Research

Cap-and-trade: Is a carbon market the best way to control greenhouse gases?

If John McCain and Barack Obama agree on one thing, it's global warming and what to do about it. Both presidential candidates say that a so-called cap-and-trade system of regulation is the best way to stem U.S. emissions of greenhouse gases. Thus it seems inevitable that this country will see a cap-and-trade system, no matter who the next president is. That's good news, says Elizabeth Bailey, a professor of economics at the W. P. Carey School of Business, because cap-and-trade regulation trumps alternatives such as a carbon tax or old-fashioned bureaucratic edicts.

2008-08-13

That's good news, says Elizabeth Bailey, a professor of economics at the W. P. Carey School of Business, because cap-and-trade regulation trumps alternatives such as a carbon tax or old-fashioned bureaucratic edicts.

It sets an explicit limit on the amount of carbon dioxide pollution that spews into the atmosphere, and it gives companies the greatest flexibility in achieving the needed reductions, explains Bailey, who wrote her dissertation at the Massachusetts Institute of Technology on the U.S. cap-and-trade system for the pollutants that cause acid rain.

"Any regulation of carbon dioxide is going to be controversial because it's going to raise energy costs," Bailey points out. But climate scientists say that doing nothing risks letting carbon dioxide levels in the earth's atmosphere grow to dangerous levels.

How it works

In a cap-and-trade system, the government issues permits allowing firms to emit a certain amount of a pollutant — each permit might allow, say, one ton of carbon dioxide. Regulators then limit the amount of emissions by imposing a cap on the total number of permits.The system can also allow firms to "bank" permits, borrow permits, and to buy and sell permits from each other, creating a valuable new form of property.

Some companies might find that they could operate using less than their allotment of permits, leaving those firms with extras to sell. Other companies, in contrast, might produce more pollution than would be allowed by their allotment of permits and have to buy additional permits from those companies with extras to sell.

"With permits, you can trade with a wide variety of entities to achieve the lowest cost solution," Bailey explains. Efficient firms would keep driving down their pollution in an effort to free up more permits to sell, and inefficient ones wouldn't waste money re-engineering their operations to meet cumbersome regulatory mandates. If it was more efficient for them to install abatement technologies, they'd do that. But if that was too costly, they'd purchase permits.

Over time, the government could reduce the number of permits that are allocated and thus cut the total amount of pollution. As that happened, the market value of the permits may rise, creating an even greater incentive to reduce emissions. A cap-and-trade system, in other words, harnesses the innovative power of the market to cut pollution.

Tax instead?

But not everyone agrees that a cap-and-trade system makes the most sense for cutting carbon dioxide emissions. An informal coalition of economists, led by Harvard University Professor Greg Mankiw, has instead endorsed a carbon dioxide tax, saying that it would be more efficient economically. These folks point out that research has amply demonstrated that people respond to taxes — make them high enough, and behavior changes, whether it's smoking or polluting.

A tax, they say, also creates less bureaucracy than a cap-and-trade system, which requires someone to issue the permits, oversee their exchange and police emissions. After all, the United States already has a burly tax cop in the Internal Revenue Service. Finally, by setting a precise price for carbon pollution, a tax would make it easier for firms to plan for the future.

"Some people say taxes are better because an uncertain price hurts firms," Bailey notes. "Their argument is that, if a firm doesn't know what the price is going to be, it's harder for the firm to make decisions regarding capital investments and R&D." In a cap-and-trade system, the price of permits would zigzag with demand and supply, just like stock prices do. A tax, in contrast, sets a single explicit price. In theory, to avoid paying the tax, firms would cut their pollution.

"Firms deal with uncertainty all the time — they buy inputs that have volatile prices," Bailey says. "Electric utilities, for example, face uncertain coal prices. They use financial instruments to deal with that uncertainty." Carbon trading would create a new financial market, with intermediaries like brokers who'd assist in the exchange of permits, she explains.

In the early days, as firms grew accustomed to this new form of trading, prices might rollercoaster. "Initially the permits may be thinly traded because people are trying to figure out what the right price is," she explains. "But soon, they'll become just another financial instrument," like a stock or a bond. Prices would still bounce up and down, but the level of volatility would fall.

From rules to incentives

To better understand the arguments on both sides — and why Bailey believes a cap-and-trade system should prevail — you have to know a bit about the history of pollution trading in America. One of the early implementations of the concept was the Clean Air Act Amendments of 1990. At the time, lawmakers and regulators were seeking an economically efficient way to reduce emissions of sulfur dioxide, which contributes to acid rain.

Historically, regulatory orthodoxy may have led regulators to just declare a limit and to tell firms to comply or face penalties. They might even have dictated the technology that companies had to use to do that. If that cost companies a huge amount of money, too bad. Those would've been the rules, and everyone would've had to follow them regardless of whether some companies could have found a less expensive way to achieve the same reductions.

Not only is that old-fashioned sort of setup costly, it doesn't create an incentive for companies to work toward reducing emissions below mandated limits. A firm that did so would be wasting its shareholders' money by making an investment for which it received no financial return. With the 1990 amendments, U.S. lawmakers created a regulatory framework that gave firms greater flexibility — they could cut their emissions or buy permits — and an incentive to innovate.

It worked. In the 1990s, "power plants participating in the program reduced [sulfur dioxide] emissions 22 percent — 7.3 million tons — below mandated levels," according to the Environmental Defense Fund. Just as important, electric power companies — who'd been skeptical guinea pigs in this giant regulatory experiment — liked the system. In 2002, The Economist magazine called it "probably the greatest green success story of the last decade."

Back in the 1990s when Bailey wrote her dissertation, global warming was just beginning to be widely debated, but she saw the potential for a cap-and trade system to stem carbon dioxide pollution. "You couldn't just take the sulfur dioxide program and plop it down for greenhouses gases, but I thought it would work well for a variety of reasons," she recalls.

Sulfur dioxide and carbon dioxide pollution differ in key ways. Perhaps most important, most sulfur pollution comes from a relatively small number of firms — electric power companies. "Something like 70 percent of the sulfur dioxide emissions came from electric utilities," Bailey points out.

"There were other sources, too, but Congress decided that it'd get a big chunk of the emissions from regulating the utilities, and that it was going to let the other 30 percent go. That'll happen with carbon dioxide. We'll look for the big chunks that we can get in the lowest cost way."

Bailey concedes that creating a cap-and-trade system for carbon dioxide will be more difficult than devising one for sulfur dioxide. Big utility companies lend themselves to regulation. Theirs is an industry with a relatively small number of players who are already closely watched by the Department of Energy, the Federal Energy Regulatory Commission and the Environmental Protection Agency.

"So there's a great legal environment to enforce the property rights associated with tradable permits, and there are enforcement bodies that can litigate to ensure compliance," she notes. Comparable regulatory bodies will have to be created to issue carbon permits, monitor emissions and oversee trading, she says.

Global problem

But perhaps the more critical complication is that acid rain and global warming affect the environment in different ways. The first tends to be a regional problem, while the second is, as its name suggests, international. Sulfur dioxide falls relatively close to its source. A power plant in Ohio might send it into the sky as emissions from its smokestacks. The pollution would return to earth as acid rain over, say, the mountains of West Virginia.

In that case, both states are within the same country and subject to the same laws, and a federal solution can solve the problem. Carbon pollution, in contrast, is a worldwide problem because it behaves like water in a bathtub: no matter where it enters, it adds to the worldwide level of greenhouse gases and thus to global warming. "Greenhouse gases mix uniformly throughout the atmosphere," Bailey explains. "So to solve the issue, you need a global program, and there's no uniform regulatory body that governs the world."

Some U.S. commentators point to that as an intractable problem for the effort to curb global warming. These folks argue that it's pointless for the U.S. to crimp its economy with a cap-and-trade system or a carbon tax because, unless giant fast-growing nations like China and India also take steps, little will change. Bailey doesn't buy that.

She points out that the United States remains the world's largest economy and, even with China's growth, will continue to be a world leader for the foreseeable future. Just as important, U.S. firms might be able to parlay their country's environmental leadership into new technologies and products. As companies strive to reduce their carbon emissions, they'll devise new, cleaner ways of doing business, Bailey says.

Firms elsewhere in the world may want to acquire those techniques, since their countries could follow America's lead in regulating carbon pollution. "The thing to keep in mind is that you can create a demand for products that cost more but have environmental benefits attached to them," Bailey points out.

"Think about Burt's Bees cosmetics. They're marketed as environmentally beneficial, and they have a price premium attached. But people buy those goods. In fact, the Clorox Company bought Burt's Bees last year to learn about marketing "green" consumer goods." In theory, developing-world consumers, as they become more affluent, will demand these sorts of products, too. Clorox, at least, is counting on it.

Bottom Line:

In a cap-and-trade system, the government issues permits allowing firms to emit a prescribed amount of a pollutant.
As the government reduces the total amount of permits in circulation, the total amount of pollution is reduced.
At the same time, the market value of the permits may rise, creating an even greater incentive to reduce emissions.
A cap-and-trade system, in other words, harnesses the innovative power of the market to cut pollution.
Some economists think a tax on carbon emissions is the answer: make taxes high enough and behavior changes, whether it's smoking or polluting.
The global dynamic of carbon pollution demands an international solution.

Economics Faculty