Climate Change Legislation: The What and Why of Cap and Trade
Many on the conservative side have had many negative things to say about the “Cap and Trade” system. It should be pointed out that “cap and trade” itself, is not the source of their ire. Rather, many conservatives do not like limitations being placed on CO2 emissions in the US.
What is this “Cap and Trade” system that is being implemented in the new climate change bill? Cap and Trade is merely an approach to regulating emissions, and it is one that efficiently reduces those emissions. It contrasts with two other approaches: one that is called the “command and control” approach to regulation and the other is an approach that taxes emissions, such as the proposed “carbon tax” to regulate greenhouse gases a decade ago. Before looking look at these regulatory systems, let’s look at the ideal environmental regulatory outcome.
At first glance, it would seem that no pollution would be the best regulatory outcome. Think of what this would mean when we consider CO2 as a pollutant. We inhale oxygen, but if CO2 is a pollutant and we want no pollution, then, we better hold that breath. But we cannot. Stopping all pollution is just too costly. Anything we do to reduce our pollution will cost us something. But, of course, pollution itself is costly, either health costs, or aesthetic costs, or costs in losses of biodiversity. The ideal, then, is really to keep the total costs of pollution and the costs of reducing that pollution to a minimum.
Generally, each extra ton of emissions of CO2 causes the added costs of pollution to increase. Also, if we look to reducing CO2 emissions, we can find some inexpensive ways to cut emissions, and after we cut emissions in those ways, to cut emissions further, we would have to employ costlier and costlier means. To keep these total costs to a minimum, the added costs from cutting a ton of CO2 emissions have to equal the added costs of the damage done by another ton of CO2 emissions. If the added costs are higher from the damage done from another ton of CO2 than from cutting emissions, we could lower total costs by cutting emissions. On the other hand, if the added costs of cutting emissions by a ton are higher than from the damage done from another ton, total costs could be lowered if we go ahead and pollute that ton. The “right amount” of pollution, then, is the amount where another ton would cause costs of cutting pollution by the same amount as the costs of the damage done by another ton of pollution.
Of the three methods of pollution control to understand, the easiest to understand is the “command and control” system. Here, the regulatory commission sets requirements for each source of pollution, monitors them for compliance, and then sets fines and punishments for those who fail to comply with the regulatory requirements. Here, possible polluters just do what they are told or face extremely high fines or other punishments. The “command and control” name for this regulatory type comes from the management form used in the military. Historically, most of regulation of the EPA has been of this “command and control” type. The best way of thinking about this approach is to recall the lines from Tennyson’s “Charge of the Light Brigade:”
Theirs not to make reply
Theirs not the reason why
Theirs but to do or die.
This command and control system of regulation does not do a very good job of keeping costs of regulation down, nor does it do a good job of balancing the costs of damage with the costs of reducing emissions. The regulatory authority just does not have information on all of the costs. This information is mostly diffused throughout the society—various electric power generating companies have a good idea of what their costs of cutting emissions are like, so a lot of people have bits and pieces of this information, and no one knows it all.
One of the earliest regulatory suggestions for reducing the costs of pollution control was made by A.C. Pigou in 1920 in his book, The Economics of Welfare (with the word “welfare” meaning “wellbeing”). Pigou suggested that a tax could be levied on certain activities, such as pollution, that would give people an incentive to reduce those activities. Economists in the 1960s and 1970s saw that such a tax would get polluters to reduce pollution in a least-cost way. Any producer who could reduce emissions at a cost below the tax would do so, while those who could only cut their emissions at a higher cost would not. Suppose the tax on emissions is $100 per ton. All pollution reduction that costs more than $100 per ton will not take place, but pollution reduction that costs less than $100 per ton will take place. Lower cost cleanup activities replace higher cost cleanup and costs cannot get any lower.
A little later on, economists came up with a slightly different approach. The environmental regulatory authority would first decide how much emissions would be allowed, create “pollution rights” which would be tradable. Polluters who could reduce pollution very cheaply could then reduce their emissions and sell their rights to those who could only cut their emissions at a very high cost. If the price of a pollution permit were higher than the cost of cutting emissions, the producer could then reduce their emissions and sell off their permit. If the emission permit sold for a price below the cost of cutting pollution, the emitter would buy up permits. If you think that such a scheme is unworkable, think again. We have been using tradable permits of this sort to control SO2 emissions that cause acid rain since the 1990s, and these permits trade on the Chicago Board of Exchange, along with various commodities.
The Pigou tax on pollution, which we saw a decade ago called a carbon tax, gives polluters a constant price to respond to, and the total amount of emissions could be higher or lower and can change over time. If the costs of cleaning up go up, we end up with higher levels of emissions. On the other hand, the tradable permits system produces a constant level of emissions but with a price of pollution that varies. Both of these methods minimizes the costs of cutting pollution because both produces a price for cleaning up so that those with costs of cutting a ton of emissions above that price do not cut their pollution and those with costs of cutting a ton of emissions below that price do cut emissions. Only the low-cost emission cutters reduce their pollution while high-cost emission cutters do not, and face either taxes or having to pay for pollution permits.
For global pollutants, such as greenhouse gases, there could be international trade in CO2 permits. This is the general idea behind “cap and trade.” For this to work well, however, there would have to be a global monitoring agency that could monitor each source of CO2 emissions and would be ready to punish those polluters who do so without a permit. This is the part of “cap and trade” that faces the biggest difficulties. Remember that real regulation is not done by Soloman-like regulators who are infinitely fair, but by actual people, like international soccer referees, so that various human biases rather than fairness would show through in international environmental regulation. The problem of political bias and lack of information in regulation is seen in this warning from Pigou himself (Some Aspects of the Welfare State,” Diogenes 7:1-11 (1954), p. 10.):
It must be confessed, however, that we seldom know enough to decide in what fields and to what extent the State, on account of them could usefully interfere with individual freedom of choice. Moreover, even though economist were able to provide a perfect blueprint for beneficial State action, politicians are not philosopher kings and a blueprint might quickly yield place on their desks to the propaganda of competing pressure groups. “Fancy” finance, like a fancy franchise, whatever its theoretical attractions, has, at all events in a democracy, dim practical prospects.
“Cap and Trade,” itself is a good idea. It is a market-based approach to efficiently reduce the amount of emission of CO2. The real difficulties are first, setting the right amount of emissions to allow and second, monitoring and regulating by a global authority, giving up sovereignty to regulators who are likely to want to tilt the playing field away from favoring Americans. Before going down the road of regulating CO2 through any approach, we should be very sure of what human reductions in CO2 will actually accomplish and whether there are alternatives that might work better, such as re-forestation of large areas of the planet.
-MC