Sample Economics Term Paper on Cap and Trade: Harnessing Market Forces to Curb Climate Change

Over the past few decades, climate change has become a hot topic across various political, economic, and academic forums. It is ironic that climate change has elicited so many divergent schools of thought including those denying its very existence despite its adverse effects. The global community is not only torn between denying and accepting climate change; some have differed on the role of humanity in causing a problem which continues to threaten their very existence. Consequently, divergent schools of thoughts have continued to emerge on how to tackle climate change too. Different solutions to this ever-exacerbating problem of global proportion have been put forward and implemented in various geopolitical regions. They include the use of carbon taxes and emissions trading. Others have even suggested that humanity should do nothing about climate change.

However, these solutions have advantages and disadvantages that curtail their effectiveness to curb climate change individually. Climate change, as a result of carbon and greenhouse gases emission, is a complex and global problem that requires a multipronged approach that cuts across geopolitical regions and concerted efforts of the global community to curb effectively. There is no one-suit-fits-all solution when it comes to tackling climate change. This paper will discuss emissions trading or cap and trade as one of the most practical policies for tackling climate change. It will also highlight its implementation and major macroeconomic pros and cons in relation to other policies.

Cap and Trade

The primary objective of all climate change mitigation measures is to reduce the emission of greenhouse gases. Primarily, reducing carbon emissions is an important step towards reducing climate change and the associated effects of global warming. While such consensus has been reached by scientists, economists, and political leaders alike, consensus building on the mechanisms or approaches to be used in accomplishing this all-important task has been a major challenge for decades. Consequently, many scientists, economists, and leaders in various jurisdictions have proposed and implemented various carbon emission reduction strategies. One such policy or strategy is cap and trade or emission trading.

            According to Center for Climate and Energy Solutions (n.d), a cap-and-trade system is a carbon pricing initiative that works by setting scientifically-backed greenhouse gas emission caps and issuance of emission allowances by government across various industries or the whole economy. Emitters that exceed the set caps are then forced to pay penalties that are also set by the government. Companies are also mandated to hold emission allowances “for every ton of greenhouse gas they emit” (Center for Climate and Energy Solutions).With a set market price, these allowances can then be bought or sold by companies. Companies can trade their emission allowances to other corporations incapable of meeting the emission cap. It is an incentive-based approach that seeks to harness the market forces of demand and supply.

Implementation of Cap and Trade

Emission trading is implemented through multiple policies that extend beyond the greenhouse emission caps and allowances policy. The primary objective of the policy is reducing the greenhouse gas effect locally and globally via the ripple effect. The government uses the available scientific data on greenhouse gases and other emissions from the whole economy or targeted industries to set emission caps and violation penalties. Companies that meet the caps are then issued with emission allowances according to their emission data. Whether received for free or bought during auctions, the companies can opt to sell their allowances at the market price. Others can bank their allowances to use in future considering that the caps are usually revised periodically downwards (Center for Climate and Energy Solutions; David Suzuki Foundation).

            Companies that earn allowances for cutting down their carbon emission have positive reputation among investors and employees who are environmentally conscious. They are better placed to attract investors, partners and top talents and land big deals. The penalties and the financial benefits that come with trading allowances can motivate companies to invest in renewable and safe energy sources which consequently reduce carbon emission.  

Advantages of Emission Trading

Emission trade is cost-effective compared to other solutions for curbing climate change such as carbon tax. It achieves results faster at a lower cost because it harnesses the existing organizational structures to implement (Lombardo n.p). Companies use their existing quality assurance and production monitoring processes to assess their emission. Moreover, they have a greater incentive to reduce their emission below the cap in order to receive allowances and avoid costly penalties (Center for Climate and Energy Solutions; David Suzuki Foundation).

Allowances can also be sold to other companies to generate capital to fund innovations aimed at reducing greenhouse and other pollutants emission. Therefore, companies have a new economic resource where they make additional profits. Such additional funds can also be used in investing alternative energy sources that are safer and that come with greater allowances and potentially, greater income when traded (David Suzuki Foundation; Lombardo).

Cap and trade use a predetermined maximum of greenhouse and pollutants companies can release into the atmosphere (Lombardo). The cap is based on science, and therefore helps authorities in monitoring the status of the atmosphere. Companies are, therefore, more conscious when it comes to their carbon footprint while the authorities can monitor the quality of air and make adjustments appropriately over time. Therefore, the government can achieve long-term emission reduction faster (David Suzuki Foundation).

Disadvantages of Emission Trading

One of the major challenges associated with carbon pricing is that it theoretically oversimplifies the monetary value of the emission. It is difficult to calculate the monetary value of the one ton of carbon dioxide emission. Greenhouse gases such as carbon are products that have no effective market pricing regulations in place. Lack of market price determination mechanism impedes the process of coming up with a standard price (David Suzuki Foundation; Lombardo).

While it provides high levels of confidence when it comes to reducing the rate of emissions in the future, cap and trade does not have a high level of certainty when it comes to the price of the emission allowances. Therefore, companies that have pegged their economic policies and growth strategies on the monetary value of their banked allowances may be faced with lower prices of emission allowances due to decreased demand, increased supply, or general depreciation. Prices of allowances are only certain when the government has set emission targets to be met which effectively affect the pricing of emission allowances since it is plausibly difficult to accurately quantify the cost of climate damages due to carbon or greenhouse emissions. The uncertainty of the damages from the climate change makes it difficult to make an accurate prediction of the economic price of emissions (David Suzuki Foundation; Lombardo).  Additionally, the price dilemma comes from the probable high or low carbon emission prices. The high prices on emissions may likely be at the expense of the economic well-being of other important areas of the economy as the energy prices increase. At the same time, a very low carbon price is likely to affect economic well-being as more emissions increase (David Suzuki Foundation; Lombardo).

The use of carbon credits or allowances that can be bought by companies that emit greenhouse gases and pollutants to offset their carbon deficit is a strong incentive for them to continue using unclean energy sources such as oil and coal. Due to the carbon credits, companies can ignore investing in renewable and safer energy options. The net effect is, therefore, insignificant reduction in greenhouse emission. The gains realized from companies meeting their emission targets and operating below the cap is offset by the high rate of pollution by companies that do not meet their targets but do not pay penalties because they can purchase carbon credits to offset their net emission credit (Lombardo). Since companies can purchase and bank such allowances, reducing emission through cap and trade is challenging because such companies can accumulate huge amounts of allowances which they can use to offset their high emission. Essentially, it allows for carbon cheating as companies can avoid being fined for surpassing the caps by purchasing allowances. According to David Suzuki Foundation, such market manipulations affect the overall effectiveness of cap and trade policy in curbing climate change especially if there are no supplementary legislations.  The Center for Climate and Energy Solutions holds that successful implementation of the cap and trade policy depends significantly on market integrity.  

Towards a Hybrid System

Cap and trade policies are volatile and may be a riskier option for many investors and end users. Moreover, the government that auctions the permits may also lose out on the unpredictability of the production activities using fossil fuels. Caps also fail to consider the non-price policies like the subsidies that accrue from renewable sources of energy. Moreover, there is a need to implement several supplementary policies that require extensive bipartisan support which may be hard to achieve (David Suzuki Foundation). Therefore, some countries have opted for carbon taxes as an alternative carbon pricing policy to offset such challenges. 

Carbon tax is based on a polluter pays principle where taxes are levied on entities that produce pollutants. The tax levied is set by the regulating body. This policy asserts that the same price of each ton of carbon dioxide emitted should be taxed at the source. One way of achieving this is by taxing all fossil fuel sources in relation to the amount of carbon in them. Different fossil fuels have different uses in the economy. Therefore, different sources of fuel also have different carbon contents, leading to the various amounts of taxes. The tax is directly controlled and the amount could be used for economical purposes.

Carbon tax has both financial and reputational implications. Financially, it cuts into the company’s profit margins. It also negatively affects the reputation of a company when it comes to environmental protection. Therefore, the company stands to lose investors, partners and talents who are environmentally conscious. The financial losses and reputational damage associated with being labeled as a polluter can drive companies into investing in renewable energy sources and reducing their carbon emissions.   

The advantage of carbon tax comes from its predictability because of the control from the source. It is unlike the cap-and-trade that relies on the emission for pricing. Carbon tax policy can be made and implemented locally, nationally, or within a given economic region. However, it would be difficult to implement such a policy on a global scale. Conversely, since it is a carbon pricing policy it also comes with various challenges associated with cap and trade policy including definitive determination of taxes due to difficulty in accurately quantifying the damage caused by the emissions (David Suzuki Foundation).

Due to these challenges, different countries are increasingly adopting a hybrid system of the two systems of carbon pricing: cap and trade and carbon tax. Both carbon tax and the cap policies on fossil fuels rely on the carbon content for pricing; however, the cap pricing depends on the specific industries. The major difference between the two systems comes from the fact that cap-and-trade allows the permitted markets to adjust carbon price automatically. This does not happen with carbon tax because of the direct control by the government from the carbon source. Similarly, two countries may have the liberty of having the same carbon permits, thus equalizing the price within their markets, an effort that leads to more efficiency.

Economics of carbon pricing remains the main factor towards adopting both carbon pricing policies. The economics of pricing does not change for either of the choices on policies by a country or region. A hybrid system allows for accurately adding a price to the emissions. This is likely to lead to economic consequences for all stakeholders. The financial benefits associated with a hybrid system including funds received from trading allowances will encourage companies to cut their carbon emissions. Moreover, such companies will be further incentive to reduce their carbon emission by the prospect of good reputation in the highly competitive labor market as well as when it comes to attracting investors and partners and winning contracts.

Climate change is increasingly becoming an emotive and highly controversial issue despite its well-documented effects. Divergent schools of thoughts have emerged not only on its existence but also its causes and mitigation measures. Over the years, carbon pricing has gained prominence as one of the ways of mitigating climate change due to the economics and efficiencies associated with it. Carbon pricing initiatives such as carbon tax and cap and trade have numerous macroeconomic advantages and disadvantages. Cap and trade policy has the potential of achieving long-term goals of reducing emissions faster if effectively implemented in markets with high integrity and supported by supplementary legislation and policies. However, they can be implemented together in a hybrid system which reduces their inefficiencies and disadvantages. 

Works Cited

Center for Climate and Energy Solutions.Cap and Trade Basics. Available at:

David Suzuki Foundation.Carbon Tax or Cap-and-Trade? David Suzuki Foundation, 5 October 2017. Available at:

Lombardo,Crystal. Pros and Cons of Cap and Trade. Vision Launch, 25 May 2016. Available at:

Weitzman, Martin. (2013). “Can Negotiating a Uniform Carbon Price Help to Internalize the       Global Warming Externality?” World Bank.