Alternative Approaches to Cost Containment in a Cap-and-Trade System

We compare several emissions reduction instruments, including quantity policies with banking and borrowing, price policies, and hybrid policies (safety valve and price collar), using a dynamic model with stochastic baseline emissions. The instruments are compared under the design goal of obtaining the same expected cumulative emissions across all options. Based on simulation analysis with the model parameterized to values relevant to proposed U.S. climate mitigation policies, we find that restrictions on banking and borrowing, including the provision of interest rates on the borrowings, can severely limit the value of the policy, depending on the regulator-chosen allowance issuance path. Although emissions taxes generally provide the lowest expected abatement costs, a cap-and-trade system combined with either a safety valve or a price collar can be designed to provide expected abatement costs near those of a tax, but with lower emissions variance than a tax. Consistently, a price collar is more cost-effective than a safety valve for a given expected cumulative emissions outcome because it encourages inexpensive abatement when abatement costs decline.

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.

They find:

Borrowing

• 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.

Hybrid Approaches

• 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.