For the past three years, the European Union has been operating the world's largest emissions trading system and the first system to limit and to trade carbon dioxide emissions. An MIT analysis of this initial "trial" phase finds that—despite its hasty adoption and somewhat rocky beginning—the European Union cap-and-trade system has operated well and has had little or no negative impact on the overall EU economy.

The MIT results provide both encouragement and guidance to policy makers working to design a carbon dioxide (CO 2 )-trading scheme for the United States and for the world. "This important public policy experiment is not perfect, but it is far more than any other nation or set of nations has done to control greenhouse gas emissions—and it works surprisingly well," said A. Denny Ellerman, senior lecturer in the MIT Sloan School of Management, who performed the analysis with Paul L. Joskow, the Elizabeth and James Killian Professor in the Department of Economics.

The cap-and-trade approach to controlling emissions is hardly unprecedented. For years, the US has operated highly successful cap-and-trade systems for emissions of sulfur dioxide and nitrogen oxides. Based on a national emissions cap, facilities that emit those pollutants receive a limited number of emissions permits, or "allowances," for a given period. Facilities that emit more than their allowed limit must buy allowances from facilities that emit less. Markets for trading allowances operate smoothly, and—in response to the strong economic incentive—facilities have reduced their emissions significantly.

Despite such success, setting up a US cap-and-trade system for CO 2 emissions has proved challenging. Carbon emissions are so central to energy consumption that the idea of imposing a policy to limit them raises serious concerns. Could putting a price on carbon emissions lead to serious economic effects? Might the outcome be the equivalent of energy rationing? How would the initial allocation of allowances work? And would a straight carbon tax be preferable after all? Such questions loom large as the US Congress debates the merits of several climate-change bills containing proposed CO 2 cap-and-trade systems.

To help address those questions and move the debate forward, Ellerman and Joskow performed an in-depth study of the development, structure, and performance of the EU Emissions Trading Scheme (ETS) to date. In 2000, leaders in the EU realized that they would not be able to meet their obligations under the Kyoto Protocol, which take effect in 2008, without taking action. Previous attempts to impose a carbon tax had failed, so—despite their earlier opposition to the cap-and-trade approach—they set up the first phase of their EU trading system covering 2005 to 2007. Their goal was not so much to achieve significant emissions reductions in these years as it was to get the system up and running by the beginning of the first Kyoto period.

Today, the EU ETS is far larger than either of the US programs. It covers 11,000 installations while the US sulfur dioxide program covers only 3,000, and the value of the allowances is about $80 billion as opposed to $4 billion. Perhaps most striking, the EU ETS operates internationally. Allowances are traded by facilities in 27 independent nations that form a loose federal union and differ widely in per capita income, market experience, institutional background, and other features.

As the EU moves into the second phase of its ETS, what are some of the lessons to be learned? First, the European experience shows that the economic effects—in a macro economic sense—have not been large. "No one talks about under-performance in Europe since 2005 because of the carbon price," Ellerman said. "Changes have occurred in certain industries, but the notion that the carbon price would wreck the overall economy is clearly disproved for the European system, which for a long time had a high price compared to what was expected." Even though reducing emissions was not the primary focus of the three-year trial, carbon reductions were in fact achieved, with minimal macroeconomic impact.

A second lesson is that permitting "banking and borrowing" will make a cap-and-trade system work more efficiently. Within the three-year period of the EU ETS, facilities can bank (save some of this year's allowance for use next year) or borrow (use some of next year's allowances now and not have them available next year). During the first three years, many facilities took advantage of the opportunity to trade across time. But they always produced the necessary allowances within the required time period. Concerns that facilities would postpone their obligations indefinitely have proved unwarranted. "We've seen no abuses of borrowing within the system at all," said Ellerman.

A third lesson is the importance of having accurate data and good communications both to ensure a smooth-running market and to achieve the desired reduction in emissions. When the EU system was established, data on actual emissions—installation by installation—were not available, so facilities received allowances based on their estimated emissions. As a result, no one was quite sure how restrictive the cap would turn out to be. That uncertainty pushed up prices—until April 2006, when the first verified emissions reports came in. Actual emissions were far lower than expected, allowances were plentiful, and the carbon price fell by half within a week (see the figure). Communication of information among the market participants has improved, and prices for allowances bought ahead for use in 2008 have been far less erratic.

A fourth lesson is that the process of allocating emissions allowances is going to be contentious—and yet cap-and-trade is still the most politically feasible approach to controlling carbon emissions. Some people have argued that the EU method of allocating free allowances to polluting facilities is morally wrong. But an emissions-control policy is more likely to succeed if those most affected—the current polluters—are given some assets along with the liabilities they are being asked to assume. "Part of the genius of these cap-and-trade systems is that you're saying, ‘Look, we're going to make a deal. You're now going to have to submit a permit for every ton of emissions you make, but we're going to give you most of the permits that you'll need—and if you're able to reduce your emissions, you'll have permits to sell,'" said Ellerman.

Perhaps the main message for policy makers is that everything does not have to be perfectly in place to start up. When the EU ETS began, the overall EU cap had not been finally determined, registries for trading emissions were not established everywhere, and many available allowances—especially from Eastern Europe—could not come onto the market. The volatility of prices during the first period reflects those imperfections. "Obviously you're better off having things all settled and worked out before it gets started," said Ellerman. "But that certainly wasn't the case in Europe, and yet a transparent and widely accepted price for CO 2 emission allowances emerged rapidly, as did a functioning market and the infrastructure to support it." Moreover, a significant segment of European industry soon began to factor the price of CO 2 emissions allowances into their business decisions.