How Cap and Trade Promotes Economic Efficiency

Critics of the Waxman-Markey cap and trade bill are painting it as an affront to free market principles. Ironically, the cap and trade approach is designed to harness market forces to reduce emissions.
An article in this month’s Smithsonian describes how the idea of cap and trade was first put into practice under George H.W. Bush, when Environmental Defense Fund (EDF) president Fred Krupp started talking with White House counsel Boyden Gray about an innovative approach to reducing acid rain:

During the early years of command-and-control environmental regulation, EDF had also noticed something fundamental about human nature, which is that people hate being told what to do. So a few iconoclasts in the group had started to flirt with marketplace solutions: give people a chance to turn a profit by being smarter than the next person, they reasoned, and they would achieve things that no command-and-control bureaucrat would ever suggest.

An inflexible regulatory regime forces emissions controls across the board, even if reducing a pound of SO2 or CO2 may differ wildly from one industry to another. A cap and trade system uses market forces instead of brute force regulation or taxes to provide incentives for cleaning up emissions:

The basic premise of cap-and-trade is that government doesn't tell polluters how to clean up their act. Instead, it simply imposes a cap on emissions. Each company starts the year with a certain number of tons allowed—a so-called right to pollute. The company decides how to use its allowance; it might restrict output, or switch to a cleaner fuel, or buy a scrubber to cut emissions. If it doesn't use up its allowance, it might then sell what it no longer needs. Then again, it might have to buy extra allowances on the open market. Each year, the cap ratchets down, and the shrinking pool of allowances gets costlier. As in a game of musical chairs, polluters must scramble to match allowances to emissions.

When properly structured, a cap and trade system leads to the most cost effective solutions to reducing emissions, and rewards technological innovation that drives down costs even further.