Managing Costs in Cap and Trade
Banking and Borrowing, a Safety Valve, and a Price Collar
May 6, 2009
The search for ways to manage costs in a federal program to limit greenhouse gas emissions produced several approaches that blend the environmental certainty of cap and trade with the economic certainty of an emissions tax. Prominent examples include allowance banking and borrowing, as well as hybrid approaches like a safety valve that sets an upper limit on allowance prices and a price collar (also known as a symmetric safety valve) that sets both a ceiling and floor.
In a new RFF Discussion Paper, "Alternative Approaches to Cost Containment in a Cap-and-Trade System," (RFF DP 09-14) Fellow Harrison Fell and Senior Fellow Richard Morgenstern compare how a set of these policies performs in terms of reaching an expected cumulative emissions target over the period 2012–2050. Their approach explicitly takes into account uncertainties about emissions abatement costs. While they compare policies based on the same expected outcome, they allow for the possibility that actual emissions could be higher or lower.
- Allowance borrowing can lower costs, significantly so when allowances are issued such that they decline at a constant rate—as in pending legislation.
- Restrictions on borrowing, including requirements to pay interest, can be costly. Interest rates in the range being considered in current legislative proposals negate virtually all the gains from borrowing.
The inclusion of either a safety valve or a price collar (symmetric safety valve) can reduce costs compared to pure quantity-based instruments by nearly 20 percent.
In terms of cumulative emissions, the high end for a tax policy is slightly higher than that of the price collar and safety valve.
A price collar is always more cost-effective than a safety valve for a given expected cumulative emissions outcome because it encourages inexpensive abatement when allowance prices decline.
There are efficiency gains from having the trigger prices in either a safety valve or a price collar rise at the rate of interest.
Richard D. Morgenstern
Alternative Approaches to Cost Containment in a Cap-and-Trade System