Cap and Trade Markets. Investing Trend of the Future?

As compared to years past, non-partisan government solutions to significant societal problems are in short supply.  One potential solution to limit carbon dioxide emissions has captured my attention: the system of “cap and trade.”  It is fascinating to me for a couple reasons.  One is that I am a free-market economics nerd.  Another is that it might create interesting investing opportunities in the future.

What is a cap and trade system?  According to the EPA, cap and trade, sometimes referred to as emissions trading or allowance trading, “is an approach to reducing pollution that has been used successfully to protect human health and the environment.  Emissions trading programs have two key components: a limit (or cap) on pollution, and tradeable allowances equal to the limit that authorize allowance holders to emit a specific quantity of the pollutant.1”  Prices for the allowances are not set by the government, but rather by the economic entities that buy and sell allowances (e.g., a power utility).  Taxes, on the other hand, set a price or penalty for something (e.g., a gas tax) while not setting any emission/consumption limit.  So, it’s not semantics to say that a cap and trade system is the opposite of a tax.

Free market economists embrace cap and trade systems because they allow the market to find the cheapest, most effective solutions to reduce emissions rather than tasking a government agency to mandate preferred solutions.  We have experienced success in the U.S. with cap and trade systems already, going back all the way to 1990.  Acid rain was a more significant health and environmental issue then, leading to the establishment of sulfur dioxide (SO2) emissions trading allowances under the Clean Air Act.  A nationwide total emissions limit was set – lower than the level existing at that time – and allowances were allocated to entities that emitted sulfur dioxide.  The emissions cap was lowered in subsequent years as emission reductions progressed.  As a result, since 1990, SO2 emission levels have decreased by more than 90%!  Emitters chose various methods (switched to lower sulfur coal, installed pollution scrubbers, etc.) to reduce their emissions, sold or banked for future years their excess allowances, and realized financial benefits.

This is where future investing opportunities may surface.  For example, companies that can provide the lowest price carbon sequestration technologies could profit handsomely in the coming years if a non-partisan carbon dioxide cap and trade program is enacted.  Utility scale renewable energy companies that supply low-carbon emission power to the grid may be able to make good money selling unused allowances.  Large industrial corporations that come up with the most innovative, low cost ways to reduce their carbon emissions could profit and gain competitive advantage.

A system of carbon cap and trade was extended in California in 2017 with a modest amount of bi-partisan support.  In the early 2000s, there was even some bi-partisan support for a proposed national carbon cap and trade system.  A national carbon fee and dividend plan has recently been proposed in the U.S. Congress as well.  Some investment companies on the cutting edge are keeping an eye on these developments to see where the best investment and profit opportunities might arise.  I’ll be doing the same with great curiosity and optimism.

  1. https://www.epa.gov/emissions-trading-resources/what-emissions-trading

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