With Ontario joining Quebec and California in the Western Climate Initiative, cap-and-trade is all the talk these days. In principle, we know that it can work just as well as a carbon tax, if designed and implemented well. But cap-and-trade is clearly more complex and a little abstract. And as a result, it can be harder to get your head around the mechanics.

So here’s a little anecdote to make cap-and-trade a bit more real. Gather round, kids, and let me tell you the story of the commuter cap-and-trade system.

It all began a few years ago, when I worked at the National Round Table on the Environment and the Economy. The NRTEE team was keen to “walk the walk” on sustainability issues. So at the suggestion of a colleague, I designed a weeklong cap-and-trade system to help us reduce our emissions from our commutes to work.

The rules of the game were as simple as we could make them.

To start, we collected baseline data for everyone’s commute. How many kilometres did everyone drive in an average week just to get to work? And how did that travel add up for the full staff?

Based on this baseline, we then set a cap: collectively, over the week of the program, we would reduce our total travel by car by 10%. We defined this cap by creating “km-travelled” permits; each permit represented a kilometer driven by one person to get to work. At the end of the week, every staff member would have to have a permit for every kilometer they drove that week. But the total number of permits equaled 90% of the total travel of our team.

Creating a market

Then we allocated permits to all of our colleagues. To keep it simple, we gave everyone permits for free based on their historical transportation. It you typically drove 10 km to work in the baseline, you got 9 permits for free. If you drove 20 km, you got 18. In cap-and-trade parlance, this approach is called grandfathering, and it’s probably one of the worst ways to allocate permits. But let me come back to that in a minute.

Next, we created a market, by allowing permit trading. We gave everyone $100 in fake money. And to give it value, we made it clear that at the end of the week, they could bid on prizes with this monopoly money (yes, Chris Ragan, monetary policy somehow makes a brief cameo in this story). The only way to make more money was to sell permits to others. But if you sold your permits, you’d have less for yourself—and so would have to drive less in order be in compliance at the end of the week (i.e., have permit for every km driven that week).

And so, we unleashed the power of the market, essentially putting a price on driving for a week. The results were fascinating… and also provide a remarkably accurate window into the design of much bigger cap-and-trade systems.

Loopholes, offsets and tradeoffs

Right off the bat, we had clever emitters looking for loopholes, and I belatedly realized that enforcement and non-compliance penalties were critical. One guy—who travelled about 50km each way to work—immediately sold all of his permits off for a good chunk of cash, hoping to have lots of money to spend on prizes… even though he wouldn’t be in compliance with the cap. As Commissioner of the system, I quickly intervened and “clarified” that only those that were in compliance with the policy would be eligible for prizes.

Maybe the most interesting part was all the grumbling about the rules of the game. Big commuters that lived outside of town complained bitterly that they were being unfairly singled out: they didn’t have any choice but to drive. Parents were also unhappy: they had to drop the kids off, so just didn’t have the option of walking, biking, or bussing to work. These folks were the commuting equivalent of emissions-intensive industries — when driving was priced, they bore the biggest cost. In fact, in our debrief afterwards, some of these big commuters suggested that next time, we should really allow for offsets(!) That is, they could gain extra credit for non-commuting activities like turning off their monitors at night.

But the chronic walkers didn’t like it either: since their baseline was zero, they didn’t receive any credits, and couldn’t raise cash by changing their behaviour. Here’s where our method of permit allocation really matters. By giving away permits for free based on historical emissions, we transferred big value to big emitters. A more fair way — recognizing that some participants had already taken actions to reduce their driving — would be to auction all of the permits. Of course, from a political perspective, the only way we could convince the big-drivers even to play the game in the first place was to give them those free permits. Welcome to a classic cap-and-trade design tradeoff.

The results and some considerations for provinces

Mostly, it all worked. At the end of the week, everyone was in compliance, and we reduced our collective driving by exactly 10%. People bartered over permits, and a semi-stable market price emerged. Still, with only thirty participants and only a weeklong compliance period we had some liquidity problems. The price of permits spiked on the last day just before everyone had to true up their permits and their driving records. A couple people even tried speculating, by buying extra permits early in the week and selling them at the end at a mark-up. These issues would be much less critical with a long-term system with lots of buyers and sellers (fortunately, by joining with California and Quebec, Ontario should be just fine).

And in the end, the biggest winners were two of the biggest commuters (and biggest complainers!), who realized that they lived close to each other and could cut their emissions in half by carpooling all week. They leveraged their free permits into a huge sale and outbid everyone else for prizes. Free permits thus did indeed have big implications for the distributional impacts of the policy.

But what struck me most was the role of self-interest. Almost immediately, the big-picture objective of reducing our driving as a group at the lowest cost was lost. Instead, it was individuals looking to win the game and maximize their own private benefits. And that’s just fine within the context of the game; in fact, it’s exactly how the market is supposed to work.

Where it gets tricky is when individual interests try to influence the rules of the game itself. Design matters, not just for overall outcomes, but also for impacts on individual emitters. Policy makers need emitters onside, but they also need to make sure that a cap-and-trade system is designed for overall effectiveness, cost-effectiveness, and fairness.

So—to Ontario, and other provinces considering joining the cap-and-trade party—here is the moral of the story: Design your system wisely. Be careful with permit allocation. And remember: emitters may have ways to reduce emissions that they haven’t even considered. Pushing for that innovation is exactly the point.

To learn more about Canada’s carbon pricing systems, including B.C.’s carbon tax and Quebec’s cap-and-trade system, check out the interactive summary of our report “The Way Forward: A Practical Approach to Reducing Canada’s Greenhouse Gas Emissions”.
Launch the Interactive Summary