Markets for Pollution Allowances: What Are the (New) Lessons?

About 45 years ago a few economists offered the novel idea of trading pollution rights as a way of meeting environmental goals. Such trading was touted as a more cost-effective alternative to traditional forms of regulation, such as specific technology requirements or performance standards. The principal form of trading in pollution rights is a cap-and-trade system, whose essential elements are few and simple: first, the regulatory authority specifies the cap—the total pollution allowed by all of the facilities covered by the regulatory program; second, the regulatory authority distributes the allowances, either by auction or through free provision; third, the system provides for trading of allowances. Since the 1980s the use of cap and trade has grown substantially. In this overview article, I consider some key lessons about when cap-and-trade programs work well, when they perform less effectively, how they work compared with other policy options, and how they might need to be modified to address issues that had not been anticipated.