Steps in developing cap-and-trade mechanisms

Considerable background work and investment is required to test the real-world potential of a cap-and-trade approach to a particular issue. Typically, this task requires the following steps:

• a background investigation is needed to establish whether a cap-and-trade mechanism is the most appropriate tool for managing harmful by-products (e.g. salt or pollution) or the natural resource management (NRM) issue in question.
• a biophysical assessment is needed to set a sustainable threshold and establish the cap. This step involves significant scientific analysis of thresholds, measurement of emissions or resource use and consideration of ongoing reporting, monitoring and evaluation.
• market feasibility needs to determine the potential to create permits or rights, and weigh up the benefits and risks of a trading environment. This step should determine if there would be sufficient gains from trade and if there will be sufficient volumes of trade to justify establishing a formal market.
• the market and rules surrounding ownership and trade must be defined. This step includes detailed consideration, negotiation and specification of initial rights to market participants (e.g. grandfathering existing rights, auctioning rights, or a hybrid of multiple approaches).
• promotion and communication is needed to inform potential participants of how the scheme works, why it is being introduced, how it will affect them and how they can participate.
• the market must be developed to facilitate trades as simply and easily as possible, clearly outlining to participants the mechanics of the market, market rules, participants’ rights and obligations and dispute resolution mechanisms. The market must operate within the bounds of its design and within the bounds of regulation.
• reporting, monitoring and evaluation involves keeping a register of permits, trades and values, as well as monitoring biophysical changes (e.g. flow rates, salinity levels, levels of pollution). Evaluation of the process involves project review, financial assessment and assessment of environmental outcomes.
• without an effective regulatory framework, combined with enforcement, the permitholders may have more to gain from cheating than by operating within their legal limits.

Key design and implementation principles

There are a number of design and implementation issues regional NRM groups and policy makers should consider:

• a cap-and-trade approach is only reasonable if a sustainable cap can be established and performance can be measured and enforced. The scale of projects can range from very large (e.g. greenhouse gases or ozone-depleting substances) to very small (e.g. pollution in a local waterway). Caps can be fixed, or declining, depending on the environmental problem.
• creating tradeable rights must be both possible and appropriate. For example, creating tradeable pollution rights or permits is generally not possible for diffuse-source pollution—quantifying rights at an individual or enterprise level can be difficult.
• there must be benefits from enabling trade. Benefits will be greater with many potential market participants, multiple ways of fixing the problem (e.g. reducing pollution, improving water use efficiency) with scope for innovation, and where prices for rights or permits vary considerably.
• cap-and-trade mechanisms should not create negative side effects. For example, some water trade could lead to the development of land that is unsuitable for irrigation, resulting in increased salinity pollution. While trade in water-pollution permits may keep catchment pollution within defined limits, the location of new polluters may produce unacceptable impacts at the local level (e.g. a tributary of high natural significance).

These considerations may rule out many NRM issues from using a cap-and-trade approach. There may also be pre-existing cap-and-trade systems that can be used to deliver environmental benefits.

Resource and skill requirements

Establishing cap-and-trade mechanisms can be complex and costly, and will require expert input from a number of fields including economics, the biophysical sciences, legislation, geographic information systems and information technology. The transaction and administrative costs of cap-and-trade mechanisms can also be significant, particularly costs associated with technical assessments, monitoring and evaluation.

Trends and opportunities for regional NRM groups

There are a number of, as yet, largely under-utilised strategic opportunities for regional NRM groups to be involved in cap-and-trade mechanisms. Regional NRM groups could:

• participate in existing cap-and-trade markets to achieve environmental objectives, for example purchase water entitlements to enhance environmental flows in over-allocated catchments
• work with regulatory agencies to establish formal ‘global’ caps
• partner with regulatory agencies to promote, monitor and evaluate market performance for environmental outcomes.

These opportunities may require regional NRM groups to partner with regulatory agencies.

• Download the final reports for the pilots funded under the National Market-Based Instruments Pilot Program:
  • tradable net recharge contracts in the Coleambally Irrigation Area
  • establishing the potential for offset trading in the lower Fitzroy River
  • Cap-and-trade for Salinity; Dryland Salinity Credit Trade.
• Download the Hunter Salinity Trading Scheme auction reports for 2004 and 2006.
• Find out more about the Murray Darling Basin Commission’s Pilot Interstate Water Trading Project, including the two-year review.
• Find out more about the Victorian Department of Sustainability and the Environment's BushBroker program, which is giving land managers native vegetation credits that can be purchased by developers as an offset.