Understanding Cap and Trade: Why It Has Been the Option of Choice

In the run up to Copenhagen and the debate over Waxman-Markey, I think it's worth laying out some of the key debating points on how cap and trade works and why it's been our weapon of choice to date in the climate change fight.

I like to think of our carbon and energy problem as follows. We built the first industrial economies and long term economic growth model in all of human history in the last 200 years on a cheap, available energy base, in part by effectively running down our existing inventories of energy stocks from the least cost to the most expensive. We now need a lot more inventory each year (since we've been successful and are a lot bigger), and we're into the expensive layer of our inventory, so it's hitting our global cost of goods heavier than before. And we know we need to find more sources to replenish inventories, and we know that if we move immediately to higher cost sources we'll pay the price in GDP.

We also know that producing and using those inventories had a non zero (and we argue about the level) cost to our environment that we have not measured well, but have been working on reducing for the last three decades. But we've now run into a new part of that cost with carbon or GHGs that's very large, and is going to take a much larger and bigger hit to take care of, and depending on your view, has an aggressive time fuse on it. Essentially this means pricing carbon into our economy, which will basically add a whole new cost in all of our supply chains, a cost that varies from country to country and industry to industry, and will shake up comparative advantage in trade. And because it's global, as far as the environment is concerned, for carbon, unlike most environmental pollutants, it doesn't matter where in the world it's emitted or reduced. So our problem is China's problem is Europe's problem is our problem.

So we start with a first climate change goal: to reduce the carbon emissions levels in the economy, by a level that we all debate by a point in time that we all debate. But we have to realize that while we do this, we do need to replace those energy supply inventories to both keep us where we are in GDP, and find new ones to sustain growth, or we'll solve our GHG problem simply by being really poor. And we have to remember that adding costs has to be paid for, and it isn't "business" that pays for it, it's us, with business as our proxy.

So my corollary is the goal should be to squeeze carbon emissions out of the global economy in the fastest, least cost path, and as fairly as possible. Sorting out what that means and how to do so is the rub. But part of fair should mean a "do no harm" principal for the economy as well as the environment - meaning that when we start, as far as possible no country or group or industry or company within industries gets penalized out of the gate without either compensation or enough time to adjust. Think of it like eminent domain. If we give something up to the greater good, we deserve to get paid for it.

We have two main ways to go about it, place a tax or penalty on the emissions, or constrain the emissions factors (like power generation, driving, etc.) Cap and trade is essentially a hybrid of the two. The cost of such carbon reduction, because of the ubiquitous nature of carbon, and typically inelastic demand curves for most energy and carbon intensive products, is spread across all consumers in any scenario, but depending on system design can be borne disproportionately by some groups, industries or countries. Our special challenge is because of that global nature, we literally HAVE to have a solution that can engage and work in every country. Unlike cleaning up a local toxic spill, where we can fix ours without our trading partners, in carbon, if China fails, we fail. So if we try and succeed, and China does not try, the environment loses, and we lose worse.

Carbon Tax - Basically with carbon tax the government picks a series of carbon intensive industries or products, assigns a carbon value to them by one of a number of methods, and levies a tax on them. It's often touted by economists as theoretically the cheapest method, and generally an industry favorite because they know how much they'll have to pay and can plan.

But carbon taxes have big drawbacks. You can't be sure you'll actually get the level of reductions you want, because the tax fixes price, not volume. Worse, carbon is a global problem, and getting global tax codes to mesh together is virtually impossible (we can't even do it inside the US), which means we may end up with everybody paying a different price of carbon and a complete mess. That certainly would throw the efficiency argument out the window. The next big disadvantage is that if you don't get the tax level and structure exactly right, businesses and consumers get hurt in unpredictable ways, and have little room to adjust if we get it wrong. So while theoretically better, it's not a very "fault tolerant" plan.

Main advantage is that you have a known cost to industry (which is why most industry prefers tax to trade or command and control). Next main advantage is that the the government gets lots and lots of revenue, which is why many politicians favor it.

The second option is classic environmental "command and control", if you'll excuse the perjorative sounding nature of that term. Esstentially the EPA or equivalent simply regulates every one who produces GHGs, and tells them how much they can produce through a permitting process.

The advantage is that you know exactly how much emissions reduction you are going to get. The disadvantage is that you may pay much more than you thought, and sink your economy, especially if your trading partners are more lax on either regulation or enforcement, and you let the EPA pick the winners and losers. The other disadvantage is that there is no upside. Under no circumstances will you ever get more reductions than you thought, unlike cap and trade, where done right, you may.

Cap and trade is the middle ground (which is why it keeps coming up). With cap and trade, the system operator (UN, EU, EPA, CARB etc) designates how many credits can enter the system, and prints, them like money. It then designates how many credits a company must turn in each year or period per unit of production (ie 0.5 tons/MWH of power produced), and penalizes or shuts down the company if they don't turn in enough to meet their obligation. So no more emissions from a regulated sector will occur than credits (often called allowances) exist.

Then the regulator decides whether to sell the credits to the industry that needs them, or to simply allocate them (often based on some measure of current production). Both methods have pros and cons, and in practice have nothing to do with environmental protection or the price of carbon (the total level of credits and the relative level of credits to demand sets that) and more with subsidizing one industry vs another, or collecting revenue for the government.

Finally, the regulator can let offset credits be produced from the remaining unregulated sectors (or from inside a regulated or "capped" sector if appropriate adjustments are made), and sold to the emitters (it simply adjusts the cap so that the total level is where we want it to be). The advantage of this is that the regulations can be phased in easier, and we get a more equal price of carbon.

And what happens is that in unregulated sectors any time potential reductions exist (eg, a very inefficient emitter that could be shut down or run more efficiently), carbon developers pay up for the rights to the reduction, and that emitter finds it's more profitable to do the right thing. The downside is that it looks like emitters are getting a profit off emissions. In reality, they are getting paid to reduce emissions for you and I, at just the right price.

Then emitters and financial parties buy and sell these credits from the government or each other or develop offset credits in a race to pay the least. And since the regulator starts reducing the number of credits it puts into the system, it's kind of like musical chairs, the slowest, most carbon inefficient company gets left out and has to shut down, or shifts to a lower carbon production in order to stay in business.

The main advantages of cap and trade:

1) it assures us that we will meet our target goals like command and control 2) but it allows industry the flexibility to figure how to meet them cheapest (which is good for all of us), 3) it tells us what the real price (or cost) of carbon actually is, 4) and it's better at equalizing the price of carbon so everyone pays the same across different industries and geographies, 5) in practice it costs less, and is easier to implement in a multicountry environment than command and control or tax.

Main disadvantages, it takes some time to get up and running, and makes it look like (not really true) emitters are making money off it. Trust me, if they thought it was a profit center, they'd be all over it. The final disadvantage is it depends on the government operator to manage a market, something where we've had some good success (like NOX and SOX trading and up until recently the Fed), but can be susceptible to politics as usual.

In essence, you can think of cap and trade as a carbon tax with a tax rate that varies with the market (going up if industry is worse at producing carbon reductions than the government thought and down if they are better, and similiarly going down when the economy is bad and we can't afford it and up when the economy is strong) and a tax base that is higher for emitters and emissions intensive industries than for those more efficient.

In any case, all three options need a lot of money spent on new technology and good measurement and verification. All three options will be expensive, and will be paid for by you and I at somepoint. And in practice, we are doing all three options to varying degrees right now.

Comments

[Ferdinand E...:]

This is a good article, Neal, in that it is well written and structured the way that good articles should be structured . The problem is that had I written it, I would have come to the conclusion that cap-and-trade is something to stay as far away from as possible.

I've published some articles on this, and almost certainly had something about it in my latest energy economics textbook, and maybe even the first. The point is that everything I have read about this option stamps it as a failure. Then why do we have to be bothered with it? The answer is that the voters do not like the word tax, as in carbon tax, and lazy and ignorant academics have convinced these voters and their representatives that the answer is and always has been cap-and-trade, and time is being wasted by not installing it as soon as possible.

I always refer people who want to know more about cap and trade to Professor David Victor of Stanford University. (Another person who has looked at this is Ruth Greenspan Bell, formerly of Resources for the Future. I)'ve never met Victor, by the way, and I have written to him several times asking more about his work, but not getting a reply, so I have no reason to recommend him. But I like his arguments, and more important, if he ever found himself in a conference or seminar room with me, I would make him feel so inferior that he would answer my letters by return mail.

Jul 19 09:12 AM

[john s. gordon:]

the main disadvantage of capntrade is that the system can be gamed by enron-type operators.
it;s important that strict rules are enforced to prevent this.
> jack

Jul 19 09:52 AM

[DLB40:]

When I woke up this morning it was 68 degrees outside. It is now 2 hours later and the temperature is 73 degrees. That is climate change. To further clarify; in our state the temperature in the summer is often 90 degrees, and in the winter is often 30 degrees. Again, that is climate change. I totally understand Cap and Tax. The Democrat party always wants more money, larger government, and more control. Cap and Tax is their latest smoke and mirrors trick for the public school educated majority in the US.

Jul 19 10:34 AM

[Hazel Hende...:]

Let's keep the cap and ditch the "trade", which is an open invitation to Wall Street to game the system. Banks are now savoring the some $2 trillion of carbon derivatives as a new profit center from this new "asset class". So far , where cap and trading of carbon is in effect in Europe , lobbyists for the electric utilities got so many free " allowances" that they crashed the carbon market. They made windfall profits by adding to consumers bills. Bottom line : no reduction of carbon emissions !
Better to go with GREEN TAX SHIFTING, where income and payroll taxes are reduced and shifted in a revenue neutral way to waste,and all forms of pollition, not just carbon. Meanwhile, the Climate Prosperity Alliance offers the best path to a low-carbon world economy ( see EthicalMarkets.com click on Climate Prosperity Funds and globalurban.org click on Climate Prosperity.)Let's change the debate from costs to incumbent fossil fuel sectors to the benefits, savings and revenues from investing over the next 10 years to ramp up energy efficiency and the renewable sectors of the emerging Solar Age.

Jul 19 10:44 AM

[BuddhaHead:]

Sounds like a Ponzi scheme to me! Like the financial bailouts of the 'too big to fail' firms, the taxpayer paid them to stay afloat when THEY were the ones that developed the leveraged scheme to get big profits and get us in this mess in the first place. The government gave them huge sums hoping these firms would improve their liquidity thus provide financing where needed by families and businesses to get us out of this mess. Didn't happen! Now they report huge profits, pay back TARP and its business as usual again. Now it's energy under the catalyst of global warming. What do our politicians do? Cap and trade funded again by the tax payer in the form of increased energy costs. Utility companies that are heavy on coal energy (and most are) have to buy Carbon credits to operate. So who pays? The consumer. If not, they don't operate? Just like the banks--'too big to fail'??? If global warming is the driver, we shouldn't have to use smoke and mirrors to look like we're doing something proactive! Let's be proactive. Let's spend our dollars on ourselves and pay for nuclear, wind, solar, and smart grid. We need our own 'Marshal Plan' to save us. I would think if we started now this would create new jobs, keep us competitive, and keep our dollars here instead of foreign oil companies that love our money but hate our country. America has in the past been a winner when it needed to be. Look at our history from national creation to now: auto industry, aircraft industry, electronics, computers, IT, biotech, nuclear, and nanotech. The heat is on guys!!! We need our Yankee ingenuity and initiative again. Let's not let this be the ending of the American era!

Jul 19 11:03 AM

[Mad Hedge F...:]

this is a no brainer. I can tell you right now that cap and trade is going to win the political battle over a carbon tax, hands down. Don’t waste a nanosecond of your time even thinking about it. Nobody wants to be tarred with pushing a new tax, and Wall Street is gearing up to make a fortune in the new trading vehicle. Europe has already adopted the system, and a Paris based exchange called Bluenext, partnered with NYSE Euronext, trades Certified Emission Reduction credits (CERS’s). Some 4-6 million CER’s trade each day worth $50-$75 million. After peaking last year at €30, CER’s crashed to €7.5 in February and then bounced to €12.72 today. They are traded in 1,000 unit lots, and are backed up with far month futures contracts. Check out their cool website at www.bluenext.eu/. Morgan Stanley and Goldman Sachs have already set up trading operations in the instrument. The EC government grants CER’s to green companies, which them sell them to big polluters, which must buy them to expand their business. The costs are passed on to consumers. The system contributed to a 3.8% reduction in CO2 emissions in Europe last year. The current world market for carbon credits is $126 billion, but if the US joins the system that will jump by $1 trillion. I was involved in the creation of the Japanese equity warrant market in the early eighties, and I can tell you that new, poorly understood markets with spreads wide enough to drive a truck through are a license to print money for the early players. Perhaps there is hope after all for the legions of traders, market makers, brokers and analysts left unemployed by last year’s collapse.

Jul 19 12:08 PM

[jljacobs406:]

This "cap and trade" business is a scam. It introduces an artificial cost element to the economy that will PUNISH America's industrial base. It will also create an entirely new government bureaucracy that will be massive, powerful, and susceptible to corruption. China and India will not participate in this nonsense and will sit back in delight as the US voluntarily slits its own economic wrists. In order to compete, US manufacturing firms will move more jobs and operations wherever they can to avoid this "tax". The big loser here will be the American consumer. The consumer will bear the cost of this in the form of higher prices for nearly everything, higher taxes to pay for the massive government infrastructure to oversee this program, and lower wages as businesses and operations flee the high operating costs in the US.

We're being led over the cliff here, folks. Time to wake up, engage, and THINK! This makes no sense. We need to stop this before it's too late.

Jul 19 12:22 PM

[mdmrjsds:]

Ha!

In China, there are 300 million people living on less than $2 US per day. In India, there are 700 million people living on less than $2 US per day. Right now, not in some future scenario. And these are the people that are not controlling their fertility, having more babies than they can afford to raise properly, thus it is certain that the problem will grow into the future. Not even considering the other billion people around the world in the same situation.

Greenhouse gases might or might not be creating a problem that will occur in 50 to 100 years time. I know, I know, the models and statistics *prove* that this is happening. Sssuurrreeee they do. If you read the details, it isn't as cut and dried as it is made out to be. And we heard the same things from the economists about their models regarding risk and pricing. Every week I see journal articles that change the picture.

So their tradeoff is between starvation, social unrest and possibe rebellion now or a possible climate issue 50 to 100 years in the future. We're freezing to death, we can burn the fruit trees and maybe starve next year or freeze to death now. Hard question. Not!

We're (meaning humanity) going to burn every hydrocarbon resource available to us, until it becomes thermodynamically unfeasible.

On a positive note, I have seen reports here on SA that the worst scenario of the climate change alarmists is not possible because there aren't enough hydrocarbon resources for it to occur.

Another possible positive glimmer is that the number of people that are impacted under projections is in the hundreds of millions range. Over the course of the last century we added more than 4 billion people, and we are going to add another 3 billion by the middle of this century. So the migrations we are talking about are small potatoes in comparison.

But the bottom line is all this carbon talk is just noise. Those billions of people struggling for existence are going to use any and all means at their disposal, despite any long term consequences.

Jul 19 02:00 PM

[keithfeather:]

Currently people make things and sell them using energy. In the future under any energy tax or trade program thousands of additional people will be paid to manage some additional program. Everyones standard of living just fell. How hard is this to understand?

Jul 19 06:14 PM

[Trane250:]

The MTV/Sesame Street generation has been sold a bill of goods about carbon. CO2 is not a pollutant. It has always been present in the earth's atmosphere albeit in varied concentrations. What the global warming blatherers really want is to reduce the USA to third world status by destroying what little industry we have left. This is what Obama means by "empathy."

Jul 20 10:09 AM

[TinyTim:]

Nicely written.
I recognize that the Carbon cap & trade proposal is a way to create "hue & cry" trading of an externality and hopefully optimize the economic cost through the mechanisms of a free market. It's been done before and supposedly works well.

Without even getting into the whole global climate change justification for this proposal, one line in your article gives me pause:
"So if we try and succeed, and China does not try, the environment loses, and we lose worse."

Where does it say China or India have to even try?
Brazil is burning the solution by the square mile.
This is either a classic game of chicken or a race to the bottom of the oil barrel, depending on your view of the science.

Jul 20 10:05 PM

[tuj:]

"When I woke up this morning it was 68 degrees outside. It is now 2 hours later and the temperature is 73 degrees. That is climate change."

No, that's a phenomena called "weather", which is caused by the sun's daily uneven UV heating of earth.

A "climate", as anyone knows, is defined as "the weather in some location averaged over some long period of time;", for example "the dank climate of southern Wales".

You can be a climate-change denier; that's fine. But don't use the sun's daily movement, or even this season's weather trends to rationalize your views.

Jul 21 08:21 AM