Best Practices
This page describes the basics of developing and implementing emissions trading programs, including mechanisms to enhance health and environmental outcomes.
The term “emissions trading” can mean different things. This overview focuses on EPA’s allowance-based emissions trading programs to reduce air emissions, which are also known variously as cap-and-trade programs, emissions trading programs, and/or allowance trading programs.
On this page:
Program Development
Determining Regulated Sources of Emissions (Applicability)
When designing a program, the regulator will need to inventory the sources that will be subject to the emissions cap and identify baseline emissions for each unit, availability of control options, and ability to measure emissions.
Source applicability should generally be determined using characteristics that remain constant, such as a source’s capacity or potential to emit, rather than characteristics that vary with utilization, such as a source’s fuel use or mass emissions.
Determining the cap
Setting the level of the cap is one of the most important decisions for the regulator. It should be based on information collected when inventorying the regulated sources.
Generally, the cap should be set at a level that is expected to address the environmental and public health problems of concern at an acceptable cost or a level that is achievable based on the control options.
While mass-based emissions trading programs have often set static budgets, it is critical to calibrate to changing fleet conditions regarding utilization and operating status. This is vital to the environmental integrity of the program and preserving the intended stringency. If too many allowances accumulate, the allowance price could decrease significantly, reducing the incentive for regulated sources to operate their emissions controls effectively.
To right-size the program’s stringency amidst evolving conditions, some existing emissions trading programs feature mechanisms to adjust the level of the emissions cap over time.
For instance, the Revised Cross-State Air Pollution Rule (CSAPR) Update established emissions caps that incorporated pre-determined adjustments over time to account for known future changes in the source inventory, including both unit retirements and construction of new units.
The EPA’s Good Neighbor Plan refined the Revised CSAPR Update's approach with a dynamic budgeting approach, where the emissions cap adjusts annually based the utilization (i.e., heat input) of regulated sources over a 3-year lookback period. This helps ensure that the cap adjusts in response to real-world fleet conditions while continuing to drive cost-effective emissions mitigation.
Allocating Allowances
There are several ways of allocating, or distributing, allowances to regulated sources in a mass-based trading program. Allowances may be auctioned, freely allocated, or a mixture of the two. For example, existing programs have distributed allowances based on factors including sources' historical heat input and emissions.
Determining how to allocate allowances is a decision of high interest to stakeholders as an allowance constitutes a valuable asset. Considerations include economic, equity, and environmental implications.
Some trading programs include set-asides or pools that allocate allowances within the cap to incentivize certain types of behavior or for certain types of sources.
Banking Allowances
Some mass-based trading programs have allowed allowances to be banked or carried over into future compliance periods. This temporal flexibility is an additional way to provide regulated sources flexibility in achieving required emission reductions and can incentivize additional or early reductions.
However, unlimited banking can affect the environmental integrity of the program. If too many banked allowances accumulate and are carried over into future compliance periods, prices could decrease reducing the incentive for regulated sources to operate their emissions controls effectively.
To maintain long-term environmental integrity, some trading programs may allow some banking but also place restrictions on the number of banked allowances to minimize the accumulation of allowances over time. The EPA’s Good Neighbor Plan restricted the bank to 21% of the total budget in the early years of the program.
Features that also Address Potential Shorter-Term or Localized Air Quality Impacts
In some circumstances, even as aggregate emissions fall to or below the level of the cap on a regional basis over the relevant period, there may be concerns about short-term or localized pollution levels.
There are several additional design features that could be incorporated into a trading program that may address these concerns:
- Backstop emissions rate: a source-specific backstop emission rate that helps ensure that localized emission reductions are achieved over a certain period.
- The EPA’s Good Neighbor Plan employs a daily backstop rate in conjunction with the cap to address geographic and temporal concerns for ozone transport.
- Increased surrender ratio: emissions from certain sources or at certain times may require sources to surrender more allowances to cover their emissions (i.e., a requirement for a certain facility to surrender two allowances per ton of emissions instead of just one allowance).
Program Implementation
Continuous Emission Monitoring
Another essential feature of an emissions trading program is having a complete, accurate accounting of the total mass emissions from sources. This ensures that the value of an allowance is the same at one source as it is at another.
EPA-administered trading programs rely on the monitoring program under 40 CFR Part 75, which generally requires continuous monitoring and regular reporting of emissions. In addition, the emissions data should be readily available to the public for transparency. Good measurement allows for verification that emission caps are not exceeded and that emission reduction goals are being met.
Program Tracking Systems
Comprehensive, accurate, transparent, and timely information is the cornerstone of a successful trading program. The regulator will need several different types of IT systems to administer a trading program: one that tracks emissions, one that tracks allowances, and one that tracks compliance. These systems may also be integrated into one, with separate modules performing each function.
- Emissions tracking system: a system that collects, reviews, maintains, and performs quality checks of emissions-related data from each regulated source.
- For EPA-administered trading programs, EPA provides the Emissions Collection and Monitoring Plan System (ECMPS) for regulated sources to provide data.
- Allowance tracking system: similar to a financial bank, this system holds official records of allowance accounts, allocations, holdings, and transfers.
- For EPA-administered emissions trading programs, EPA provides the CAMD Business System (CBS) to host allowance accounts.
- Compliance tracking system: compares regulated sources’ emissions and allowance holding data in order to assess program compliance.
Determining Compliance
The rules for implementing a trading program should clearly specify the deadlines for reporting and for holding sufficient allowances to cover emissions for the compliance period. In addition, regulated sources should be given sufficient time to verify emissions data for the compliance period.
Upon the compliance date, reconciling allowance holdings with emissions data should be straightforward (e.g., sources surrender one allowance for each ton of corresponding pollutant emitted).
Likewise, enforcement should be straightforward and automatic. The rules for implementing a trading program should specify the penalties for noncompliance—that is, when a regulated source does not hold sufficient allowances to cover its emissions for the compliance period. These may come in the form of financial penalties, additional allowance surrender requirements, or removal of the emissions overage amount from future compliance period allocations.
Rate-Based Trading
Rate-based trading is another policy approach that can provide compliance flexibility, protect human health and the environment, and ensure accountability like that of mass-based trading, but with important distinctions.
Generally, under a rate-based trading program, regulated sources performing at an emissions rate below the required standard of performance are awarded credits or allowances (or the appropriate compliance instrument). These overperforming sources may sell their excess to other sources. A regulated source operating above their standard of performance may purchase compliance instruments to cover this excess when demonstrating compliance.
Unlike mass-based trading, regulators do not develop a cap for rate-based trading programs, as credits or allowances are generated based on the actual emissions performance of individual regulated sources relative to their standard of performance. Likewise, regulators do not generally consider features like updating budget mechanisms to ensure continued program stringency.
Like mass-based trading, regulators implementing rate-based trading programs still need to consider elements discussed under “Program Implementation,” like emissions monitoring and program tracking systems.
While rate-based trading programs do provide certainty of emissions performance in the aggregate, they may not provide as much certainty on the overall mass emissions (i.e., environmental goal), which could increase or decrease significantly, depending on the utilization of regulated sources.