Lessons from a Cap-and-Trade Program in Chicago

Jul 1, 2006

Taking up the Slack: Lessons from a Cap-and-Trade Program in Chicago

When the state of Illinois set up a cap-and-trade program to cut volatile organic emissions in Chicago, beginning in the year 2000, something unexpected happened: Prices for emissions allowances fell far below the expected levels, and many allowances went unused. What went wrong?

Research Associate David A. Evans and former Visiting Scholar Joseph A. Kruger analyze the case in “Taking Up the Slack: Lessons from a Cap-and-Trade Program in Chicago” (Discussion Paper 06-36) . They identify three reasons for the disappointing results of Chicago’s trading experiment. First, the allocation of allowances was overly generous. In addition, unrelated regulations for hazardous air pollutants affected emissions of volatile organics, and many sources of emissions shut down during this period.

They point out that Chicago's experience demonstrates “the inherent unpredictability of economic, regulatory and other factors when setting an emissions target.” One conclusion they draw is the importance of mechanisms to make mid-course corrections. To avoid disruptive price drops, and to maintain steady pressure on sources to reduce emissions, programs could be designed to have emission allowances withdrawn from the market whenever the price reaches a predetermined minimum, Evans and Kruger suggest.

However, they also note that such a mechanism may not be necessary to ensure near-term allowance scarcity if there is a banking mechanism and there is a general expectation that abatement costs will increase or allocations will decrease in the future.

The experience in Chicago is similar, Evans and Kruger point out, to other and larger markets in emissions permits --- notably the European Union’s Trading Scheme (EU ETS). The EU ETS experienced a sharp drop in permit prices in the spring of 2006, when it became apparent that many of the participating countries had provided industry with overly generous allowance allocations. Targets in the EU ETS will be readjusted when it enters a second phase in 2008.

Link to Discussion Paper
Taking up the Slack: Lessons from a Cap-and-Trade Program in Chicago
David A. Evans and Joseph A. Kruger
Discussion Paper 06-36 | July 2006 | Abstract

Despite its miscalculations, was the Chicago cap-and-trade program a success? Evans and Kruger argue that it depends on one’s perspective. Most economists would like to see allowances having a relatively high price because harmful emissions should be scarce. In the Chicago market, volatile emissions are not scarce, given their minimal price and the vast amount banked. However, from the perspective of affected sources and the state regulators, reductions in volatile organic emissions were greater than required, at what was most likely a lower cost than it could have achieved under conventional regulation.