The Overallocation Problem In Cap-And-Trade: Moving Toward Stringency

20th July 2009 By: Lesley K. McAllister

Many view cap-and-trade regulation as the most promising policy tool for reducing the emission of traditional air pollutants as well as greenhouse gases that cause climate change. The political success of cap-and-trade can be credited to its ability to accommodate the very distinct interests at play in environmental policy. Regulated sources like the trade part of cap-and-trade. They tend to support cap-and-trade regulation because of the compliance flexibility that trading provides. Individual regulated sources have much greater flexibility than they did under conventional regulation to decide if, how, and when they will reduce emissions.2 Environmentalists, on the other hand, like cap-and-trade because of the cap. They view the cap as providing certainty about the overall amount of pollution that will be emitted by the set of sources included in the program over the program’s lifetime.

The environmental gains of cap-and-trade programs depend on the level of the program cap. The program cap in a cap-and-trade program is the overall regulatory goal, and its level is the “key factor in the environmental success of a cap-and-trade program.”
If the cap is not adequately stringent, the program will not achieve its environmental goals even if sources comply with the cap. In several existing cap-and-trade programs, the caps have not been adequately stringent. These programs suffered from the problem of overallocation, with caps that allowed sources to make few, if any, emissions reductions from business-as-usual emissions. While advocates of these programs may boast about participants’ overcompliance with the program cap, such overcompliance has often been the product of an overallocation of allowances.

This article examines the overallocation problem present in four major cap-and-trade programs, including the United States Acid Rain Program (ARP), Los Angeles Regional Clean Air Markets (RECLAIM), the Chicago Emissions Reduction Market System
(ERMS), and Phase I of the European Union Emissions Trading System (EU ETS). ERMS and Phase 1 of the EU ETS were characterized by “absolute overallocation,” meaning that allowance allocations were greater than emissions and expected to remain greater than emissions such that the price of allowances collapsed.  RECLAIM and the ARP had “early overallocation,” with allowance allocations greater than emissions in the programs’ early years. As discussed below, overallocation and its accompanying effects compromised the environmental effectiveness of these cap-and-trade programs.

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