MIT: European system for cutting CO2 emissions is working well

In a bid to control greenhouse gas emissions linked to climate change, the European Union has been operating the world's first system to limit and to trade carbon dioxide. Despite its hasty adoption and somewhat rocky beginning three years ago, the EU "cap-and-trade" system has operated well and has had little or no negative impact on the overall EU economy, according to an MIT analysis.

The MIT results provide both encouragement and guidance to policy makers working to design a carbon dioxide (CO2)-trading scheme for the United States and for the world. A key finding may be that everything does not have to be perfectly in place to start up similar systems.

The cap-and-trade approach to controlling emissions is not new. For years, the United States has operated highly successful cap-and-trade systems for emissions of sulfur dioxide and nitrogen oxides. Based on a national emissions cap, facilities that emit those pollutants receive a limited number of emissions permits, or allowances, for a given period. Facilities that emit more than their allowed limit must buy allowances from facilities that emit less. Markets for trading allowances operate smoothly and facilities have reduced their emissions significantly.

What are some of the lessons to be learned from the European experience? First, it shows that the economic effects-in a macroeconomic sense-have not been large.

Second, permitting "banking and borrowing" will make a cap-and-trade system work more efficiently. Within the EU ETS, facilities can bank (save some of this year's allowance for use next year) or borrow (use some of next year's allowances now and not have them available next year). Many facilities took advantage of the opportunity to trade across time. But they always produced the necessary allowances within the required time period. Concerns that facilities would postpone their obligations indefinitely have proved unwarranted.

A third lesson is that the process of allocating emissions allowances is going to be contentious-and yet cap-and-trade is still the most politically feasible approach to controlling carbon emissions. In a cap-and-trade system, those most affected-the current polluters-receive some assets along with the liabilities they are being asked to assume.

Finally, the MIT analysis shows that everything does not have to be perfectly in place to start up. When the EU ETS began, the overall EU cap had not been finally determined, registries for trading emissions were not established everywhere, and many available allowances-especially from Eastern Europe-could not come onto the market. The volatility of prices during the first period reflects those imperfections.