Setting the Cap: Top-Down vs Bottom-Up
The cap is the defining feature of emissions trading. It sets the limit on total emissions and determines the stringency of the system. Setting the cap too high means no real emissions reductions; setting it too low risks excessive economic costs. This lesson explores how to get it right.
What the Cap Means
The cap is the maximum number of allowances available in the system for a given period. Since each allowance represents one ton of CO2 equivalent, the cap equals the maximum emissions allowed.
The cap is the source of environmental integrity in an ETS. Unlike a carbon tax where emissions depend on market response, an ETS guarantees that emissions will not exceed the cap (assuming compliance and enforcement work).
Two Approaches to Cap-Setting
Top-down approach
Start with the overall climate goal and work down to sector-specific caps.
- Determine the national emissions target (e.g., 40% reduction by 2030)
- Allocate emissions budget across sectors
- Set ETS cap for covered sectors
Bottom-up approach
Start with what covered entities can achieve and build up to a total cap.
- Assess current emissions from covered facilities
- Evaluate reduction potential and costs
- Set cap based on achievable reductions
The Top-Down Approach in Detail
Top-down cap-setting aligns the ETS with broader climate goals.
EU ETS cap-setting (Phase 4):
The EU set its overall target: 55% emissions reduction by 2030 (from 1990 levels).
For ETS sectors, this translated to:
- 62% reduction from 2005 levels by 2030
- Linear reduction factor of 4.2% per year (increased from 2.2%)
The cap declines automatically each year, ensuring the system delivers its share of the overall target.
Advantages of top-down:
- Ensures ETS contributes to climate targets
- Provides long-term clarity on ambition
- Aligned with international commitments
Disadvantages:
- May not reflect what covered sectors can actually achieve
- Risk of caps that are too stringent or too lenient for specific sectors
- Requires good data on baseline emissions
Top-down is like budgeting for a household. You start with total income and decide how much goes to each category (rent, food, savings). Each category gets its allocation from the whole. Climate targets are the "income," and sector caps are the "spending categories."
The Bottom-Up Approach in Detail
Bottom-up cap-setting starts with covered entities' circumstances.
Korea ETS cap-setting (early phases):
Korea initially set caps based on:
- Current emissions from covered facilities
- Assessment of feasible reduction measures
- Industry engagement on costs and timelines
This resulted in caps that were achievable but also contributed to national targets.
Advantages of bottom-up:
- Reflects actual reduction potential
- Builds on industry engagement and buy-in
- Reduces risk of severe economic impacts
Disadvantages:
- May result in less ambitious caps
- Risk of regulatory capture (industry lobbying for loose caps)
- Harder to align with top-down climate targets
Hybrid Approaches
Most ETS systems use a combination:
Top-down for overall ambition:
The total cap reflects climate goals and international commitments.
Bottom-up for calibration:
Industry data informs how the cap is translated into facility-level requirements and whether adjustments are needed.
Cap-setting is intensely political. Key dynamics include:
Industry lobbying
Covered industries argue for looser caps, citing competitiveness and job concerns. Regulators must balance these concerns against environmental goals.
Environmental advocacy
NGOs and scientists push for tighter caps aligned with climate targets. They argue that loose caps undermine the system's purpose.
Economic modeling
Models project impacts of different cap levels on prices, costs, and emissions. But models have significant uncertainty.
International comparison
Countries compare their caps to others, seeking neither to lead too far ahead (competitiveness) nor lag too far behind (credibility).
The risk of loose caps
Several ETS systems have suffered from caps set too high:
- EU ETS Phase 1: Cap exceeded actual emissions, prices collapsed to zero
- Korea early phases: Generous caps led to low prices
- Some regional systems: Loose caps undermined effectiveness
Lesson: It is better to err slightly stringent and adjust than to start too loose. Loose caps are hard to tighten later due to political resistance.
The Baseline Question
Whether using top-down or bottom-up, you need a baseline: what are current emissions?
Historical emissions baseline
Use actual emissions from a recent period (e.g., average of 2015-2019). Simple and objective, but may be outdated.
Projected emissions baseline
Model what emissions would be without the ETS. Allows for growth but introduces uncertainty.
Best available technology baseline
Set the cap based on what emissions would be if all facilities used best available technology. Ambitious but may not reflect current reality.
| Baseline type | Pros | Cons |
|---|---|---|
| Historical | Objective, data-based | May be outdated, rewards high past emissions |
| Projected | Forward-looking | Uncertain, can be manipulated |
| Best technology | Ambitious | May be unrealistic, penalizes existing facilities |
Setting the Initial Cap
The initial cap should:
Cover current emissions minus planned reductions
Start at or slightly below current emissions to create an immediate, if modest, reduction requirement.
Signal clear direction
Even if the initial cap is not extremely stringent, the trajectory should be clear. Prices depend on expectations of future scarcity.
Be credible
An initial cap that is obviously too loose undermines market confidence. Better to start reasonably tight.
China's national ETS initial cap:
China set its initial cap based on historical emissions and intensity benchmarks. The cap was not extremely stringent initially, but the signal of establishing a national market and plans for tightening were important.
The government announced that coverage would expand to additional sectors and that the cap would tighten over time. This forward guidance matters as much as the initial level.
Data Requirements
Good cap-setting requires good data:
Emissions inventories
What are current emissions from covered sectors? This requires robust MRV even before the ETS launches.
Facility-level data
For bottom-up approaches, you need data from each covered facility.
Reduction cost curves
How much does it cost to reduce emissions at different levels? This informs how stringent the cap can be without excessive economic harm.
Growth projections
How will covered sectors grow? A cap that is stringent today might be very loose if growth is higher than expected.
Many jurisdictions run a "pilot phase" or mandatory reporting period before launching trading. This builds the data needed for cap-setting and develops MRV capacity.
Adjusting the Cap Over Time
Once set, caps need periodic adjustment:
Regular review cycles
Most systems review caps every 5-10 years, with annual adjustments possible between reviews.
Response to new climate commitments
When countries increase their ambition (like the EU's shift to 55% by 2030), ETS caps should adjust accordingly.
Market feedback
If prices are persistently very low (suggesting oversupply) or very high (suggesting excessive stringency), caps may need adjustment.
Economic changes
Major economic shifts (recession, structural change) may warrant cap reconsideration.
Common Mistakes in Cap-Setting
Setting caps based on unrealistic projections
If caps assume high economic growth that does not materialize, the cap becomes loose.
Free allocation that undermines the cap
Generous free allocation can effectively loosen the cap if combined with other provisions.
Ignoring banked allowances
Allowances saved from previous periods create a "bank" that can satisfy future caps. Setting new caps without accounting for banking can lead to persistent oversupply.
Yielding to short-term political pressure
Caps should reflect long-term climate goals, not short-term economic or political convenience.
Looking Ahead
Setting the overall cap is just the beginning. The cap must decline over time to drive emissions reductions. The next lesson explores cap trajectories: how to design declining caps that deliver climate goals while giving the economy time to adjust.