It does not take a policy expert these days to notice that climate change issues have taken the world by storm. While the United States has not ratified the Kyoto Protocol (the main global initiative to curb greenhouse gas [GHG] emissions), and although the federal government has not yet implemented a mandatory GHG emission reduction program, individual states and private entities have taken the lead in attempting to mitigate the impact of GHG emissions on our environment.

While it is unclear yet what final shape any impending federal climate change law might take, many experts have observed that an effective federal initiative must implement some form of a market-based mechanism as a part of any overall emission reduction program. Although numerous market-based mechanisms may theoretically prove workable in the emission reduction context, thus far emissions trading has served as the key market-based mechanism for reducing GHG effects. Arguably, the benefits of a market-based mechanism in the emission reduction scenario are akin to the benefits of a market-based mechanism in any other context: it permits market forces to move the commodity, here emissions allowances or credits, to the highest value use. In the emission reduction context, an emissions trading scheme allows an emitting entity with lower emission reduction costs the opportunity to sell its unused emission rights to an emitter that would incur a higher cost to reduce its emissions, and for whom it is less economical to achieve emission reductions. In this way, advocates argue, an emissions trading mechanism can be economically superior to a typical "command and control" regulatory scheme, where all regulated entities are required to cap their emissions to a certain level regardless of the cost, or where the use of specific technologies might be dictated.

Thus far, three key emission reduction programs have emerged in the climate change context: the cap-and-trade program, the project-based program, and the voluntary initiative. Not surprisingly, each of these key programs, which are discussed below, employs some form of an emissions trading mechanism. Many experts have concluded that, by specifically incorporating an emissions trading scheme, these initiatives have effectively mitigated emissions while providing an economic incentive for firms to reduce their emissions.

Cap-and-Trade Programs

The cap-and-trade program involves a scenario in which a state (or country) caps its total emissions of certain pollutants at some target amount. The regulatory authority then determines the sector(s) and/or entities that would be subject to the program, and either issues or sells (or both) to the emitting firms the right, or "allowance," to emit a certain amount of the targeted pollutants. Each allowance is worth a certain number of units of emissions—to be determined by the regulating authority. The regulating authority issues a limited number of allowances per year, the total of which cannot exceed the cap. Each regulated firm is either given, or would be required to purchase, a set number of allowances. Because emissions from regulated firms that do not accompany a valid allowance carry steep penalties, this program can effectively limit emissions of the designated pollutant within the jurisdiction. As advocates of market-based programs conclude, because the cost of cutting emissions to meet the allowance limits is not the same for each regulated entity, the trading aspect of a cap-and-trade program offers economically beneficial results that are not matched in a standard "command and control" regulatory scheme. Under a cap-and-trade scheme, the regulated entities can trade their allowances among each other. Trading allowances provides those regulated entities that can cut their emissions at a lower cost with the opportunity to sell their unused allowances to another regulated entity whose emission reduction costs are higher. As the demand for allowances increases, so does the price of the allowance. In addition to emitting firms, any entity can purchase allowances, such as environmental groups or entities without emissions, and either retire those allowances or donate them for a tax benefit. These purchases also increase demand and have an impact on allowance prices. Under such a program, therefore, reducing emissions can be both cost-effective and economically efficient.

Cap-and-trade programs are not novel. In the United States, the 1990 Clean Air Act's Acid Rain Program is perhaps the most well-known regulatory cap-and-trade initiative. The Acid Rain Program requires that electric utility sources, primarily sulfur dioxide and nitrogen oxides, be reduced to their 1980 levels. According to the Environmental Protection Agency (citing a 2005 study in the Journal of Environmental Management), it is estimated that in 2010, the Acid Rain Program's annual benefits will be approximately $122 billion, with an annual cost of only about $3 billion.

Globally, the European Union Emission Trading Scheme (EU ETS) is the world's most prominent mandatory carbon dioxide cap-and-trade program in operation today, with over 25 participating member states (all within the European Union). According to the World Bank, in the first three quarters of 2006, the EU ETS emissions trading market traded nearly 764 million allowances, worth US$18.9 billion. In its second phase (2008-2012), the EU ETS scheme will include all GHGs, in addition to carbon dioxide.

As with most regulatory initiatives, the effectiveness of any cap-and-trade program depends, in large part, on various design elements, including which sectors and entities to include in the program, the method of allowance allocation (i.e., auction or free issuance, or both), and effective enforcement of the program. Notwithstanding its design, many experts and advocates agree that a cap-and-trade program is effective in mitigating sources of GHG emissions. Moreover, because the cap-and-trade system allows companies to reduce their emissions in any manner they please, advocates of the program emphasize that it is likely to lead to the emergence of more innovative technologies with which to more effectively mitigate GHG emissions.

Project-Based Programs

Another market-based mechanism in the emissions trading context is the project-based program. Under a project-based initiative, various emitting firms (or sectors) are required to limit their individual emissions, similar to a cap. Where the cost of meeting the cap is uneconomical, however, a regulated firm may increase its emissions by "offsetting" those additional emissions. An "offset" occurs when the regulated firm reduces the emissions of some other project below the project's ordinary emissions, thereby creating a "credit." Under a project-based program, therefore, the emitting firm must either meet its own emissions cap or, in lieu of meeting its cap, create or purchase emission reduction credits from some other project to counteract its own additional emissions. The resulting "credit" can be used by the regulated firm toward its own emissions, or it can be traded by the regulated firm (or the project's developer). Project-based credits, therefore, unlike allowances, are instruments that are created through a compliance process that involves regulation; development of the project; formal verification and certification by a third party that the emission reductions generated by the project are indeed "additional" to that which would occur in the absence of the project activity or that would have happened anyway; and continued performance of the project (reductions are permanent). By their nature, project-based credits involve additional risks and higher transaction costs than are generally the case with allowances.

The most prevalent project-based program in operation today is the Kyoto Protocol's Clean Development Mechanism (CDM). Under the Kyoto Protocol, the developed country parties (Annex I parties) have committed to a reduction in various emission sources. One method in which an Annex I party may meet its target reductions is through the CDM. The CDM allows the Annex I party to meet its emission reduction commitment through the purchase of certified emission reductions (CERs) that are generated in non-Annex I countries (developing country parties to the Kyoto Protocol). Under the CDM, Annex I parties (or their designees) typically either invest in the development of an emission reduction project in a non-Annex I party's country (and oftentimes finance the project) to secure the CERs or may purchase the CERs directly from the non-Annex I party (or its designee), oftentimes through CER brokers.

The rules that govern CDM projects are strictly enforced. In order for a project's emission reductions to qualify for CER status under the CDM, project developers must submit to the strict rules governing CDM projects. The CDM rules require approval of almost every aspect of the project, including, for example, the project and its developers (i.e., registration), development of the project's baseline emissions, and the methodology that will monitor the emission reductions (i.e., verification and certification). This process, while thorough, is not as arduous as it may appear. This is due, in large part, to various strategies that the CDM Executive Board has adopted to help expedite CDM projects' registration, verification, and certification processes. In fact, it is estimated that since the CDM's inception, approximately 513 projects have been registered by the CDM Executive Board, and that these projects reduce emissions by an estimated 114 million tons of carbon equivalent per year.

The success of a project-based program will undoubtedly depend, in large part, on the rules that will govern the program. The challenge, under a project-based program, is to create effective rules that do not render project development overly burdensome, but that also ensure that the credits generated are truly verifiable and permanent. If properly designed, a project-based mechanism is capable of abating GHG emissions in an innovative and cost-effective manner, as is evident in the CDM context.

Voluntary Initiatives

In the absence of federal and local climate change laws, voluntary initiatives have served as the primary market mechanism for GHG emissions trading in the United States. This voluntary mechanism reflects many of the characteristics of the project-based program, with the caveat that transactions in the voluntary market frequently occur in the absence of a mandatory program or a universally accepted set of rules for verifying projects or the resulting emission reductions. The lack of a single set of governing rules in the voluntary market has resulted in a variety of efforts that are not interlinked.

The Chicago Climate Exchange (CCX), for example, is a voluntary exchange that functions like a cap-and-trade market for its members. The CCX is a self-regulating exchange that functions under its own rules, which have been designed and governed by CCX members. Members of the CCX commit to voluntary but legally binding reductions to their GHG emissions. CCX members may engage in reduction of sources and offset projects in the United States, Canada, Mexico, Brazil, and worldwide. Offset projects may include a wide range of sources, including forestry, agriculture, renewable fuels, and fuel efficiency. All offset projects must be verified by a CCX-approved verifier.

Outside of the CCX, various U.S. and global corporations, organizations, and individuals have voluntarily committed to either emission reduction policies or to reducing their emissions through project-based programs. In the latter case, firms often will engage in over-the-counter trading of emission reduction credits from projects in which they have invested or that they have created.

The main drivers of the voluntary emissions trading market in the United States have more or less been in the energy-intensive sectors. In the absence of a mandatory program or a multiparty binding agreement, the motivation of these firms to take voluntary action has involved a range of factors, including public pressure, interest to gain experience in the emissions trading market in anticipation of climate change legislation, or anticipation that any impending legislation will provide some recognition for early action. Emissions trading in the voluntary market often has involved either bilateral agreements between firms or, more recently, the emergence of emission credit brokers through which firms may purchase credits.

Another recent phenomenon has been the growth of the retail market for emission permits. In the retail market, retail trades involve purchases of emission reduction credits by individuals or nonprofit groups for nonemitting purposes, rather than by emitters or traders. Nonprofit organizations such as the Climate Trust offer businesses, individuals, and regulators the opportunity to counteract their carbon footprint through the purchase of emission reduction credits that are generated from a variety of projects, from steam plant efficiency upgrades to rain forest restoration.

Emission reductions notwithstanding, the voluntary market, by its nature, faces many challenges. Unlike the CDM context, there are no clear or standardized rules by which to verify the authenticity of the emission reduction credits. The absence of a universally recognized standard has led some trading parties to rely on varying standards, which has previously rendered it difficult to measure or create a uniformly accepted "credit." The lack of a universally recognized "credit" or commodity has complicated ownership and property rights. To complicate things even further, current efforts to develop a voluntary standard also are proving to be complex, particularly with the growth of the retail market where the existence of rules has been varied and perhaps of a lesser concern. In fact, the emergence of the retail market may make it even more difficult to create a uniform set of rules, as individuals and business that might retire the permit anyway may not be as concerned with the precise rules governing the emission reductions. These wrinkles in the voluntary market have undoubtedly led some firms that are otherwise ready to participate to wait out the impending regional, state, and federal climate change initiatives.

Impending Mandatory Initiatives

In addition to the regulatory and voluntary initiatives, mandatory emission reduction initiatives are in the works here in the United States. Although federal lawmakers have recently proposed a number of bills to address climate change, the initial legislative response to climate change in the United States has been a state-driven phenomenon.

In the Northeast, New York Governor George Pataki extended an invitation to several states to develop a regional cap-and-trade program to limit GHG emissions. As of the writing of this article, eight states—Connecticut, Delaware, Maine, Massachusetts, New Hampshire, New Jersey, Rhode Island, and Vermont—have joined New York in developing the Regional Greenhouse Gas Initiative (RGGI). RGGI, which is expected to be operationally launched in 2009 and continue through at least 2019, is a mandatory cap-and-trade program that aims to reduce carbon dioxide emissions from the electric sector, largely through capping fossil fuel-fired electricity-generating units with a capacity greater than 25 megawatts. RGGI's emission reduction objective is to cap emissions at 2009 levels initially, with an aim to attain a 10 percent reduction from 2009 emission levels by the year 2019.

On the other side of the country, California Governor Arnold Schwarzenegger signed, on September 27, 2006, Assembly Bill 32 (AB32), known as the California Global Warming Solutions Act. AB32 implements a cap on the state's emissions of GHGs at 1990 levels by the year 2020. Unlike RGGI, which implements a generator-based cap, it appears that the California initiative might include a load-based cap. A load-based cap would subject the emissions associated with a utility's total load to the applicable cap or allowance, and would therefore provide an incentive for California utilities to ensure they purchase power from the cleanest generators—whether those generators are in the state of California or not.

Unlike RGGI, AB32 authorizes but does not mandate the implementation of a market-based mechanism to meet the targets set out in AB32. The absence of a market-based mandate is attributable to various factors, including certain environmental justice concerns, the state's history of implementing "command-and-control" regulatory programs, and the mixed results that the state has received in its recent experience with market-based programs in other contexts. Nonetheless, there does appear to be considerable recognition in California of the benefits of a market-based mechanism, particularly from the governor himself, whose executive order on AB32 strongly favors a cap-and-trade program.

One of the key policy goals of AB32 is also to encourage the development of a federal climate change law, and to serve as the model for such legislation, and, indeed, California legislation in other contexts has previously spurred action by the federal government.

An important consideration with respect to federal and local climate change legislation is the importance of avoiding "patchwork" regulation. This consideration encapsulates the concern that has been raised by various entities that they not be subject to overlapping regulations from different jurisdictions. The RGGI states appear to be cognizant of this concern by coordinating with local authorities to ensure cooperation. Others advocate that this concern also may be addressed through linking the various programs. State officials from California have engaged in discussions with RGGI state officials, although it is too soon to predict whether and how such a link would function. The importance of addressing this concern may be most significant for federal lawmakers in ensuring that federal legislation does not overburden those firms that are active in the AB32 and RGGI programs (and any other regional or local programs).

These global, regional, local, and voluntary GHG emission reduction programs, together with public opinion, have undoubtedly placed pressure on the federal government to take action with respect to climate change. As of the writing of this article, both the U.S. Senate and the House of Representatives have collectively introduced five climate change bills. With the exception of a bill jointly sponsored by Senators Bernard Sanders (I-VT) and Barbara Boxer (D-CA), each of the remaining climate change proposals mandates a cap-and-trade program, in some form or other. Even the Sanders-Boxer proposal authorizes a cap-and-trade program at the discretion of the Environmental Protection Agency. Thus, while the final form and substance of the anticipated federal climate change law will likely be the subject of considerable debate, it can probably be assumed that the impending policy will incorporate, at least in some form, a market-based mechanism to meet all or a portion of any GHG emission reduction commitment.