Our discussion of environmental policy to this point has generally abstracted from the many ways that institutional and design elements can affect the performance of the suite of policy instruments. For example, while we have distinguished between auctioned and freely distributed permits in cap and trade programs, we have not addressed the many ways that freely distributed permits can be assigned to participating firms. In this chapter we discuss a collection of institutional issues in cap and trade programs, analyzing how design elements that are common in practice may affect performance.

We focus specifically on cap and trade because its theoretical merits have long been stressed by economists, and these efforts have paid off in the sense that emission trading is now part of the common parlance in environmental policy discussions. Indeed we now have experience with two major programs – the US sulfur dioxide program, and the European Union Emissions Trading System for carbon dioxide – and several smaller, regional programs. It is telling, however, that few if any of the existing programs were designed according to the principles described in the theoretical papers. Instead, they combine political compromises, interest group demands, and economic ideas in ways that have on occasion contributed to disappointing performances for cap and trade programs.

In what follows we examine seven topics related to cap and trade programs, and which economists have examined. In section 8.1 we present an analysis that explicitly accounts for differences in the location of polluting firms and the spatial extent of the damages their emissions cause. We show that cap and trade programs can be designed to accommodate the spatial dimension, but that it involves a change in focus from emissions to ambient pollution outcomes. In section 8.2 we address the temporal dimension by considering the merits of allowing polluters to transfer emissions across time by permitting them to bank (or borrow) emissions rights. Both the US SO2 program and the European Union CO2 program allow some form of permit banking, and so understanding how this affects behavior in these programs is necessary for evaluating their success. We show that, under some circumstances related to abatement cost uncertainty, some limited forms of banking are welfare improving.