO2 Allowance Trading Program, 

units may purchase these allowances in the marketplace or directly from the government in the government-operated auction. 

Regional NOx trading programs in the 

Northeastern United States utilize an updating inputor output-based allocation scheme (the methodology varies from state to state). The treatment of new 

sources in the OTC Regional NOx Trading Program 

will also vary by state, but states generally include a 

set-aside account to provide allowances for the addition of new sources (McLean, 2002). 

quantity of electricity produced). The measures 

of input and output will vary by sector, but any 

of these processes could be used as a basis for 

the allocation of allowances. Policymakers should 

consider the character and quality of existing 

data (e.g., it may be difficult to base allocations 

on historic output if multiple sectors with different products are included in the cap and trade 

program) and the behavior they want to reward 

(e.g., allocations based on historic emissions benefit the largest and least-efficient emitters, 

whereas allocations based on historic input or 

output benefit those that used the most fuel or 

produced the most product). Additionally, allocations could be based on the above information in 

conjunction with a performance standard, control 

measures, or existing control technology requirements, again depending upon the resources 

available and the desired effect. 

• Reference period: The reference period for allocations could be historic, current, or even projected. Though an important decision in any 

allocation scheme, the relative importance of the 

reference period decision increases with the 

length of the allocation, as further explained 

below. Allocations using historic reference periods are attractive to firms that typically have 

been big emitters, or in the case of input or output approaches, near their maximum capacity in 

the past (whether they have subsequently 

reduced these activities or not) because they are 

guaranteed a relatively large allocation under the 

new cap and trade regime. Using the average of 

several years’ data can smooth out possible irregularities (e.g., extreme weather conditions, plant 

shutdowns for maintenance). 

An important issue to consider when determining the reference period is how the choice 

will affect sources that implemented emission 

reduction measures prior to the start of the cap 

and trade program. For example, if the 

allowances are allocated based on historic emission levels, choosing a recent year for the reference period will penalize those sources that 

voluntarily reduced emissions early. If emission 

sources predict that such a choice may be made 

in the design of the program, it could provide a 

disincentive for sources to take early actions beneficial to the environment and human health. 

One way to avoid this problem is to choose an 

earlier year as the reference period. However, 

this may have a negative impact on the availability or quality of the data used. Another option is 

to choose an allocation method that is not based 

on historic emissions, but one that may still be 

based on some historic information. In the U.S. 

SO2 Allowance Trading Program the allocation 

method uses a performance standard applied to 

historic utilization (i.e., heat input). This heat 

input data was readily available and did not 

reward plants with high emission rates. 

•	 Allocation period: Policymakers must decide 

whether allocations will be permanent or updated periodically. Because updating systems 

change allowance allocations at periodic intervals, entities may have an incentive to do more of 

the activity that will earn them more allowances. 

Therefore, updating allocations can influence 

3-15 Developing a Cap and Trade Program 
Length of allocation:

Preserving the cap:

Incorporating new sources:

future behavior. The time period of the interval 

will affect the level of influence updating has on 

future behavior. For example, if updating is done 

annually based on output, it could provide a 

strong incentive to increase output in order to 

receive additional allowances. If, however, the 

time period is longer (e.g., 10 years) the effect 

will be considerably less. Permanent allocations, 

on the other hand, provide no such incentive 

because changes in behavior will not affect 

future allocations.19 

•	 Length of allocation: The regulating authority 

may decide to allocate allowances to emission 

sources in advance of the allowance vintage period (i.e., the period in which the allowance can be 

used for compliance). Having allowances allocated in advance can add liquidity to the market 

because sources and other market participants 

can trade future allowances. This also helps emission sources develop and implement compliance 

strategies in advance of the compliance period 

(e.g., a source that installs an emission control 

device can sell future excess allowances to generate revenue to help offset the cost of the control). 

•	 Preserving the cap: Once policymakers determine the method for distributing allowances and 

calculate the sources’ allocations, policymakers 

should compare the resulting total allocations 

and the size of the cap. If too many or too few 

allowances were created while calculating 

sources’ allocations, policymakers can employ a 

ratchet (i.e., a formula that adjusts each source’s 

allocation proportionately). The resulting total 

allocation will then match the number of 

allowances in the cap. This ensures that the cap 

is not inflated through the allocation process.20 

•	 Incorporating new sources: Policymakers must 

decide how new entrants into the program will 

obtain the allowances needed to operate. In 

some systems with updating allocations, new 

emission sources may receive some allowances. 

In the case of permanent allocations, new units 

may obtain needed allowances from the market. 

In a permanent allocation system, facilities that 

are shutdown continue to receive allowances 

indefinitely. These allowances may then be used 

by the owners of the shutdown facility to cover 

emissions at new or other existing facilities that 

they own, or they can sell the allowances in the 

market. This system works well when there are 

many facility and allowance owners and no 

monopoly exists on current allowance holdings. 

Alternatively, an allocation set-aside could be 

created for new entrants. The set-aside could 

hold a specific percentage of the overall cap to 

cover growth in new sources. 

Finally, some analysts have noted that both economic theory and empirical experience suggest that 

there is not a competitive barrier to new entrants that 

do not receive no-cost allowance allocations in cap and 

trade programs. These analysts argue that emission 

sources that receive no-cost allowances allocations 

have the same marginal “opportunity cost” for every 

ton emitted as the marginal cost paid by the new 

entrant. In support of this argument, there is no evidence of entry problems for new electric power plants 

under the U.S. SO2 program, which requires new 

power plants to purchase allowances from the market. 

There has been significant entry by new units, even 

coal-fired units that do not receive a no-cost allowance 

allocation (Ellerman, 2003). 

Auctions 

Auctions are an alternative approach to distributing 

allowances. Under this approach, sources are required 

to bid for the number of allowances they would like to 

purchase (i.e., as opposed to receiving an initial 

amount of allowances free of charge via allocations). 

There is considerable research in economic literature 

that supports the view that auctions are more economically efficient than allocations. Supporters of auctions 

argue that auctions: 

•	 Create a source of revenue that can be used to offset administrative expenses or distributed to 

affected groups. If the revenue is used to replace 

existing distortionary taxes (e.g., labor taxes) it can 

create additional economic benefits (Crampton 

and Kerr, 1998). Distributing auction revenues, 

however, may be politically contentious and there 

19 For further information on alternative allocation methods, see ICF, 1999, and Harrison and Radov, 2002. 

20	 In developing the U.S. SO2 Allowance Trading Program, the U.S. Congress initially allocated about 10 percent more allowances than it established by the cap. However, it also required EPA to proportionally ratchet allocations back down to the cap level. 

3-16 Developing a Cap and Trade Program 
Frequency of auction:

“Spot” and “Advance” auctions:

Bidding procedures:

is no guarantee that revenues will be used for economically beneficial purposes. 

•	 Collect “windfall” profits that might otherwise 

accrue to emission sources if allowances are allocated at no charge. 

•	 Avoid politically contentious issues regarding 

allocation methodology and lead to an efficient 

distribution of allowances. 

•	 Provide an immediate price signal in the 

allowance market. 

•	 Create an equal opportunity for new entrants 

into the allowance market. 

In establishing the design of an auction, the regulating authority will need to consider the following issues: 

•	 Frequency of auction: The following are factors 

to consider when determining the frequency of 

conducting auctions (e.g. annually, semi-annually, quarterly, biannually): (a) the lifetime of an 

allowance and the length of the compliance period; (b) the administrative burden of conducting 

auctions; and (c) other methods of distributing 

allowances. If the auction is used in conjunction 

with other allowance distribution methods and is 

intended as a means to provide an early price 

signal to the allowance market it may not be necessary to conduct auctions as frequently. 

•	 “Spot” and “Advance” auctions: Spot auctions 

refer to allowances that are sold for current use. 

Advance auctions refer to allowances for a future 

compliance period that are auctioned in the current year, even though they cannot be used for 

compliance until the future compliance period. 

Early auctions can facilitate development of an 

active future and options market, thus improving 

risk allocation. 

•	 Bidding procedures: There are many approaches 

to conducting auctions. The auction can be 

designed so that all successful bidders pay the 

same price or the price they bid. Bidding options 

for conducting the auctions can be categorized as 

either sealed bid, ascending bid, or declining price 

auctions. Ascending bid auctions may take the 

form of “ascending-clock,” or English auctions.21 

Generally, with sealed bid auctions, potential 

buyers submit bids for a specific quantity of 

allowances. The auctioneer ranks the bids by 

price and, starting with the highest bids, tallies 

the requested allowances until it is equal to or 

greater than the number of available allowances. 

The price of the last winning bid is called the 

clearing price. Those who bid at least as much as 

the clearing price receive allowances at that price 

(i.e., uniform pricing methodology) or the price 

they bid (i.e., “pay-your-bid” methodology.) 

With ascending bid auctions, potential buyers 

have the opportunity to increase their bids, 

changing losing bids into winning bids. When 

there are no more bids, the allowances are distributed to the highest bidders. Descending 

price actions, also called Dutch auctions, are the 

reverse of ascending bid. Generally, the auctioneer starts with a high price for each allowance. 

Potential buyers can accept the price for a specific number of allowances. The auctioneer 

decreases the price until all allowances are sold. 

The different auction approaches have different effects on bidding behavior, which can thus 

influence the efficiency of the allowance distribution.22 With “pay-your-bid” pricing, potential 

buyers try to bid slightly above the estimated 

clearing price. Ascending bid auctions reveal 

greater information about what a potential buyer 

is willing to pay for allowances. This improves a 

bidder’s value estimates and, as a result, the efficiency of the final allowance distribution 

(Fischer, et al., 1998). 

U.S. Experience with a Direct Sale 

Set Aside 

In the U.S. SO2 Allowance Trading Program, a small 

direct sale set aside provision was included for the 

first several years of the program to provide assurances to new sources that allowances would be 

available for purchase. The direct sale offered a small 

percentage of allowances at a fixed price of $1,500 

each (adjusted for inflation), which was about two to 

three times the projected allowance price (marginal 

cost) at the start of the program. The direct sale was 

eliminated in 1997 because allowance prices were 

much lower than expected, and the allowance market was highly liquid. 

21 For more information about forms of auctions, see Crampton and Kerr, 1998.


22 For more information about the effects of bidding behavior with different forms of auctions, see Crampton and Kerr, 1998.


3-17 Developing a Cap and Trade Program 
The U.S. Conservation and Renewable Energy Reserve Program of the U.S. SO2 

Allowance Trading Program 

The U.S. SO2 Allowance Trading Program featured a special set-aside of allowances as an added incentive for electric power companies to undertake demand-side energy efficiency and renewable energy generation programs. 

Under the program, known as the Conservation and Renewable Energy Reserve, EPA can award allowances to 

sources for actions taken before a source was required to comply with emissions limits under the U.S. SO2 

Allowance Trading Program. Allowances for the set-aside were taken from the cap and were limited to a maximum 

of 300,000 allowances. 

Under the program, electricity generators applied for these extra allowances by submitting information to EPA 

on specific energy efficiency programs or renewable energy projects. Sources were required to submit information 

on energy savings or renewable energy generation, and EPA awarded allowances at a pre-determined rate one 

allowance per 500 megawatt hours of energy saved or renewable energy generated. 

As the first program to provide actual emission credits or allowances for efficiency and renewable energy projects, the program provides many valuable lessons. On the positive side, the program featured several elements 

that reduced transaction costs including a standard award formula, a pre-approved list of eligible measures, and 

standardized measurement protocols that allowed companies to use conservative default values for energy savings as a way to reduce measurement costs. On the negative side, it is unlikely that the program spurred actions 

that wouldn’t have happened in the absence of the program. This is largely because the award formula was too 

conservative and allowances prices were too low to provide an adequate incentive for additional activities. 

Auctions may also be used to distribute only a portion of allowances with the remainder distributed by 

an allocation method. Some analysts have proposed 

beginning with an allocation system and transitioning 

to an auction-based system over time (Kopp, et al., 

1999). This would increase economic efficiency over 

time and decrease political opposition from emission 

sources worried about the cost of allowances. 

Set-asides 

Another tool that can be used in allowance distribution is an allowance set-aside. Under a set-aside, the 

regulating authority withholds a certain number of 

allowances from within the cap for a specific purpose. 

The set-aside can be a fixed number of allowances or 

a percentage of the total amount of allowances. 

The regulating authority can distribute the setaside allowances for purposes such as an incentive for 

certain technologies, as a way to address equity issues, 

or as a reserve for new units as explained in the earlier 

section. Policymakers can create set-asides that last for 

a fixed period, such as five years, after which the setaside expires, or it can last in perpetuity. 

Policymakers or the regulating authority should also 

address how excess allowances from the set-aside will 

be managed if they are not distributed. Options for 

managing excess set-aside allowances include canceling the allowances, saving them for future use, and 

distributing them to sources through an allocation or 

auction. Canceling decreases the quantity of allowable 

emissions (i.e., the cap) and may therefore increase 

compliance costs for sources. Saving excess allowances 

for the future can provide flexibility in the future for 

unforeseen circumstances (e.g., many new emission 

sources in the cap and trade program) but it reduces 

the number of available allowances in current years 

and can lead to increased compliance cost for current 

emission sources. Distributing excess allowances 

through an allocation or auction is perhaps the most 

common approach for existing cap and trade programs, 

but policymakers must address the same issues discussed earlier in the sections for allowance allocation 

and auction. 

The most important aspect of set-asides is that the 

allowances come from within the cap so that new 

allowances do not inflate the cap and undermine the 

ability to achieve the environmental goal. If a setaside will be used, policymakers will need to decide 

the basis for awarding allowances from the set-aside 

and the size of the set-aside allowance pool that will 

be awarded. 

3-18 Developing a Cap and Trade Program 
Allowance Use 

Policymakers or the regulating authority must create 

rules governing the use and trading of allowances. 

These rules should be neutral (i.e., favoring no particular individuals or groups of market participants) and 

provide for low-cost exchange among participants. 

Accounting for allowances works like a banking system. Each affected emission source should have an 

allowance account for holding their allowances. 

Transfers of allowances between these accounts 

should be made as simple as possible, with few limits 

or restrictions to impede the market. There are, however, two possible categories of restrictions on 

allowance trades that may be considered — temporal 

and spatial. 

Temporal Considerations 

Allowances are typically allocated for use in a specific 

compliance period. Policymakers might consider 

whether current allowances can also be used for compliance in future periods, referred to as “banking” (see 

Figure 9). Allowing banking in a cap and trade program creates additional flexibility for sources, encourages early emission reductions, can reduce compliance 

costs, and, partly for these reasons, can increase economic and political support for the program. 

Although the ability to bank allowances in a cap and 

trade program can provide significant reductions early 

in the program, policymakers must recognize that 

banking can also delay the achievement of the emission target if banked allowances are used. Because 

Figure 9. Banking Emissions 

YEAR 

Allocated Allowances 

EMISSIONS 

Banked Allowances 

Use of banked allowances 

Actual Emissions 

banking does not delay achievement of cumulative 

reductions, this tradeoff does not represent an environmental concern for problems such as acid deposition 

and climate change, where the environmental problem 

is caused by total accumulation of a pollutant in the 

atmosphere. However, for problems such as groundlevel ozone, where the environmental problem is 

caused by short-term episodes of high emissions, 

analysis should be undertaken to weigh the potential 

effects of banking. Nevertheless, the U.S. experience 

with limits on banking has shown that such limits 

complicated or hindered the operation of cap and trade 

programs and failed to provide apparent benefits. 

“Borrowing” is another form of temporal flexibility. 

With borrowing, allowances from a future compliance 

period are brought forward to meet a compliance obligation in an earlier period. As with banking, borrowing provides compliance flexibility and can be helpful 

in smoothing out spikes in allowance prices (Ellerman, 

2002). For example, if prices reach a certain level, 

sources might be allowed to buy allowances from the 

government that would be deducted from allowances 

available in future compliance periods. The potential 

downsides of borrowing are that emission reductions 

are delayed and there is a greater risk of future noncompliance if an emission source cannot “repay” the 

borrowed allowances. In addition, borrowing can create an incentive for emission sources to act to disrupt 

the cap and trade program’s performance and longevity in order to avoid “repayment” of allowances. 

Furthermore, the health and environmental benefits 

of emission reductions today are delayed until the 

future. All else being equal, benefits 

in the near term are better than benefits in the future. 

There is little experience with borrowing, so policymakers should carefully assess the potential 

environmental and programmatic 

effect of delaying some emission 

reductions and weigh these effects 

against the potential flexibility and 

cost savings of borrowing. In addition, 

policymakers should apply a discount, 

or interest, rate on borrowed 

allowances that is at least as high as 

the discount rate applied to the capital the source saves by not undertaking the abatement or purchasing 

3-19 Developing a Cap and Trade Program 
Limits on Banking in the United 

States: RECLAIM and the OTC 

Regional NOx Trading Program 

In the Southern California RECLAIM program, emission sources are grouped into two categories with 

overlapping compliance periods (i.e., some sources’ 

compliance is based on January to December emissions and others are based on July to June emissions). The RECLAIM program permits sources to use 

allowances to cover emissions within the period for 

which they are issued, so any allowances not used 

within that period effectively expire. However, 

sources in one compliance period can trade 

allowances with sources in the other compliance 

period thereby enabling limited banking and borrowing. One reason program designers chose to 

limit banking was that the locality faced a severe air 

quality problem and policymakers were concerned 

that banking would cause potential emission spikes. 

Policymakers initially allocated allowances in excess 

of actual emissions by a significant amount to provide sources with flexibility. Combining these high 

allocations with banking could have inflated the cap 

in future years, delaying the achievement of environmental goals. In practice, the absence of banking 

provisions may have discouraged sources from 

undertaking early reductions and may have contributed to volatility in the market that required 

major program revisions to address. 

In the OTC Regional NOx Trading Program in the 

Northeastern United States, the banking of 

allowances for future use is permitted. However, 

there are automatic limits imposed on the use of 

banked allowances whenever the bank reaches a 

certain level of allowances. These limits require that 

sources using more than a percentage of their 

banked allowances for compliance must surrender 

allowances at the rate of two allowances for every 

ton of emissions. The limits are imposed in order to 

guard against the excessive use of banked 

allowances in any single compliance period, while 

still attempting to maintain the incentives associated with banking. What has resulted is a segmented 

allowance market and a stratified price structure 

which values banked allowances significantly less 

than present year allowances (Farrell, et al., 1999). 

allowances. In lieu of this discount rate, sources will 

find it less expensive to delay abatement, invest the 

capital saved, and borrow allowances. 

Spatial Considerations 

Because a cap and trade program allows for the flexible 

use of allowances across the geographic scope of the 

trading program, a common concern for a cap and trade 

program aimed at reducing emissions with localized 

impacts (e.g., SO2 and NOx ) is that hotspots may 

occur.

23 

Assuming that a firm’s objective is to maximize 

profits, those with low marginal abatement costs will 

offer to sell their allowances to firms with higher marginal abatement costs. If sources with high marginal 

abatement costs (i.e., net buyers of allowances) are 

congregated in specific areas, those areas are likely to 

experience less environmental improvements than 

others (depending also on meteorology and wind patterns). Furthermore, such areas could experience 

increased emissions and harmful local environmental 

or human health effects, even as the larger goal of 

aggregate emission reductions is achieved. 

For pollutants with localized impacts, an evaluation 

of potential trading patterns may be useful. Potential 

trading patterns can be assessed with economic models or with less resource-intensive methods such as 

spreadsheet analysis. If the results indicate that geographic trading patterns will arise, it may be necessary 

to assess where the largest emission reductions are 

likely to take place compared to where the most sensitive environmental areas are, and whether the program 

will adequately address the environmental problem 

(see Figure 10) or be less effective than direct controls 

on sources. This involves an analysis of the sourcereceptor relationship and includes predicting changes 

in concentrations or deposition resulting from changes 

in precursor emissions, the influence of emission 

sources in one region on concentrations or deposition 

in other geographic regions, and the levels of concentrations or deposition in certain sensitive receptor 

regions. 

If spatial issues are likely to arise, then the cap and 

trade program will need to be designed accordingly. 

23	 This issue is not relevant for greenhouse gas emissions since these 

emissions do not have local air quality impacts, and trading patterns 

will not have localized environmental effects. However, ancillary 

reductions of criteria pollutants may have local benefits. 

3-20 Developing a Cap and Trade Program 
Figure 10. Spatial Considerations 

Prevailing wind direction 

Where are emission reductions most likely to occur? 

20 tpy 

100 tpy 

40 tpy 

Sensitive 

Ecosystem 

Sensitive 

Ecosystem 

How U.S. Trading Programs Address Spatial Issues 

While environmentalists initially feared the potential creation of hotspots from the U.S. SO2 Allowance Trading 

Program, no such local impacts have been observed and overall air quality has improved (Swift, 2000). There are 

several reasons why the trading provisions have not led to hotspots. 

First and foremost, other regulatory standards (e.g., ambient air quality standards, technology and performance 

requirements) protect the local air quality from excess pollution. The United States employs conventional pollution 

regulations (e.g., mandated emissions limits or air pollution control equipment) that are designed to achieve healthbased air quality standards (Schreifels, 2000). The U.S. SO2 Allowance Trading Program represents an additional level 

of pollution control that is designed to reduce total loading of sulfur into the atmosphere. Hence, all utilities regulated under the U.S. SO2 Allowance Trading Program are also required to comply with all other requirements of the 

Clean Air Act—in particular, the requirement to meet the health-based National Ambient Air Quality Standards, New 

Source Performance Standards, and Prevention of Significant Deterioration provisions. These requirements are independent of the trading program and cannot be circumvented through purchase of allowances. 

Second, the significance of the reductions required under the U.S. SO2 Allowance Trading Program—50 percent 

below 1980 levels—ensured that the majority of high-emitting facilities would have to reduce emissions significantly, 

even with the flexibility provided by emission trading. Third, the most cost-effective emission reductions are often at 

the largest, highest-emitting plants and areas with such facilities have reduced emissions more than average. As a 

result, there have been significant benefits to human health and the environment (Burtraw and Mansur, 1999). 

The RECLAIM program employs two trading zones. Trading is restricted so sources in the downwind zone may 

not sell or trade allowances to sources in the upwind zone. 

The OTC Regional NOx Trading Program in the Northeastern United States chose a different tactic. The OTC is composed of three zones with varying levels of ozone problems, and thus varying levels of emission reduction requirements in accordance with the severity of each zone’s air quality problem. In the program development phase, the OTC 

conducted an analysis to determine whether trading restrictions were needed between zones to ensure reductions 

were achieved. When analysis failed to provide affirmative proof that a trading ratio would influence air quality, the OTC 

opted to minimize program complexity and allow unrestricted trading between zones — with the caveat that the 

issue may be revisited in future years as new information becomes available from implementation of the program. 

3-21 Developing a Cap and Trade Program 
NONATTAINMENT 

AREA 

FREE 

TRADE 

Figure 11. Trading Zones approach can be effective if the cap and 

trade program includes 

sources with different 

characteristics that 

influence the local 

effect of the sources’ 

emissions (e.g., stack 

height). For example, 

the regulating authority 

may restrict a tall-stack 

source from trading 

allowances to a shortstack source because 

the shorter stack will 

likely have a greater 

impact on local air 

quality. 

The third approach 

is to adopt a “tiering” 

of environmental policies, requiring sources 

to comply with local 

Generally, there are three approaches for addressing 

this issue. The first is the possibility of introducing 

spatial restrictions on trading. For example, if unacceptable concentrations or deposition are expected to 

arise in a particular area, trading restrictions could be 

imposed by introducing “zones” where net flows of 

allowances into the sensitive area are prohibited or 

discounted by an appropriate amount (see Figure 11). 

A drawback of trading restrictions is the effect on fungibility of allowances and market efficiency. Spatial 

restrictions on the use of allowances mean that an 

allowance is not a standard commodity that is fully 

interchangeable with all other allowances. This lack of 

full fungibility can diminish the economic efficiency 

of the cap and trade program and can complicate the 

allowance market (e.g., lead to price stratification 

between allowances of different zones). 

A simpler way of achieving the same effect as discounting without affecting fungibility is to have a higher retirement rate (e.g., 1.5 allowances per ton of 

emissions) in the zone of concern. This does not prohibit trading or differentiate among types of allowances; 

it simply makes it more expensive in such zones. 

The second approach is to restrict trading between 

different categories of emission sources. This 

environmental quality 

provisions as well as 

those imposed by the cap and trade program. In its 

simplest form, this allows the appropriate regulatory 

authority to limit emissions of the sources identified 

as contributing to the local air quality problem, while 

not tampering with the allowance program. This third 

approach is the one employed by the U.S. SO2 

Allowance Trading Program. 

Allowance Accounting 

Each source that is responsible for compliance should 

have an allowance account. These accounts are the 

official records for allowance allocations, holdings, and 

transfers and can be used to track compliance. Initial 

allocations (or initial winning bids in an auction) provide the beginning balance for the allowance accounts. 

Policymakers might also consider whether the program will allow other interested parties to have 

allowance accounts and hold allowances. These nonsource accounts provide the vehicle through which 

organizations, such as brokers or environmental 

groups, can hold and trade allowances. Brokers, 

investors, and other market makers may play a crucial 

role in facilitating allowance trades. Because the 

allowance brokering and pooling functions are intend3-22 Developing a Cap and Trade Program 
Entitlements:

Takings:

ed to facilitate sources’ efforts to maximize the cost 

savings of their compliance strategies, these nonsource accounts should be integrated with the account 

system for emission sources. 

Allowance Serialization 

Allowances can be serialized to facilitate tracking the 

allowance from creation to use for compliance. There 

are a number of benefits to identifying allowances by 

serial number. Although tracking serial numbers 

increases the administrative burden to both regulators 

and industry, it provides additional transparency and 

protection against accounting discrepancies. The use 

of serial numbers could also facilitate record keeping 

so allowance holders can track the different costs 

incurred in acquiring allowances. This may be necessary for tax purposes. Finally, the inclusion of serial 

numbers in the allowance tracking system provides the 

opportunity to analyze trading patterns and the movement of allowances over time. This may be useful for 

assessing the impacts of the trading program.24 At a 

minimum, allowances should be identified by vintage 

(i.e., the compliance period for which they are issued) 

to identify when the allowances are authorized for 

compliance use. 

Property Rights 

The program rules must clearly define the legal rights 

and responsibilities of emission sources and the nature 

of allowances. Because allowances can be traded, the 

rights and responsibilities of ownership must be established so that these rights and responsibilities can be 

transferred from one participant to another (AGO, 1999). 

When addressing allowance use, the regulating 

authority might want to consider certain property 

rights issues, namely entitlements and takings. Both 

can be addressed in the implementing legislation or 

program rules. The type of legal system in place will 

also affect whether or not allowances are perceived as 

property rights. 

•	 Entitlements: Sources that have historically polluted with limited or no restrictions might argue that 

they have an implied right to allowances based on 

their historical emissions levels (AGO, 1999). 

•	 Takings: If the implementing institution reduces 

the number of allowances at a later date, participants might argue that they are entitled to comHow the U.S. SO2 Allowance Trading 

Program Dealt With Property Rights 

In the SO2 Allowance Trading Program, the legislation specifies that allowances are not property 

rights. This provision was inserted to obviate a challenge of an unconstitutional “taking” should the government decide to alter the emissions cap (i.e., to 

reduce the number of available allowances). 

Functionally, however, the ownership rights and 

responsibilities of allowances are similar to property 

rights (Ellerman, 1999). 

pensation from the regulating authority based on 

the value of the lost allowances. 

Compliance Determination 

The compliance determination process for a cap and 

trade program should be simple and straightforward. 

Prior to implementation, the rules should clearly 

specify the deadlines for reporting and for holding 

sufficient allowances to cover emissions. At the end of 

the compliance period, the emission sources should be 

given enough time to verify emission data for the period and to submit them for compliance. This verification period should not be so short as to cause the 

emission sources to submit data that has not been 

properly quality assured, but not so long as to unreasonably delay compliance assessment. It should also 

allow enough time for the regulating authority, once it 

receives the data, to finish conducting the compliance 

determination well before the end of the subsequent 

compliance period, when the process will begin again. 

At the end of each compliance period and during the 

time when sources are assuring the quality of their 

emission data, the rules should provide for a short 

grace period (e.g., 60 days) so that sources can make 

final allowance trades. This will allow sources to assure 

that their account has allowances equal to or greater 

than their emissions. The regulating authority should 

specify an allowance transfer deadline—the final date 

for sources to trade allowances for use in the compliance year—in advance. 

It may be advisable to freeze allowance transfers 

into or out of accounts after the transfer deadline until 

24	 For example, EPA has conducted analysis showing no adverse environmental impacts from trading under the U.S. SO2 Allowance Trading 

Program (Kramer, 1999). 

3-23 Developing a Cap and Trade Program 
the regulating authority completes the compliance 

determination and deducts allowances for compliance. 

Enforcement 

Penalties for Noncompliance 

Stringent penalties for noncompliance are an integral 

feature of a well-functioning cap and trade program. 

These should be applied automatically in cases where 

a source does not have sufficient allowances to cover 

mass emissions during the compliance period. In cases 

where there is noncompliance with requirements of 

the cap and trade program (e.g., measuring emissions, 

reporting, and other requirements), the penalties 

should be determined based on the nature and severity 

of the violation. The penalties should be sufficiently 

high to provide the appropriate incentives for compliance and can take the form of allowance, financial, 

and/or criminal penalties. 

Excess Emission Offsets 

In cases where a source does not have sufficient 

allowances to cover its emissions, an allowance restoration rate of at least one-to-one should be applied to 

maintain the environmental integrity of the program. 

Under a one-to-one rate, one allowance from the next 

compliance period would be retired for every unit of 

excess emissions in the current compliance period. 

Alternatively, the shortage of allowances can be purchased from the allowance market. 

Aside from the one-to-one allowance restoration rate 

to maintain environmental integrity, the regulating 

authority should apply financial penalties for noncompliance if the goal is to deter such behavior. The existence of a one-to-one restoration rate without other 

accompanying punitive measures for noncompliance 

implies that sources can, in effect, use allowances from 

future compliance periods to attain their emissions 

reduction target. This can result in a scenario in which 

the emission cap is never attained. Hence, it is very 

important that the incentives deter noncompliance. 

Financial Penalties 

Deterring noncompliance can either take the form of 

allowance or financial penalties. With allowance penalties (i.e., where a source would have to turn in a multiple of its allowance shortfall at a ratio greater than 

one-to-one) the aggregate cap of emissions in the next 

compliance period is reduced. The environmental benePenalties to Deter Noncompliance in 

U.S. Trading Programs 

Under the U.S. SO2 Allowance Trading program, the 

penalty consists of a one-to-one allowance restoration rate and a financial penalty applied at a level of 

US$2,000 (1990 dollars), adjusted annually for inflation, for each ton of excess emissions above 

allowances held. In 1990, this level of financial penalty was thought to be approximately three times the 

expected market price of an allowance. Based on the 

inflation adjusted penalty amount and actual market price of allowances, this is actually on the order 

of 20 times the market price of allowances, and 

could, in retrospect, be too stringent. For example, 

when non-compliance results from imperfect or late 

data or miscalculations, these penalties may be 

viewed as inappropriately punitive. 

In contrast, the penalty for non-compliance in the 

OTC Regional NOx Trading Program is an allowance 

penalty at a ratio of three-to-one. In other words, for 

each ton of excess emissions, a source must submit 

three allowances to the regulating authority. 

Additionally, states within the OTC have the option 

of imposing financial penalties. This penalty, however, may not be sufficiently high. For example, during 

1 year, the price of a NOx allowance fluctuated 

between US$500 and 3,000. Some sources might 

have sold allowances for US$3,000 and purchased 

for US$500 at the end of the year. 

fits of the program increase due to the allowances that 

are deducted as a penalty, but this could lead to further 

noncompliance because the necessary reductions are 

greater in the following compliance period. 

Alternatively, market volatility may tempt some to 

speculate and intentionally be in noncompliance if they 

believe the market price for allowances will drop in the 

future. Furthermore, taking allowances out of the market reduces the supply and raises the price of allowances 

for all participants, not just those that are out of compliance. However, this should not be a significant factor 

unless there is large-scale noncompliance. For these reasons, a financial penalty (in addition to the one-to-one 

offset) may be preferable to deter noncompliance. 

Policymakers or the regulating authority should set the 

level of the financial penalties significantly higher than 

the expected marginal abatement cost—the expected 

3-24 Developing a Cap and Trade Program 
market price of allowances—to create an effective deterrent for noncompliance. Policymakers could also create a 

graduated financial penalty to reflect the severity of the 

violation or the length of delay in making payment. For 

example, if a source exceeded its emission cap because 

of an accounting error, the penalty might be twice the 

price of allowances, payable in 30 days. For a more serious violation or if the penalty is not paid in 30 days, it 

could grow to several times the price of an allowance. If 

the penalty is in dispute, the source could put funds 

into an escrow account awaiting adjudication. 

The allowance price from which the penalty is calculated can be based on a projection of the allowance 

price (established during the development of the program) and adjusted for inflation. Alternatively, it can 

be based on a multiple of either the actual average 

price or the highest monthly price of allowances for 

the preceding year in which the program was in operation. Establishing the penalty based on a multiple of 

the projected market price of allowances can be difficult because different economic models often yield 

substantially different estimates. However, indexing 

the compliance penalty to actual prices can also be 

difficult without a liquid market/exchange. In some 

cases, a periodic, government-run auction can reveal 

price information that the regulatory authority can use 

to set the penalty level. 

If a source is out of compliance with the monitoring, reporting, and/or other requirements specified by 

the regulating authority, financial penalties should 

also be applied. These also can be graduated depending on the nature of the noncompliance (or “degree of 

fault”), with higher penalties for repeat. To maintain 

consistency, the penalty levels should, to the extent 

possible, be defined in advance. Finally, to ensure that 

the penalties are enforced in a timely manner, the 

penalty rate might increase if the source does not pay 

the penalty within a specified period of time. 

The revenues from these penalties might be collected and redistributed in several ways. For example, they 

can be collected by the national treasury and redistributed in the same way as income taxes or they can be 

paid directly to the regulating authority to offset program costs. The revenues may also be collected in a 

special fund to provide resources for research and development into abatement technology and/or environmental purposes related to the pollutant being regulated. 

Regardless of the type and severity of penalties, 

they should be objective and automatic. Eliminating 

penalty negotiations between regulating authority and 

emission source promotes impartiality and equity and 

reduces opportunities for dishonest behavior. In addition, it sets clear expectations so that sources know 

the consequences for noncompliance. 

Criminal Penalties 

The regulating authority might also impose criminal 

penalties on individuals who knowingly violate any 

requirements, with maximum sentences for first-time 

and repeat offenders. Criminal penalties provide direct 

incentives for the legally responsible individuals (“designated representatives” or owners and operators) at 

the affected sources to behave responsibly. Owners, 

operators, and designated representatives should be 

required to sign each form that is submitted to the regulating authority for the source (e.g., allowance transfers or emissions reporting) indicating that they are 

liable for acts and omissions within the scope of their 

responsibilities under the cap and trade program. 

Other Design 

Considerations 

Integration of Cap and Trade 

with Other Policy Approaches 

There are a number of ways in which policymakers can 

integrate cap and trade programs with other approaches for environmental policy. Command-and-control 

approaches can be compatible with cap and trade, but 

policymakers should identify the relationships 

between the different policies and ensure there are no 

contradictions or duplications. With command-andcontrol, the regulating authority specifies sector-wide 

technology and/or performance standards that each of 

the affected sources must meet, whereas cap and trade 

provides sources with the flexibility to choose the 

technologies that minimize their costs. 

Depending on the type of pollutant that is being 

regulated by cap and trade, integration with command-and-control approaches can aid in the prevention of hotspots that may result from the use of 

allowances. For example, additional reductions 

3-25 Developing a Cap and Trade Program 
through a cap and trade program could be layered on 

top of existing requirements.25 

Finally, with regard to integrating alternative forms 

of emission trading, if the regulating authority decides 

to establish more than one type of emission trading 

program, each should affect distinct sectors. If 

desired, allowances from a cap and trade program 

could, in theory, be fully interchangeable with offsets 

from project-based mechanisms or credits from a ratebased program. However, the regulating authority 

must ensure that project-based mechanisms do not 

undermine the environmental integrity of the cap. 

Stringent oversight, verification, and conservative 

crediting methodologies need to be established to 

account for uncertainties and to avoid the creation of 

“anyway” tons, paper credits, leakage, or double 

counting (see Chapter 2). 

The United Kingdom ‘Gateway’ 

Mechanism: Trading Between 

Allowances and Credits 

One mechanism that has been proposed to enable 

trading between allowances and credits from ratebased trading is the ‘gateway’ in the U.K.’s Emissions 

Trading Program for greenhouse gases. Under this 

approach, sources affected by the rate-based trading 

program can purchase as many allowances from 

sources regulated under the cap and trade program 

as they wish. However, sources regulated by cap and 

trade program can only purchase credits from 

sources under the rate-based program if the net flow 

of units in this direction is zero. The U.K. Emissions 

Trading Program is still in its infancy; hence, it is too 

early to evaluate this approach. It is likely that the 

transaction costs associated with undertaking these 

inter-program trades (vs. intra-program trades) are 

likely to be higher due to the administrative costs 

associated with assessing net flows. 

25 For more information about layering command-and-control and market-based programs, see Schreifels, 2000. 

3-26 Developing a Cap and Trade Program 
Increased data accuracy:

Reduced time and costs:

4 

How to Implement


and Operate a Cap


and Trade Program


Introduction 

T

he credibility of the cap and trade program and 

confidence in the market depend on the accuracy 

of emission measurement and enforcement by 

the regulating authority. Because allowances, and 

therefore emissions, have an economic value, sources 

might misrepresent emission data if there are no consequences or low probability of discovery. The regulating authority must ensure that enough resources are 

dedicated to verifying emission reports and auditing 

affected sources. 

The regulating authority must also ensure that 

allowance accounting is undertaken with the appropriate scrutiny and security to avoid errors and fraud. 

Computerized accounting systems for emissions and 

allowances can facilitate the management of these 

responsibilities. 

This chapter describes the functions necessary to 

implement and operate a successful cap and trade program including tracking information on emissions, 

allowances, and compliance; auditing and verifying 

emissions reports; providing technical support and policy guidance to regulated sources; and costs and 

resources necessary to operate a cap and trade program. 

Integrated 

Information Systems 

Perhaps one of the most important lessons learned 

from existing cap and trade programs is the need for 

comprehensive, accurate, transparent, and timely information about emissions and allowances. The regulating authority that operates the program must collect, 

verify, maintain, and disseminate the data if the program is to operate with environmental integrity, economic efficiency, and public credibility. Computerized 

information systems are the most effective method 

available today to process and disseminate these data. 

Using an information system to collect and manage 

large amounts of data on emissions and allowances can 

provide numerous benefits, including: 

•	 Increased data accuracy: Tools such as electronic 

reporting and automated data quality checks 

reduce errors and eliminate redundant data entry. 

•	 Reduced time and costs: Electronic reporting 

and automated data quality checks reduce the 

time and costs required to complete, process, 

and review paper forms. In addition, the electronic storage of data can significantly reduce, or 

4-1 How to Implement and Operate a Cap and Trade Program 
Enhanced access:

Improved consistency and comparability:

even eliminate, the costs associated with the collection, transportation, storage, and dissemination of paper forms. 

• Enhanced access: Electronic data storage makes 

it easier and faster to retrieve, analyze, and evaluate relevant data on demand. Improved access to 

data can also promote confidence in the trading 

program by permitting emission sources and 

interested members of the public to retrieve data 

to ascertain compliance, evaluate a program’s 

effectiveness, and make informed decisions. 

Data transparency can also facilitate efficient 

markets, build public acceptance, and foster 

credibility (Kruger, et al., 2000). 

•	 Improved consistency and comparability: 

Electronic reporting and electronic data storage 

encourage consistency by requiring all emission 

sources to report the same information in a common reporting format. This consistency promotes comparability across time and among 

program participants, leading to a fully fungible 

tradable commodity and efficient market. 

In the early stages of a cap and trade program, the 

data system may be as simple as a spreadsheet with 

manual audit procedures. As an interim measure, this 

approach can be reliable if volume is low, and it might 

provide an opportunity to assess whether automation 

is necessary and to what extent. As resources become 

available and the program evolves, the information system can be modified, expanded and, if appropriate, 

automated to address the needs of the program. 

A comprehensive information system should 

include modules to collect, review, and manage data 

on emissions and allowances and a module to determine compliance.26 

Emissions Tracking Module 

(ETM) 

The most data-intensive component of the information 

system may be the emissions tracking module, or ETM. 

The purpose of the ETM is to collect, review, and 

maintain relevant emission-related data from each 

source. The type and quantity of data collected will 

depend on the measurement requirements for the cap 

and trade program. For example, a program that relies 

on emission factors to calculate emissions from combustion sources might require participants to report data on 

the type and amount of fuel consumed, the combustion 

technologies installed, and the emission factors used. A 

cap and trade program requiring continuous emission 

monitoring systems might collect data on measured pollutant concentration and volumetric flow of exhaust gas. 

Although the frequency of reporting will depend upon 

the calculation method, the length of the compliance 

period, and administrative requirements, it should be 

frequent enough to supply sources, the regulating 

authority, other market participants, and interested parties with timely information about emissions and facilitate compliance determination. 

Regardless of the method used to calculate emissions, the data must be consistent, accurate, and 

objective if sources, market participants, and the public are to have confidence in the program. To facilitate 

access to the data, the regulating authority can make 

the emission data from the ETM available to interested parties through a publicly accessible interface (e.g., 

the Internet). The data are useful to market participants who can use them, along with allowance data, to 

gauge potential supply and demand for allowances. 

The public, interest groups, and academics can use 

the data to evaluate the effectiveness of the cap and 

trade program (e.g., emission reductions and environmental effects). However, simply making data available may not be sufficient. True transparency 

necessitates making the data available in a useful and 

usable format (Teitenberg and Wheeler, 1998). 

Determining the appropriate format will depend on 

the type and quantity of data collected, as well as 

their end use. 

Due to the potentially large volume of data, the 

regulating authority operating the program might benefit by requiring all sources to submit emissionrelated data electronically. Electronic submissions 

improve accuracy and reduce the burden on sources 

and the regulating authority by eliminating the need 

for redundant data entry, facilitating automated data 

quality checks, and providing immediate feedback 

about data quality. In the event that electronic submission is not feasible, sources might submit data on 

diskettes, compact discs, or paper forms. The regulating authority can then transfer the data to the ETM. 

This manual process could be cumbersome for the 

regulatory authority and prone to data entry errors. 

After sources submit emission data, the ETM 

should check the data for omissions, mathematical 

26 For more information about data systems for cap and trade, see Schreifels, 2001. 

4-2 How to Implement and Operate a Cap and Trade Program 
errors, and methodological problems. If the ETM uses 

electronic reporting, it can acknowledge the submission and report the results of the quality check directly to the sources. The ETM can also perform 

in-depth analysis and quality assurance checks. For 

example, the system might compare the submitted 

data to historical data from the source and similar 

facilities to search for inconsistencies. Potential problems that the ETM identifies might be reported to 

the regulating authority so an auditor can check the 

data and, if necessary, request additional information 

from the source. In the absence of a computerized 

information system, the regulating authority should 

oversee these functions. 

Once the data passes the data quality check, it can 

be recorded in the ETM and made available to interested parties. An automated data quality check 

reduces the time and cost of data review in two ways. 

First, the ETM identifies minor errors immediately 

and reports to the source so they can correct the 

errors. Second, the regulating authority can focus on 

problems identified by the second stage of the review 

in order to prioritize in-depth reviews. The automated 

data quality check can also reduce processing delays 

and provide interested parties with faster access to 

emission data. 

Allowance Tracking Module 

(ATM) 

The Allowance Tracking Module, or ATM, is the 

accounting system for the trading program, keeping 

track of account information, account holdings, and 

transactions. As with other components of the system, 

public access to the data is important. Market participants, including sources, brokers, and other allowance 

owners, can use the data to verify transactions and monitor holdings. The public, interest groups, and academics can use the data to evaluate the effectiveness of the 

cap and trade program, identify barriers to cost-effective 

trading, assess overall market activity, identify trading 

trends, and analyze the emission implication of trades. 

The potentially large volume of transactions in a 

trading program may necessitate electronic submission 

of transactions. As discussed earlier in the section on 

submissions of electronic emissions data, electronic 

submissions have many benefits, including improved 

accuracy, reduced burden on the regulating authority, 

immediate feedback and transaction confirmation to 

participants. 

The ATM can play a critical role in all allowance 

transactions, including the issuance, transfer, retirement, and cancellation of allowances. The regulating 

authority can use the ATM to issue and distribute 

allowances according to a prescribed method (e.g., 

allocation formulas, auctions, sales). A computerized 

ATM can also ensure that trades are valid by reviewing 

the data to verify that account numbers are correct, 

the seller owns the allowances being transferred, and 

the allowances are still valid (i.e., they have not been 

retired for compliance or cancelled). Once the information is verified, the ATM can deduct the traded 

allowances from the seller’s account and add them to 

the buyer’s account. If the transaction is not valid, the 

ATM should notify the buyer and seller and, if appropriate, record the failed transaction as an acknowledgement that the transaction was submitted. 

The ATM, in conjunction with the Reconciliation 

and Compliance Module, can facilitate compliance 

assessment by retiring the appropriate number of 

allowances from each account. In addition to issuance, 

transfers, and retirement, the ATM can facilitate canceling allowances for environmental or other reasons 

(e.g., administrative penalties, purchases by environmental groups). 

Public Participation in the U.S. 

Allowance Market 

The public can participate in emission trading programs by purchasing allowances. Environmental and 

student groups have taken advantage of this option, 

purchasing allowances with the intention of retiring 

them from the system. Retiring allowances for the 

environment prevents them from being used to 

emit pollution. For example, in the U.S. SO2 

Allowance Trading Program, these groups acquired a 

total of 934 allowances in the period of 1994 to 

1997. In RECLAIM, environmental activists acquired a 

total of 1,925 allowances in the first year of the program. This represented about 4 percent of the annual allocation. Despite the small volume of 

allowances, these transactions are symbolic of the 

openness of the system and the ability of the public 

to take direct action on behalf of their environment. 

4-3 How to Implement and Operate a Cap and Trade Program 
Reconciliation and 

Compliance Module (RCM) 

The Reconciliation and Compliance Module (RCM) is 

the vital link between the ETM and ATM to determine compliance. At the end of each compliance period, the RCM compares a source’s allowance holdings 

against the total emissions from the period. If the 

source’s emissions are equal to or less than their 

allowance holdings, the source is in compliance (see 

Figure 12). Conversely, if emissions are greater than the 

allowance holdings, the source is not in compliance 

and is subject to any noncompliance consequences and 

penalties. 

The RCM, in conjunction with the ATM, should 

deduct the appropriate number of allowances from 

each source’s account. The deductions might be 

made on a prescribed basis (e.g., first in, first out) or 

by specific instructions as to which allowances are to 

be deducted. The latter approach may be desirable for 

a variety of reasons (e.g., tax consequences, forward 

trade contracts). 

If the source is not in compliance, the RCM 

should: 

•	 Instruct the ATM to deduct all allowances from 

the source’s account and withhold future 

allowances equal to the overage penalties. 

•	 Report the noncompliance and emissions overage to the regulating authority for enforcement. 

Figure 12. Reconciliation 

Auditing and 

Verification 

Auditing and verification of emission data can take 

several forms. If data submitted by sources are required 

in a standard electronic format, regulating authorities 

can use software to audit the data and identify potential discrepancies or issues to investigate. The regulating authority can use these electronic “desk” audits to 

target more in-depth audits. If sources submit emission data using paper forms, the audit and verification 

will be more resource intensive. For this reason, requiring sources to submit emission data in standard electronic format is strongly recommended. 

When sources use measurement devices, either to 

measure actual emissions or to measure some other 

parameter involved in calculating emissions, such as 

fuel flow, the regulating authority should review data 

collected from measurement devices for reasonableness. In addition, the audit should review results of 

any quality assurance and quality control tests performed on the measurement equipment to ensure that 

the equipment is operating properly. If possible, the 

regulating authority should compare submitted data to 

independently obtained data. 

Verification of submitted emission data should also 

involve field audits — visits to the emission sources 

— especially when sources use measurement equipment. Such field audits can include observing quality 

assurance tests, reviewing on-site records, inspecting 

measurement equipment, and/or comparing installed 

measurement equipment to independent reference 

methods. Such field audits can be perBeginning of year 

Net Allowance 

(Bought and Sold) 

Total Allowance 

Available for Compliance 

Deductions for 

Emissions 

Allowances Remaining 

15,812 

-3,201 

12,611 

-11,867 

744 

Allowances 

11,867 tons 

Emissions 

formed on a random sample of all sources, 

and/or field audits can be performed on 

sources identified with potential measurement or data problems during the electronic desk audits. 

(Source in Compliance) 

4-4 How to Implement and Operate a Cap and Trade Program 
Auditing in the U.S. SO2 Allowance 

Trading Program 

Under the U.S. SO2 Allowance Trading Program, the 

state and local environmental agencies, EPA regional 

offices, and U.S. EPA Headquarters form an auditing 

team. Where possible, regulatory officials (usually 

from the local agencies) observe QA/QC testing of 

emissions measurement equipment that is undertaken by regulated sources. The purpose of the audit 

is to verify that the testing is completed according 

to standard procedures and accurately represented 

in the reports to EPA. In addition, emissions and test 

data are reported to EPA in a standard electronic format, are screened for errors, and are electronically 

audited to identify potential discrepancies. Problems 

found in electronic audits are used to target facilities 

for field audits. Regulatory officials perform both 

random and targeted field audits during which they 

visit facilities to inspect measurement equipment 

and on-site records to verify that the data reported 

to EPA accurately reflects what is happening at the 

facility. In support of this process, EPA provides training and audit software for regional, state and local 

inspectors. 

Technical Support for 

Regulated Sources 

An important element of implementing and operating 

a cap and trade program is the ongoing technical support for sources. The program is more likely to be successful if the regulating authority and emission sources 

keep open lines of communication on the rules and 

procedures of the program. Before implementation of 

the program begins, sources may benefit from workshops that explain and clarify the rules of the program. 

In addition, throughout the life of the program, as new 

issues arise, new sources and new employees enter the 

program, and revisions are incorporated into program 

rules, a continued dialogue between the regulating 

authority and the sources will facilitate the smooth 

operation of the program. 

It is wise for the regulating authority to plan workshops for sources after the rules of the program have 

been publicly disseminated but prior to the beginning 

of the program. The workshops can address all aspects 

of implementation for which the sources are responsible, and should inform them about the role of the regulating authority. For example, the workshops could: 

•	 Explain the applicability criteria of the program 

and address questions about which sources are 

and are not affected. 

•	 Explain the allocation process, including when 

and how each source will know its allocation or 

the procedures for participating in an auction, if 

applicable. 

•	 Address source responsibilities, such as the procedure for identifying the person who will be 

responsible for making submissions and demonstrating compliance for each source. 

•	 Discuss the requirements for measuring emissions and reporting to the regulating authority. 

•	 Outline the procedures for reporting allowance 

trades to the regulating authority. 

•	 Answer any questions related to the determination of compliance and potential enforcement 

actions. 

During implementation of the program, it might be 

necessary to supplement the initial published rules of 

the program with guidance documents that focus on 

specific questions or clarifications regarding the rules. 

It is likely that the initial rules of the program will not 

cover all of the situations that actually arise. 

Sources may need interpretations of the rules by 

the regulating authority to help apply the rules to the 

source’s unique circumstances. This may be particularly true for emission measurement and reporting. 

The more individualized the measurement methods 

and the more options available, the more questions 

are likely to arise. For consistency in the program, it is 

important that sources receive the same guidance. 

One option to ensure consistency is for the regulating 

authority to create a guidance document that includes 

answers to both commonly asked questions and 

unique questions. The regulating authority can modify the document as new guidance is created. Such a 

document is useful as an internal reference to help 

maintain consistency over time, as well as to provide 

information to the public and sources. 

4-5 How to Implement and Operate a Cap and Trade Program 
Administrative Costs 

Associated with Cap 

and Trade 

Although cap and trade programs can cost significantly 

less than more traditional policy options, the programs 

require resources to operate efficiently and effectively. 

Regulating authorities should consider these costs 

when designing the program so they can identify 

appropriate funding sources and budgets. 

The smaller a cap and trade program is, the more 

likely it can operate effectively and efficiently with a 

simple spreadsheet or paper-based system. However, 

as the number of participants or data requirements 

increase, a computer-based system with automated 

data processing becomes necessary. The costs of 

designing and developing27 such a system can be considerable, but the savings in staff time and error 

reductions can help offset some of the expense. 

Additionally, the system may undergo modifications as 

program rules change, automation is enhanced, or 

technologies improve. 

Enforcement 

Oversight and enforcement assure that sources are 

accountable for their emissions and compliance with 

the program requirements. The functions of oversight 

and enforcement include the verification of emissions 

and the enforcement of penalties for fraud or noncompliance. 

Additional Costs 

Other costs associated with cap and trade programs 

may include: 

• General administration. 

• Recording allowance trades. 

•	 Providing public access to program information 

(e.g., emission reports, allowance holdings and 

trades). 

• Monitoring program results. 

•	 Responding to questions from program participants and the public. 

Operational Resources for the U.S. 

SO2 Allowance Trading Program 

The U.S. SO2 Allowance Trading Program requires 

significantly fewer administrative and operational 

resources than traditional command-and-control 

programs in the United States. This is due in part to 

automation and the use of information systems, as 

well as the fundamentally new approach whereby 

administrators can focus on verification and compliance rather than reviewing compliance plans, baseline calculations, and emission reduction 

transactions. Approximately 100 government staff 

members nationwide play a role in the SO2 or NOX 

allowance trading programs. 

• 25 to 30 federal headquarters staff members 

provide policy guidance, develop and operate 

the information systems to track emissions 

and allowances, certify monitoring equipment, 

verify reported emissions data, audit facilities, 

determine compliance, and enforce penalties 

when necessary. The vast majority of these 

staff members perform quality assurance and 

verification of emissions measurement data. 

• 15 federal headquarters environmental staff 

members assist with administration, outreach, 

training, assessment, and operation of a 

national network of monitors to track acid 

deposition and environmental impacts. 

• 15 federal regional environmental staff members and approximately 40 state and local staff 

members help verify the emission measurements by conducting field audits at participating sources. 

All federal costs for development and operation of 

the U.S. SO2 Allowance Trading Program amount to 

less than $1 per ton of SO2 reduced (McLean, 1997). 

27	 EPA has created comprehensive design documentation for an integrated emission and allowance information system. This documentation is 

available to interested governments through the Clean Air Markets Division. 

4-6 How to Implement and Operate a Cap and Trade Program 
5 

Assessment and


Communications


Introduction 

T

his chapter describes how outreach and communications can facilitate a credible and successful cap 

and trade program and discusses some of the communication issues that are unique to emission trading 

programs. The chapter emphasizes the importance of 

transparency (i.e., the full and open disclosure of relevant public and private decisions) for cap and trade programs. Finally, the chapter discusses ongoing data 

collection and assessment recommended for cap and 

trade programs to determine whether they are delivering the desired environmental and economic results 

and to identify potential improvements. These include 

environmental, economic, and market assessments. 

Communicating Status 

and Results 

Research has shown that public acceptance of a government policy is critical to ensure successful implementation; keeping stakeholders informed and involved helps 

build trust in both the policies themselves and in the 

regulating authority (Jasanoff and Wynne 1998). In 

addition to simply conveying information, communication and outreach activities can help generate public 

support for cap and trade programs. This support is particularly important in the case of environmental issues, 

which frequently engender considerable public debate 

between competing interest groups with differing values and objectives. Because there are many misconceptions about cap and trade, regulating authorities 

implementing cap and trade programs need to provide 

complete, accurate, and balanced information on how 

the program works and how it will help achieve environmental objectives. It is also important to engage in 

communication and outreach activities in the beginning of the policymaking process and use these activities throughout implementation to develop credibility 

for the new approach to emission control. 

Multiple Audiences for 

Outreach 

The audience for most outreach activities is highly varied, and each constituency has a unique set of concerns. For example, the general public and the 

environmental community may be primarily interested 

5-1 Assessment and Communications 
“Emission trading is immoral.”

in learning how the trading program affects human 

health and ecosystems, particularly in and around their 

own communities. The affected emission sources, on 

the other hand, may need access to account information or guidance on how to measure and report emissions (see Chapter 4). The academic community might 

show a preference for technical information, such as 

data on long-term emission trends or prices. 

Policymakers might be interested in whether program 

goals are being met (e.g., whether emissions are 

decreasing, by how much, and where). Policymakers 

might also be interested in the program’s overall costeffectiveness. The needs of each of these stakeholder 

groups can be met through a well-designed monitoring, 

assessment, communication, and outreach program. 

Information for the Market 

Another important role of a communication program is 

to provide information to the emission sources to help 

facilitate market operation. Sources need to know what 

their reporting requirements are under the system, how 

to comply with program rules and regulations, and 

whom in the regulating authority to contact regarding 

questions. Moreover, for a cap and trade system that 

relies on trades recorded in near real time, it is necessary for the regulating authority to provide data on 

allowance availability and individual accounts. 

Fortunately, recent advances in information technology are making it possible to provide data relevant to cap 

and trade programs in real time and in many highly 

useful forms (Kruger, et al., 2000). For example, before 

an allowance trade is completed and money changes 

hands, the party acquiring allowances may want to 

know that the ATM has recorded the transaction. 

Availability of this information helps keep the program 

running smoothly and efficiently without long lag 

times. Ultimately, transparency of information makes 

the market more efficient by letting those who wish to 

buy and sell allowances know who is trading and what 

volume of allowances are being traded. This information allows participants to make trading and compliance 

decisions more easily and quickly than if critical information were not available. 

Public Involvement in the Design 

Stage of U.S. Trading Programs 

Both the U.S. SO2 Allowance Trading Program and 

the U.S. RECLAIM program involved the public in 

their design and implementation. During the development of the SO2 Allowance Trading Program regulations, members of the utility, coal and natural gas 

industries; environmental organizations; consumer 

interest groups; regulatory commissions; and members of academia provided input through participation in the Acid Rain Advisory Committee (ARAC). 

RECLAIM was also developed through the use of 

advisory committees comprising representatives 

from public agencies, the business community, trade 

unions, environmental organizations and financial 

institutions. In both instances, the involvement of 

these groups early in the design process helped to 

overcome misconceptions about the use of this new 

instrument and to educate stakeholders on the 

process of program development and implementation (Schwarze and Zapfel, 2000). In addition, it 

helped facilitate implementation because it produced a cadre of knowledgeable individuals who 

were committed to making the program work. 

Communication Issues 

Unique to Emission 

Trading Programs 

There are some unique communication issues associated with cap and trade programs. These programs are 

sometimes met with skepticism from the environmental community and the public. Unique concerns or 

misconceptions about emission trading are summarized below. 

•	 “Emission trading is immoral.” Some critics of 

emission trading start with a philosophical opposition to what they call “the right to pollute.” 

Even under conventional regulation, however, 

permitting establishes the “right” to emit pollution at a certain level. Sometimes this right is in 

the form of an emission rate and sometimes it is 

in the form of the emissions that result from specific, mandated pollution control technologies. 

Unlike cap and trade, most of these traditional 

mechanisms do not limit the total tonnage of 

5-2 Assessment and Communications 
“Emission trading is unfair.”

“Companies will cheat.”

pollutants from each plant (i.e., plants can emit “Trading doesn’t clean the air.”

more when they operate more). The marketbased incentives in cap and trade can also spur 

innovation and new technologies. 

•	 “Emission trading is unfair.” A second misperception of emission trading is that it is unfair 

because companies can buy their way out of 

their responsibilities to reduce emissions. 

Similarly, some have argued that emission trading favors large companies at the expense of 

small companies. These arguments ignore the 

fact that under a cap and trade system, companies that buy allowances are essentially paying 

for emission reductions at other companies. 

Moreover, small companies often benefit the 

most from cap and trade because they may have 

fewer internal options for emission reductions 

and they may benefit from the flexibility of buying allowances. In addition, the largest and highest emitting facilities often have the lowest cost 

per ton for reducing emissions. This was the case 

in the U.S. SO2 Allowance Trading Program, 

where the highest emitting plants in the 

Midwestern United States made the most significant emission reductions. 

•	 “Companies will cheat.” Some believe cap and 

trade will allow companies to avoid their obligations because enforcement and oversight is left to 

“the market.” In fact, if programs are properly 

designed, accountability can be better under a 

cap and trade program than under conventional 

approaches. Cap and trade programs require the 

creation of compliance structures that are useful 

regardless of whether any trading occurs. 

Participating sources must fully account to the 

government for each ton of emissions according 

to stringent emission measurement protocols to 

ensure completeness, accuracy, and consistency 

of emission data. Automatic financial penalties 

can be used that are set at levels that discourage 

noncompliance. The regulating authority’s role in 

the program is to ensure emissions are measured 

accurately and that all participating sources are in 

compliance. Finally, reported information on 

emissions can be made available to the public on 

the Internet or through other means. This transparency can help build the necessary confidence 

in the efficacy of the cap and trade approach. 

•	 “Trading doesn’t clean the air.” Critics of emission trading sometimes argue that trading does 

not reduce emissions; it merely shifts the location of existing pollution. However, this argument fails to account for the cap. Under a cap 

and trade system, the overall level of emissions is 

reduced and capped. The environmental objective is embodied in the cap and the economic 

objective in the trade. Moreover, the larger the 

overall reduction reflected in the cap, the less 

concern there is about the environmental 

impacts of any individual trade or group of 

trades. This point is particularly relevant in 

addressing concerns about hotspots that may 

arise due to trading. Economic and atmospheric 

modeling done in conjunction with an EPA 

study of the U.S. SO2 Allowance Trading program showed that in the Eastern United States, 

the difference in acid deposition with and without trading was less than 5 percent. Differences 

in deposition of less than 10 percent are not 

expected to measurably change the acidification 

of lakes and streams (USEPA, 1995). 

Public Reaction to the U.S. SO2 

Allowance Trading Program 

Although reactions to some of the initial SO2 trades 

in the United States were negative, acceptance of 

emissions trading has grown as the program has 

achieved environmental results. Several observers 

have noted that the key to effectively communicating the benefits of the SO2 cap and trade program 

to the public and environmental groups has been to 

make the point that the flexibility of emission trading was tied to a significant environmental benefit 

(Loeb, 1995). Essentially, the argument is that the 

cost savings from the allowance trading program 

were used “to buy” additional environmental benefits and to therefore ease the concerns of environmentalists over this nontraditional form of 

regulation. Ultimately, once the emissions and environmental results of the program became available, 

the program began to receive more favorable media 

treatment. In addition, a broader range of environmental groups began to embrace cap and trade 

(Kruger and Dean, 1997). 

5-3 Assessment and Communications 
Clean Air Mapping and Analysis Program (C-MAP) 

EPA’s Clean Air Markets Division uses geographic data to assess the environmental effectiveness of the Acid Rain 

Program and to help the public better understand the results and benefits of its SO2 trading program. One of the 

most sophisticated electronic information sources is the Clean Air Mapping and Analysis Program (C-MAP), which 

allows users to assess national and regional impacts of the Acid Rain Program. C-MAP is a Web-based Geographic 

Information System (GIS) assessment tool used to better understand and characterize the environmental results 

and benefits of national and regional pollutant emission reduction programs. The geographic component of GIS 

allows for a clearer understanding of the spatial relationships between emissions reductions and the associated 

effects to air quality, surface water quality, acid deposition, forest health, and sensitive ecosystems. The user can 

analyze national-, regional-, and state-level trends, according to the geographic and environmental area of interest. 

C-MAP files are provided via the Web site and are also included in written reports (see: 

www.epa.gov/airmarkets/cmap). 

For example, this map from C-MAP illustrates the geographic mean centers of SO2 allowance trading (buying 

activity of plants emitting more than their allocation in a given year, and selling activity of sources) for 1995 

through 1999. The proximity of centers of trading each year indicates that there was no significant shifting of emissions from one region to another among these units. The tight geographic correlation corroborates EPA’s observations that units tend to acquire additional allowances from within their own company (or geographic region). 

< 25 

25 – 50 

50 – 75 

75 – 100 

> 100 

Plants Acquiring 

Additional Allowances 

(Thousand Allowances) 

< 50 

50 – 100 

100 – 150 

150 – 200 

> 200 

Plants Supplying 

these Additional Allowances 

(Thousand Allowances) 

1995 Acquiring Activity 1996 Acquiring Activity 1997 Acquiring Activity 1998 Acquiring Activity 1999 Acquiring Activity 

1995 Supplying Activity 1996 Supplying Activity 1997 Supplying Activity 1998 Supplying Activity 1999 Supplying Activity 

Figure 13. Allowance Trading Activity 1995 – 1999 

5-4 Assessment and Communications 
Independent analysis also shows that emission 

trading can lead to greater human health and 

environmental benefits than non-trading policies 

(Burtraw and Mansur, 1999). 

Modes of 

Communication 

By far the most effective means of communication and 

outreach is the World Wide Web. Electronic information can reach a vast audience at low cost. For example, visitors to EPA’s Clean Air Markets Web site28 read 

more than 300,000 files every month. A well-designed 

Web site should be user-friendly, rely on intuitive navigation, and, ideally, undergo usability testing before it 

is made available to the public. It should also be regularly updated to reflect the latest program data and 

developments. An up-to-date Web site can greatly add 

credibility to the trading program and can be used to 

provide information that builds confidence in the cap 

and trade program (see box on C-MAP). 

Information can also be made available to the public via print media. Depending on available budget, a 

regulating authority may prepare and distribute fact 

sheets, brochures, and topical reports that can be distributed by mail. Periodic newsletters are another 

effective means of keeping the public informed of the 

program’s status and results, including emission 

reductions to date, auction results, and allowance 

prices. Similarly, information can be conveyed at workshops and conferences. 

Regardless of the mode of communication, it is 

important to bear in mind that keeping the public 

informed about the status and results of the cap and 

trade program can help ensure the program’s success 

by highlighting its environmental and economic benefits, facilitating market operation, and building public 

and decisionmaker support. To ensure that adequate 

resources are available to meet public demand for 

information throughout a program’s lifetime, a communication function should be designed at the program’s outset, rather than on an ad-hoc basis after 

results are available. Consistently available, up-to-date 

information will help build public confidence in the 

cap and trade program. 

Continued Assessment 

Environmental Assessment 

A cap and trade program, by setting a quantifiable emission goal and using accurate and consistent emission 

measurement, lends itself well to periodic assessment. 

Reviewing emission levels will help determine how 

effectively the program is operating and whether the 

emission cap level has been achieved. Equally important 

to program success is determining how the environment 

is responding to emission reductions and whether overarching objectives for environmental protection are 

being met. Periodic measurement of these environmental endpoints will help provide information on how well 

the cap level is protecting the environment.

29 

The scope of the assessment is determined, to a 

large extent, by the specific policy questions being 

addressed. Continued assessments can include evaluation of emission data, ambient air concentrations monitoring data, and pollutant deposition monitoring data. 

Assessment may also include an evaluation of endpoint parameters or receptors, such as changes in surface water chemistry resulting in decreases in acid 

deposition. Examples of environmental endpoints 

include acidic levels of rainwater and sulfate deposition levels for acid rain, and ground-level ozone levels 

for NOx emissions. 

In order to evaluate the effectiveness of environmental policies and programs, a strong commitment to 

long-term monitoring programs is critical. Effective 

assessment requires a full suite of monitoring capabilities, including tracking stack emissions, analyzing 

atmospheric concentrations of pollutants, measuring 

wet and dry deposition to land and water surfaces, and 

evaluating environmental impacts through surface 

water chemistry and biological monitoring. These programs not only help in evaluating environmental compliance and progress towards program goals (e.g., 

through tracking emissions reductions), they also 

enable assessment of the effectiveness of emission 

controls in addressing human health and environmental concerns. Over the long term, investment in such 

program accountability mechanisms will yield great 

benefits through their contribution to the credibility 

of the policy. 

28 The Web site’s URL is www.epa.gov/airmarkets.


29 For a detailed discussion on ecological assessments and analytical tools in the context of acid deposition in the United States, see USEPA, 2001.


5-5 Assessment and Communications 
Environmental Assessment in the U.S. SO2 Allowance Trading Program 

Since its first year of operation in 1995, there has been extensive assessment of the impacts of the U.S. SO2 

Allowance Trading Program. This assessment has been critical in evaluating the success of the program and in 

building support for the cap and trade approach. Some of these results are summarized below: 

Emissions: One benefit of using continuous emissions monitors is having accurate, complete, and timely emission data that can be used to quantify the overall environmental effectiveness of the program. In 2001, the second 

year of Phase II, affected emission 

sources achieved total SO2 emission reductions of approximately 

39 percent relative to 1980 levels 

(33 percent relative to 1990 levels). 

Compared to 2000 levels, these 

sources reduced their SO2 emissions 

by 5 percent or 569,000 tons. Figure 

14 shows the trend in SO2 emissions 

for all affected sources since 1980. 

Air Quality: Data collected since 

1988 indicate that ambient SO2 concentrations are declining (see Figure 

15). 

Wet Deposition: Field data collected by the National Atmospheric 

Deposition Program/National 

Trends Network (NADP/NTN) show 

that sulfate levels in precipitation 

have dropped sharply since the SO2 

Emissions Trading Program began in 

1995 (see Figure 16) (Lynch, et al., 

2000). 

Dry Deposition: The Clean Air 

Status and Trends Network 

(CASTNet) measures dry deposition 

of sulfur and nitrogen at approximately 100 sites. Like wet deposition, dry deposition can cause 

acidification of surface waters. It is 

also linked with damage to materials. CASTNet data show that dry 

deposition sulfate concentration 

levels also have declined by approximately 30 percent in the 

Northeastern United States and 

Mid-Atlantic (Holland, et al., 1999). 

Source: EPA 

0 

2 

4 

6 

8 

10 

12 

14 

16 

18 

Phase I sources 

Phase II sources 

all sources allowances allocated for that year 

17.30 

16.09 15.73 

11.87 12.51 12.98 13.10 12.46 

11.20 10.63 

1980 1985 1990 1995 1996 1997 1998 1999 2000 2001

Emissions (million tons) 

7.90 

9.40 

6.79 

9.30 

7.03 

8.70 

6.57 

5.30 5.44 5.47 

7.07 7.51 7.81 

5.29 

7.52 

4.94 

11.20 10.63 

1989 – 1991 

1 

5 

10 

15 

>20 

1999 – 2001 

SO2 (μg/m3) 

USEPA/CAMD 08/01/02 Source: CASTNET USEPA/CAMD 08/01/02 

Source: Clean Air Markets Division, EPA 

Source: EPA 

* Regional trends in ambient SO2 concentrations. Percentage is the percent drop in SO2 concentration in 

each Region. Trends are decreasing, with most prominent trends in the Northeast and Mid-Atlantic states. 

Figure 14. SO2 Emissions From Affected Emission Sources 

Figure 15. Regional Trends in SO2 Concentration Sources 

5-6 Assessment and Communications 
Surface Water Impacts: A recent study examining surface water quality in acid-sensitive regions of the United 

States found that, since the beginning of the U.S. SO2 Allowance Trading Program, sulfate concentrations in lakes 

and streams have declined significantly in all monitored regions of the Eastern United States, except Virginia. 

Nitrate concentrations have decreased significantly in the Catskill and Adirondack Mountains and Vermont since 

1990. Increasing Acid Neutralizing Capacity (ANC) demonstrates that recovery is occurring in the Adirondacks and 

Pennsylvania, spurred by the sulfate reductions achieved by the program. (USEPA, 2003). 

1989 – 1991 

1999 – 2001 

Wet SO4 

2 

(kg/ha) 

Wet SO4 

2 

(kg/ha) 

Source: National Atmospheric Deposition Program USEPA/CAMD 07/31/02 

USEPA/CAMD 07/31/02 

0 

5 

10 

15 

20 

25 

30 

35 

>40 

0 

5 

10 

15 

20 

25 

30 

35 

>40 

Source: Lynch et. al., 2000. (Units are in kilograms per hectare). 

Figure 16. Trends in Wet Sulfate Deposition 

5-7 Assessment and Communications 
Continued Economic Assessment in the U.S. SO2 Allowance Trading Program 

To evaluate the scientific (and economic) effects of acid deposition in the United States, a National Acid 

Precipitation Assessment Program (NAPAP) was established in 1980. After a decade of research on the causes and 

effects of acid rain, NAPAP produced a comprehensive Integrated Assessment Report, published in 1991. Part of 

this effort included an economic evaluation of environmental impacts in selected affected areas for which data 

were available and where the valuation methods could be credibly applied. The report explicitly recognized that 

there were limitations in the assessment due to a lack of proper scientific or economic data and models and that 

the results did not present a full picture of the total value of the damages caused by the regional air pollutants. 

A decade later, as methodologies for the economic evaluation of environmental effects improved and continued research was undertaken, more comprehensive estimates indicate that the benefits of the SO2 reductions 

achieved are very high, particularly the reduced health risks of premature mortality and morbidity. Estimates of the 

annual health benefits alone in 2010 are in the order of 17 to 70 billion 1995 U.S. dollars per year (Ostro, et al., 

1999). An updated analysis conducted in 2000 projects annual benefits of about 50 billion 1997 U.S. dollars per 

year beginning in 2010 (Watkins, 2001). 

In addition, recent estimates of the costs of attaining the emission reduction target have been significantly 

lower than expected. In 1989, the EPA estimated annual costs of the program to participating sources at full implementation (2010) to be approximately $5.7 billion annually. A current EPRI estimate predicts annual costs of $1.6 

billion in 2010. Other recent annual cost estimates have been as low as about $1 billion per year by 2010 (Carlson, 

et al., 2000). 

Economic Assessment 

Economic assessments are useful to evaluate whether 

the cap and trade program is delivering the expected 

economic benefits. Assessments include a comparison 

of the environmental and human health benefits (or 

damages avoided) as a result of the program, and the 

total costs of compliance (NAPAP, 1998; Burtraw, et al., 

1998). These types of analyses can be used for a more 

comprehensive cost-benefit analysis to evaluate 

whether further emission reductions and/or additional 

control programs are warranted. 

Market Assessment 

Market assessment (i.e., tracking allowance trading 

activity and prices) is another important aspect of a cap 

and trade program. The volume of activity (i.e., the 

number of transactions that occur) indicates whether 

the market for allowances is liquid and whether it is 

working effectively to minimize the economic costs of 

achieving the emission reduction target. Of particular 

importance is a measure of the number of allowances 

traded in “arm’s-length” transactions, or trades that 

occur between unaffiliated companies. It is these 

trades that have market significance (Kruger and 

Dean, 1997) and demonstrate that an allowance market 

has developed. 

Program Refinement 

Once a cap and trade program has been implemented, 

assessment of the program is valuable to ensure its 

effectiveness. It is important not only to assess the environmental and economic effectiveness of the program, 

but also to assess the implementation. Policymakers 

should consider whether these procedures could be 

improved or if they could be more cost-effective. 

After gaining some experience of program implementation, policymakers should consult with the 

emission sources, as well as use the experience from 

the sources to assess whether changes are warranted 

in the implementation rules and procedures. In addition, input should be solicited from other stakeholders. Based on such input, it can be determined 

whether the program would benefit from refinement 

and if so, a process and timetable can be established. 

It is important to minimize disruption in the program 

and realize that some changes, even if they would 

have been a better choice from the start, are not worth 

implementing because of the disruption they would 

cause. The sources, as well as the regulating authority, 

have learned the rules and any changes, even improvements, might require more time on their part to learn 

and implement. On the other hand, it is very possible 

that there will be changes where the benefits will outweigh the disruption caused by change. 

5-8 Assessment and Communications 
Rule Revision Based on 

Implementation Experience in the 

U.S.SO2 Allowance Trading Program 

Under the U.S. SO2 Allowance Trading Program, EPA 

initiated a stakeholder process after the first few 

years of implementation to solicit input on the 

implementation and experience with the emissions 

measurement requirements of the program. The EPA 

office responsible for the design and implementation of the program led the stakeholder process. The 

process involved the regulated power plants that 

were implementing the requirements, the state and 

local environmental agencies that help EPA perform 

field audits of affected facilities, and environmental 

groups interested in the integrity of the program. 

Based on the input from the stakeholder process, 

EPA developed a revised set of emissions measurement rules and procedures aimed at streamlining 

the process for both the sources and the regulators. 

While maintaining or improving the quality of the 

emissions data and the integrity of the program, the 

revised rules clarified sections that were unclear or 

misleading, increased the cost-effectiveness of the 

rules, and addressed real-life situations that were not 

envisioned when the rules were first written. EPA 

released the revisions in draft form to interested 

stakeholders and requested comments on the revisions, which were incorporated, as appropriate, 

before finalizing the revised rules. Once the revised 

rules were finalized, EPA provided an additional year 

before requiring their use. This gave sources time to 

learn and implement the new rules. 

5-9 Assessment and Communications 

Acid deposition:

Acid rain:

Acid Rain Program:

Additionality:

Affected source:

Allowance:

Anyway tons:

Arm’s length transactions:

Ascending bid auctions:

Glossary of Terms


Acid deposition: The process by which acidic particles, 

gases, and precipitation leave the atmosphere. More 

commonly referred to as acid rain, acid deposition has 

two components: wet and dry deposition. 

Acid rain: The result of sulfur dioxide (SO2) and nitrogen oxides (NOx ) reacting with water in the atmosphere and returning to earth as rain, fog, or snow. 

Broadly used to include both wet and dry deposition. 

Acid Rain Program: The regulatory program created 

under the U.S. Clean Air Act to reduce acid rain. It 

employs a cap and trade framework to reduce SO2 

emissions from electric power plants. The Acid Rain 

Program is also known as the U.S. SO2 Allowance 

Trading Program, the U.S. SO2 cap and trade program, 

and the U.S. SO2 emission trading program. The Acid 

Rain Program also requires reductions in NOx emission rates from coal-fired power plants. 

Additionality: A determination of whether emission 

reductions from a project would have occurred under 

normal business conditions (i.e., in the absence of a 

crediting program). 

Affected source: A facility that produces emissions and 

is subject to the provisions of an emission control regulation. 

Allowance: An authorization to emit a specific amount 

of a pollutant under a cap and trade program. For 

example, in the U.S. SO2 Allowance Trading Program, 

one allowance is the authorization to emit 1 ton of 

SO2. Allowances are used for compliance and can be 

traded among sources participating in the cap and 

trade program. 

Anyway tons: See “Additionality.” 

Arm’s length transactions: Allowance transactions 

between companies that are unaffiliated with one 

another. 

Ascending bid auctions: An auction in which both 

price and allowance quantity are determined through a 

process of open competition. Each bidder has full 

information about the current clearing price and can 

update their bids to increase price or change quantity, 

changing losing bids to winning bids. Those willing to 

pay the most win the allowances. 

Glossary-1 Glossary of Terms 
Banking:

Broker:

Bubble:

Cap:

Cap and trade:

Clean Air Act Amendments (CAAA) of 1990:

Command-and-control:

Credit:

Crediting period:

Designated representative:

Downstream:

Emission target:

Environmental integrity:

Flue gas desulfurization (FGD):

Fuel flow meter:

Fungibility:

Banking: A form of temporal flexibility that gives 

sources the opportunity to save unused allowances 

and/or offsets for use in a later compliance period. 

Broker: The person who acts as an intermediary 

between a buyer and a seller, usually charging a commission. 

Bubble: A regulatory term that applies to the situation 

when a company combines a number of its sources in 

order to control pollution in aggregate; under a bubble 

facility operators are allowed to choose which sources 

to control as long as the total emissions from the combined sources is less than or equal to the amount each 

source would have emitted under the conventional 

requirement 

Cap: The overall emission limit that a group of affected sources cannot exceed under a cap and trade program. May also be referred to as the aggregate 

emission quota, level, target, or budget. 

Cap and trade: A market-based policy tool that establishes an aggregate emission cap on total emissions 

from a group of sources and creates a financial incentive to reduce emissions. The emission cap is 

expressed as allowances distributed to individual emission sources that must surrender allowances to cover 

their emissions. The program provides the flexibility 

for sources with low-cost reductions to reduce even further and sell allowances to others with higher costs of 

control, resulting in achievement of the environmental 

goal at lowest cost. 

Clean Air Act Amendments (CAAA) of 1990: A reauthorization of the Clean Air Act passed by the U.S. 

Congress in 1990. The CAAA, which included provisions for the U.S. SO2 Allowance Trading Program, 

strengthened the ability of EPA to set and enforce pollution control programs aimed at protecting human 

health and the environment. 

Command-and-control: A policy tool in which the regulating authority establishes the necessary emission 

reduction or applicable emission limit for specific 

sources, typically by setting a source-specific emission 

rate standard or mandating the installation of specific 

emission reduction technology. 

Credit: Under a rate-based trading program, credits can 

take the form of an authorization to emit a specific 

quantity of emissions (e.g., 1 ton) when an emission 

source achieves an emission rate below the specified 

performance rate. Under a project-based trading program, once certified by an authorized expert to ensure 

the emission reduction is real, additional, and longterm, a credit is an authorization to exceed a rate or 

other pre-existing standard by a specific amount (e.g., 

1 ton). 

Crediting period: the number of years during which an 

emission reduction project is eligible to receive credits 

for actual emission reductions. 

Designated representative: Under the U.S. SO2 

Allowance Trading Program, the individual who represents the owners and operators of an affected source 

and performs allowance transfer requests, emission 

reports, and all correspondence with EPA concerning 

compliance with the U.S. SO2 Allowance Trading 

Program. 

Downstream: A type of cap and trade system in which 

affected sources are those facilities or consumers after 

the point in the product cycle where the emissions 

actually escape to the atmosphere. For example, electricity consumers are downstream from the emissions 

that occur at the electricity generator. 

Emission target: The level of allowable emissions in a 

cap and trade program. See also “cap.” 

Environmental integrity: The ability of an emission 

control policy, such as an emission trading program, to 

achieve its environmental objective (e.g., reduce or 

limit emissions to a specific quantity). 

Flue gas desulfurization (FGD): Post combustion control technologies designed to remove SO2 from flue 

gases. FGD technologies can be grouped into two general categories of wet and dry processes. In the most 

common type, a wet limestone scrubber, the flue gas 

enters a large reaction vessel (spray tower or absorber), 

where it is sprayed with water slurry containing limestone. The calcium in the slurry reacts with the SO2 to 

form calcium sulfite or calcium sulfate that is removed 

from the reaction vessel and the water is removed. The 

thickened waste can either be disposed of or used to 

produce a by-product such as gypsum. 

Fuel flow meter: An instrument that measures the volume or mass of fuel burned. 

Fungibility: The interchangeability of allowances, 

credits, and/or offsets, assuming that each represents a 

Glossary-2 Glossary of Terms 
Ground-level ozone:

Hotspots:

Leakage:

Marginal abatement cost (MAC):

Mass balance approach:

Net buyer:

Nitrogen Oxides (NOx):

Offset:

Ozone Transport Commission (OTC) Regional NOx

Trading Program:

Paper credits:

Performance standard:

Permanence:

Point of emission:

Project host:

Price signal:

Ratchet:

consistently measured and standardized unit of emissions. 

Ground-level ozone: The occurrence in the troposphere (i.e., at ground level) of a gas that consists of 

three atoms of oxygen (O3) and is formed through a 

chemical reaction involving oxides of nitrogen (NOx ), 

volatile organic compounds (VOC), heat, and light. At 

ground level, ozone is an air pollutant that damages 

human health, vegetation, and many common materials and is a key ingredient of urban smog. 

Hotspots: Geographically and temporally concentrated 

pollution levels that exceed desired emission levels or 

ambient air quality standards. Under some circumstances, hotspots may result in conjunction with an 

emission trading program if appropriate safeguards are 

not designed into the program (e.g., a stringent cap). 

Leakage: Occurs when economic activity is shifted as 

a result of the emission control regulation and, as a 

result, emission abatement achieved in one location 

that is subject to emission control regulation is offset 

by increased emissions in unregulated locations. 

Marginal abatement cost (MAC): The amount of 

money a source will need to spend to reduce the next 

ton of emissions of a specific pollutant. 

Mass balance approach: An emission estimation 

method in which inputs and outputs are compared to 

calculate the emissions of the relevant pollutant. 

Net buyer: Under a cap and trade program, an 

allowance trader that acquires more allowances than 

they sell. 

Nitrogen Oxides (NOx): Gases produced during combustion of fossil fuels in motor vehicles, power plants, 

industrial furnaces, and other sources. NOx is a precursor to acid rain and ground-level ozone. 

Offset: An emission reduction of a specific quantity of 

a pollutant (e.g., 1 ton) verified through a projectbased trading program. An offset can be applied to regulatory emission limits as an authorization to emit that 

specific quantity of pollutant. See also definition of 

“credit.” 

Ozone Transport Commission (OTC) Regional NOx 

Trading Program: A NOx cap and trade program 

adopted by jurisdictions (states and the District of 

Columbia) in the Northeastern United States to 

address ozone transport in that region. 

Paper credits: Generated under project-based trading 

programs if the emission baseline for a project is set at 

a level greater than the one at which the source actually operates. If such a baseline is used to calculate the 

quantity of credits or offsets generated by the project, 

the resulting credits or offsets do not reflect real emission reductions. Similarly, paper credits could also 

occur under a rate-based trading program if the performance standard is set at a level above which a source 

actually operates. 

Performance standard: A quantity of emissions allowed 

per unit of heat input or product output. 

Permanence: A concept associated with project-based 

trading that refers to whether carbon stored in the 

biosphere (i.e., carbon sequestration and sinks) might 

later be emitted to the atmosphere (e.g., by a forest 

fire). Permanence should be addressed so that offsets 

awarded for carbon stored in a tree which later burns 

down are not used to allow extra emissions elsewhere. 

Point of emission: A type of cap and trade system in 

which affected sources are those facilities where the 

emissions actually escape to the atmosphere. For 

example, the U.S. SO2 Allowance Trading Program is a 

point of emission program because the affected 

sources are electric generating units that combust fossil fuel and emit pollutants into the atmosphere. This 

kind of program is often referred to as a downstream 

program in the United States and a midstream program 

in Europe. 

Project host: An emission source that hosts a project to 

reduce emissions and generate offsets under a projectbased trading program. 

Price signal: An indicator of what people or businesses 

are willing to pay for allowances or what firms are willing to accept as payment for their surplus allowances 

(or credits). Transactions, whether auctions or sales, 

provide a signal of the price that emission sources and 

other market participants are willing to pay for 

allowances. 

Ratchet: A procedure that adjusts each source’s allocation proportionately, so that the total allocation matches 

the number of allowances in the overall cap. This system promotes environmental integrity by ensuring that 

formulas used to determine allocations do not inflate 

the cap. 

Glossary-3 Glossary of Terms 
Rate-based trading:

Scarcity value:

Scrubber:

Stationary source combustion:

Source:

Sulfur dioxide (SO2):

Trade:

Trader:

Transaction costs:

Upstream:

Rate-based trading: A trading approach in which the Vintage:

regulating authority determines an emission rate performance standard (i.e., an amount of emissions 

allowed per unit of heat input or product output) for a 

sector (e.g., tons/kWh) and allows sources that overand under-comply with the standard to trade credits. 

(The rate difference needs to be multiplied by each 

sources’ utilization to establish a tradable mass emission based credit or offset.) 

Scarcity value: The economic value of an allowance or 

credit due to the limited quantity available. 

Scrubber: A post-combustion control technology utilizing a sorbent to remove SO2 from the emission stack. 

See also “Flue gas desulfurization.” 

Stationary source combustion: The process of burning 

fuel by a source, such as a boiler, that is in a fixed location (i.e., not mobile). 

Source: An entity that releases airborne pollutants into 

the environment. 

Sulfur dioxide (SO2): A gaseous pollutant that is primarily released into the atmosphere as a by-product of 

fossil fuel combustion. The largest sources of SO2 are 

power plants that burn coal and oil to make electricity. 

Trade: An exchange of allowances, offsets, or credits 

for cash or other considerations under an emission 

trading program. 

Trader: Anyone who buys or sells allowances. 

Transaction costs: Financial costs associated with a 

transaction under an emission trading program. The 

costs are usually related to identifying, verifying, and 

certifying emission reductions. These may include 

partner search costs, travel and communication, negotiation activities, legal and contracting costs, potential 

litigation costs, ex-post challenges, opportunity costs 

associated with delays and uncertainties, and other 

related costs. 

Upstream: A form of cap and trade where the obligation of compliance is placed ‘upstream’ of the actual 

emission sources (e.g., at the fuel producer), such that 

the affected sources under the program are not the 

facilities where emissions actually escape to the atmosphere. 

Vintage: Represents the first year, or compliance period, in which a particular allowance can be used for 

compliance in a cap and trade program. 

Glossary-4 Glossary of Terms 
Acronyms


ARAC Acid Rain Advisory Committee 


ATM Allowance Tracking Module


CAAA Clean Air Act Amendments 


CEMS Continuous Emission Monitoring System 


CH4 Methane


C-MAP Clean Air Mapping and Analysis Program


CO2 Carbon Dioxide


DAHS Data Acquisition and Handling System


ELI Environmental Law Institute


EPA U.S. Environmental Protection Agency


EPBs Environmental Protection Boards 


ETM Emissions Tracking Module 


FGD Flue Gas Desulfurization 


GHGs Greenhouse Gases 


ISO International Standards Organization 


MAC Marginal Abatement Cost 


MMBTU Pounds per million British Thermal


Units 

MSD Marginal Social Damage 

NAPAP National Acid Precipitation Assessment 

Program 

NOx Nitrogen Oxides 

OTC Ozone Transport Commission 

QA/QC Quality Assurance/Quality Control 

RCM Reconciliation and Compliance Module 

RECLAIM Regional Clean Air Incentives Market


RFF Resources for the Future


SIP State Implementation Plan


SO2 Sulfur Dioxide


TEV Total Economic Value


USD U.S. Dollar


Acronyms-1 Acronyms 

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A 

The Optimal 

Level of Pollution 

According to economic theory, excessive levels of 

pollution occur due to so-called “market failures,” such as the public goods nature of environmental quality, imperfect information, and other 

factors. Hence, according to economic theory, governments should intervene to provide the correct incentives for pollution control. Determining the optimal 

level of pollution control requires an analysis of the 

level of the environmental externality that is being 

generated as a result of an economic activity. An externality is defined as a cost or a benefit that is not being 

properly accounted for by either the producers or the 

consumers of the activity. For example, consider the 

case of a firm located upstream that is emitting pollution into a nearby stream. As a result, ecosystems 

downstream may be adversely affected (e.g., fish population decline, decline in recreational fishing and 

swimming, adverse health effects from contaminated 

drinking water). These are all examples of negative 

externalities (i.e., costs). If these effects are not reflected in the firm’s production costs, and hence in the 

market price of the economic activity, the firm will 

emit a level of pollution that is above the social optimum. Generally, two conditions need to prevail for an 

external cost to exist: (1) an activity by one party causes a loss of welfare to another party; and (2) the loss of 

welfare is uncompensated. 

Figure A-1 depicts the socially optimal level of pollution. The Marginal Social Benefit (MSB) curve 

shows that initial emission reductions provide greater 

benefit than subsequent emission reductions. 

Pollution abatement, however, costs less for the initial reductions but each additional (or marginal) unit 

of pollution control costs more than the previous unit. 

Thus, the Marginal Abatement Cost (MAC) curve is 

steeper as the quantity of emission reductions is 

increased. 

The optimal level of pollution control occurs where 

MAC = MSB. Hence, to achieve this level, the regulating authority would want to limit the aggregate 

level of emission reductions to the level Q*, which 

reflects the marginal cost associated with that level of 

economic activity, P*. 

A-1 The Optimal Level of Pollution 
Figure A-1. Economically Efficient Control of Pollution 

Cost per Unit of Pollution 

Marginal 

Social Benefit 

CAP AND TRADE 

Marginal 

Abatement 

Cost 

P* 

Q* 

Quantity of Pollution Reduced 

The Economics of


Emission Trading


Cap and trade programs are superior to the more traditional command-and-control approaches for environmental regulation because the emissions 

target—established via the cap—is achieved at a minimum economic cost through the trading of the 

allowances. The regulating authority determines the 

total allowable level of emissions and issues allowances 

for this amount (ideally Q* in Figure A–1 above). The 

allowances are then allocated to the sources, which are 

allowed to trade with other sources in the allowance 

market. In this way, firms with low marginal abatement 

costs will opt to reduce emissions beyond the number 

of allowances they hold and sell the excess allowances 

to firms with higher marginal abatement costs. Thus, 

marginal abatement costs across all sources are equalized and the costs of attaining the environmental target 

are minimized. 

A-2 How to Develop a Cap and Trade Program 
B 

Example Assessment 

of the Potential For 

Cap and Trade 

Case Study of SO2 in the United States: Assessing the Potential for Cap and Trade 

Questions for Consideration A Case Study of SO2 in the United States 

ENVIRONMENTAL SCIENCE ISSUES 

What is the nature of the Emissions of SO2 and sulfates damage human health, ecosystems, visibility, 

environmental problem? and materials (e.g., buildings and monuments (NAPAP, 1991)). During the 

1980s, the most pressing concern was the impact of acid deposition on lakes 

and streams. Today, there is more research linking sulfate particles to human 

health problems and mortality (USEPA, 1995). New studies also show links 

between acidic deposition and forest damage. 

What is the geographic scope of Acid deposition was greatest in the northeast United States and Canada, but 

problem? other regions of the United States had some impacts and emissions were 

known to travel from west to east across the country. Electric utilities operate 

in more than one state so national coverage was important to minimize generation and emission shifting outside of the control area. 

Can emission sources be linked to A decade of research collected by the National Acid Precipitation Assessment 

the environmental problem or Program (NAPAP) quantified the transformation and long-range transport of 

health issue? sulfate particles (NAPAP, 1991). The largest emission sources were located in 

the Midwest and found to impact downwind areas. 

B-1 Example Assessment of the Potential For Cap and Trade 
Case Study of SO2 in the United States: Assessing the Potential for Cap and Trade 

Questions for Consideration A Case Study of SO2 in the United States 

What are the major sources of In 1980, electric utilities were responsible for more than 70 percent of total 

emissions? SO2 emissions in the United States (NAPAP, 1991). 

Are there accurate measurement Technology existed to accurately measure emissions but was not widely 

methods for the sources identified? applied. The trading program required continuous emission monitors for all 

coal-fired boilers in the program, and all sources were required to provide a 

complete accounting of emissions. 

What are emission projections Emission projections showed that emissions from the utility sector alone would 

from each sector? increase to nearly 20 million tons by 2010 if action was not taken (NAPAP, 1991). 

ECONOMIC ISSUES 

Are there available emission A variety of cost-effective technological, fuel switching, and energy efficiency 

reduction options? options existed. 

Do different sources face different Sources faced a wide range of compliance costs and control options (e.g., 

costs? installing scrubbers, switching fuels, increasing energy efficiency). 

What do different marginal costs Generally, the highest emitters had lowest costs to reduce emissions (on a 

imply about where to expect cost per ton basis). In the United States, most of those sources were located 

reductions? in the Midwest and Ohio River Valley. 

What are the overall costs and Economic models were used to estimate the costs of different alternatives. 

benefits? The cost of emission trading was estimated to be significantly lower than traditional approaches. The NAPAP report estimated significant benefits, but 

were not initially monetized. 

Are there any adverse Analyses were undertaken to predict which sources are likely to be buyers of 

environmental implications to allowances and which sources are likely to be sellers of allowances. Estimates 

using emission trading? of the location of emission reductions and trading activity can then be made. 

This information can be used to predict trading activity and air quality 

impacts. There are also ways to incorporate specific requirements to prevent 

problems, like “hotspots.” 

Are there sufficient sources for a The electric power sector contained over 2,000 sources including coal burning, 

fluid market? natural gas, oil and wood-fired sources (serving generators larger than 25 MWe). 

INSTITUTIONAL AND TECHNICAL ISSUES 

Is there sufficient enforcement Automatic penalties for not holding enough allowances were established. 

authority to make a trading These penalties were set at $2,000 per ton, with annual increases to reflect 

program work? inflation. Allowances for the following year are confiscated for every ton 

emitted over allowance levels. The CAAA has additional criminal and civil 

penalties of up to $25,000 a day per violation. 

B-2 Example Assessment of the Potential For Cap and Trade 
Case Study of SO2 in the United States: Assessing the Potential for Cap and Trade 

Questions for Consideration A Case Study of SO2 in the United States 

Is there an infrastructure to The existing infrastructure was not sufficient to provide the needed accuracy 

measure, report, and manage and handle the volume of data in a timely fashion. EPA established standard 

source specific emission data? measurement and reporting protocols for affected sources. Tracking systems 

were developed for unit specific (i.e., boiler-level) emission data and for 

allowance transfers. Data are available to the public on the EPA Internet site. 

Are there adequate resources to Approximately 75 percent of administrative resources in the U.S. SO2 

manage emission data? Allowance Trading Program are devoted to measuring, tracking and quality 

assuring emissions. An electronic emission tracking system was developed to 

receive emission data electronically directly from sources. 

Is there a system and central In the United States new systems were created (emission and allowance 

authority that can be used to tracking systems) to determine compliance. Authority for determining 

determine compliance? compliance was part of the legislation, and EPA historically had been responsible for a variety of compliance and enforcement actions. 

Does legal authority exist for an New legislation was developed for the SO2 Allowance Trading Program— 

emission trading program? Title IV of the 1990 CAAA. 

How can an emission trading Title IV of the CAAA requirements was separate from existing regulatory 

program be integrated with programs and written to interface smoothly with other policies. Sources still 

existing policies? have to comply with existing ambient standards and permitting requirements for SO2. 

What developments are occurring Energy power restructuring has proceeded as the U.S. program has been 

in the affected source sector? implemented. Cap and trade is compatible with a competitive energy sector. 

OTHER CONSIDERATIONS 

Are there any social or economic Concerns about unemployment in the coal mining industry were a 

factors limiting fuel choices? significant factor in the United States. 

Are the needed emission The process for assessing policy approaches to address acid rain involved 

reductions politically acceptable? many government agencies. After the Act was passed, there was an extensive 

Is emission trading politically stakeholder process, including an Acid Rain Advisory Committee, to solicit 

acceptable? input into implementing regulations. Outreach is continuously needed to help 

educate the public about the environmental benefits of emission trading. 

B-3 Example Assessment of the Potential For Cap and Trade 
Office of Air and Radiation Clean Air Markets Division (6204N)


EPA430-B-03-002


www.epa.gov/airmarkets


June 2003