This is the fourth in a short series of posts that explain some important but often overlooked policy issues in the Western Climate Initiative—the West’s regional cap-and-trade system.

In cap and trade, bigger is better—or at least cheaper. That’s because of the flexibility that is built into the program: the “cap” sets the overall level of emissions while the “trade” harnesses the profit motive to seek out the cheapest and easiest reductions wherever they occur in the economy. So it’s good news when the Western Climate Initiative expands to add new member states and provinces.

Cap and trade gets even better (and cheaper) when different cap and trade programs “link” with one another. Linking means that two different programs honor one another’s carbon permits. So the members of WCI could, in theory, trade carbon permits with the members of the European cap and trade program (the ETS), or with the carbon market in the northeast United States (RGGI). By linking, we can create huge economies of scale where all the participants can benefit because the emissions reductions will come at the lowest possible price across a very large economic area. Basically, linking is free trade for reducing climate pollution.

But linking can only happen if cap and trade programs are designed correctly.

  • To preserve environmental integrity, we need to be sure that the carbon permits from different programs are all standing for an equivalent amount of emissions—that a permit for one ton of carbon-dioxide in WCI equals one ton of carbon-dioxide in RGGI.  It’s great if a company in Montana buys a carbon permit from a firm in France, just as long as the overall number of permits in circulation guarantees that the programs meet their caps.

    To preserve economic integrity, we need to be sure that carbon permits in linked programs have real and exchangeable value. It’s really not much different than exchanging currency. Everyone feels comfortable trading US dollars for Euros knowing that both currencies have recognizable value. But you probably wouldn’t want to trade your US dollars for Zimbabwean dollars. (Zimbabwe recently devalued its wildly-inflating currency by a factor of 10 billion.)

    In order for linking to work, we need to observe a few rules:

    No “off ramps” (aka “safety valves” or price controls). An “off ramp” effectively turns carbon permits into Zimbabwean dollars: it works by flooding the market with permits at a set trigger price. Not only does flooding the market with permits destroy the environmental integrity of the cap, it’s the monetary equivalent of printing money recklessly. One reason you don’t want to buy a Zimbabwean dollar is because you can’t be sure that the government won’t mint vast quantities of new currency, effectively devaluing the dollar asset that you hold.

    Limit “offsets.” I’ll have more to say about offsets in a subsequent post in this series, but without careful limits on the treatment of offsets, they can damage both the environmental and economic integrity of the cap.

    Stabilize markets. Commonsense financial-market practices aid linking. It’s important the participants can see clearly how many carbon permits are in circulation now and in the future; and that there’s a predictable schedule for releasing new permits. Emissions reporting should be rigorous (and if possible, third-party verified) and the programs should maintain open accounting.

    Beyond these basic rules, carbon markets can link even when they are pretty different from one another. The markets don’t need the same cap—linking works with different schedules for reducing emissions. And similarly for the scope of the programs—linking works between markets that cover different parts of the economy, such as the transportation sector and the electricity sector. These are big virtues: linking means that we can get real cost-effective carbon reductions even when not everyone agrees to the same program.

    Done properly, linking could create vast economies of scale for reducing emissions, even in the absence of coherent federal leadership. In fact, that’s why our map of the climate leaders is so important: it depicts all the places in North America that may soon have a cap and trade program. Those places are home to more than half the continent’s economy and population (though not every element of the economy in those places will be under a cap and trade program).

    Linking also bears closely on the issue of “pre-emption,” which I’ll discuss in a coming post in this series. What happens if the US or Canadian federal governments creates an ur-cap and trade program, as the Lieberman-Warner bill would have? Would WCI cease to exist? Would it get subsumed into a larger program? It’s hard to know, and I’ll hold my speculations until later. But with linking, it’s perfectly possible to create new federal, regional, or state programs without undoing what’s already been done. Linking means we don’t have to agree about every detail: we can still all get along.