DESIGNING EFFECTIVE CLIMATE POLICY: CAP-AND-TRADE AND COMPLEMENTARY POLICIES.

In this article, I analyze a difficult and surprisingly under-examined issue about how to reduce greenhouse gas emissions most effectively at the lowest cost. If policy-makers commit to using cap-and-trade as a central regulatory mechanism--the dominant policy choice to date--to what extent should they also adopt regulatory programs that contain more traditional direct regulation? Cap-and-trade is by definition designed to harness market forces to allow polluters to make choices about whether and how they will reduce their own emissions or trade for a right to emit more while another polluter cuts emissions more dramatically. Complementary policies, by contrast, designate in advance how greenhouse gases ("GHGs") must be reduced and the sources from which these reductions must come. While complementary policies can effectively reduce emissions, they also constrain the market options available under cap-and-trade by limiting the choices emitters have about how to reduce their emissions. That constraint can lead to higher compliance costs. Though policymakers may enact complementary policies for reasons other than greenhouse gas emissions reduction, if the goal is solely to reduce greenhouse gases most cost-effectively, cap-and-trade alone is a better choice in a well-functioning market. However, if systematic market failures prevent emitters subject to a cap-and-trade system from choosing the lowest cost compliance options, then, from a climate policy perspective, complementary policies to correct the market failure make sense. Energy efficiency measures are one example of a complementary policy that corrects such a market failure. If no market failure exists, policymakers should recognize the trade-off inherent in limiting the market mechanisms cap-and-trade is designed to promote and evaluate whether ancillary benefits justify the reduction in market flexibility and the potentially higher costs. [ABSTRACT FROM AUTHOR]