Cap and Trade: what matters, and what doesn’t

Kevin Drum says a cap and trade carbon reduction program is only ‘real’ if the allowances are auctioned to emitters, not given away. He’s wrong, so much as I like thoughtful attention to global warming, I need to weigh in, especially given how completely lost his commenters appear to be on this issue. I desperately want to offer a pocket-sized statement of this program: non-specialists have a right to understand something this important without taking a semester course. Something like, “Social Security is basically a bank: you put your money in while you work, and you take it out with interest when you retire.” Unfortunately, simple and clear as that characterization of Social Security is, it’s entirely wrong, and I can’t provide a responsible one-sentence soundbite for cap and trade either.

Here are the key elements of greenhouse gas reduction, described from the point of view of a government deciding how to proceed:

(1) Individuals and business emit nearly all the greenhouse gases, so from the start, we have to decide how they will be induced to do something different from what they do now. Many people’s instinct is to just regulate “less”, say 20% less for everyone, and enforce it with fines and jail terms. We learned decades ago, though, that it’s really expensive for some emitters to release less GHG, and pretty cheap for others, so if we let them find each other and make deals, we can get the same environmental benefits much cheaper than with across-the-board actual reductions, which is hard to argue against: hence, the trade part of cap and trade. No serious person advocates regulating GHG without a market for emission permits.

There’s another approach to changing behavior, though, which is the one we use quite broadly to get everyone to use just the right amount of corn flakes, 2x4s, books, etc., give people property rights in what they make and then let them sell it. Stuff that costs a lot to make, like one-off designer dresses, have high prices and people use not much; stuff like t-shirts are cheap to make, have low prices, and people use more. Putting GHG into the atmosphere has a cost that emitters don’t pay (warming the planet), so we might just make them pay what it costs and watch them figure out ways to emit less than they do now. Furthermore, we would be pretty sure that what they continue to emit was worth it in terms of the other kinds of benefit it provides. This is the logic behind the carbon tax (actually a GHG tax), which should be called a carbon charge, as it’s actually conceptually quite different from a tax. We don’t collect it in order to fund government services, but to give people good signals about the cost of what they’re doing and to make sure no-one uses up public resources (in this case, planetary coolth) without paying for what he takes. It’s about selling something valuable for its real worth rather than giving it away.

(A1) Here the analysis meets a fork in the road. If we choose the GHG charge path, we need to decide how much to charge, which means we have to know the marginal cost of a unit of emission at current emission levels. After a while, emissions will go down, and the charge might get lower; eventually things settle down at the right level.

This charge will generate a lot of revenue, and a completely different analysis applies to what it should be spent on. It’s not as simple as it looks to argue that it should be spent on environmental programs or even GHG reduction, for example. It’s an interesting question, but the subject of another post. With a carbon charge, we’re done.

(B1) If we decide to go down the cap and trade route, we have to determine the “right” amount of global warming gases society should emit. To know this, we need to know the benefits of every possible level of emissions relative to where we are now, and the economic cost of getting to each of those levels. The right amount is where the cost of reducing more is greater than the benefits. Note that to get a cap right requires a lot more information about the world than to get a carbon charge right, and the information we need (costs of compliance) is the kind of thing firms tend to be prickly about disclosing and likely to flat-out lie about. When we started to clean up cars, all the auto manufacturers swore up and down that catalytic converters and such would lead to super-expensive cars that wouldn’t start or run right, and basically wreck the US economy. They may even have believed what they were saying. The extra information requirements for cap and trade are a big part of the relative advantages of the carbon charge.

(B2) But this is not a policy yet, because we also have to decide how much each player is allowed to emit – that is, to allocate the total emission cap across everyone in society. This is not quite as complicated as it looks, because if we assign an emission cap to a power station, for example, we don’t have to look into everyone’s house and measure their electricity use, but it’s still a piece of work. The two ways to do it are (i) to give everyone rights to, say, 80% of what they emitted last year, or (ii) to auction the whole amount of the cap. The first one entails a fair amount of administrative effort to be sure people don’t lie in order to get a larger allocation; the second is much simpler.

(B3) Then we let people buy and sell their emission rights and make sure no-one emits without the rights to do so. After an auction, there will be relatively little buying and selling, because emitters will start out with pretty close to the “right” respective entitlements of rights. After a giveaway allocation, there will be lots of trading.

The difference between a giveaway and an auction of the same total emissions is not a difference in environmental outcome or the economic cost of getting to it; it’s only a matter of whose ox is gored: a giveaway with cap and trade is a real cap and trade. It’s the difference between a cost and a transfer. To see this, imagine that we proceeded through an auction and some trades, and then felt so bad about all those utility stockholders that we wrote checks to every emitter for the value of the allocation they would have been given under a free scheme. They would be happy, and maybe reduce their prices in the face of competition, but there would be no important change in emissions at each firm, even though this surprise rebate makes the auction into a giveaway.

From an environmental perspective, a giveaway and an auction of the same total allocation are about the same; an auction is better in my view, by a lot, but not on global warming grounds. If I had to settle for a giveaway politically to get some serious GHG controls, I would, even though its my third choice, and even though I gnash my teeth at the trouble we’ve bought for ourselves by dismissing the carbon charge on grounds of ignorant, ideological assertions and punditry rather than really understanding what we were getting ourselves into with substitutes.

Author: Michael O'Hare

Professor of Public Policy at the Goldman School of Public Policy, University of California, Berkeley, Michael O'Hare was raised in New York City and trained at Harvard as an architect and structural engineer. Diverted from an honest career designing buildings by the offer of a job in which he could think about anything he wanted to and spend his time with very smart and curious young people, he fell among economists and such like, and continues to benefit from their generosity with on-the-job social science training. He has followed the process and principles of design into "nonphysical environments" such as production processes in organizations, regulation, and information management and published a variety of research in environmental policy, government policy towards the arts, and management, with special interests in energy, facility siting, information and perceptions in public choice and work environments, and policy design. His current research is focused on transportation biofuels and their effects on global land use, food security, and international trade; regulatory policy in the face of scientific uncertainty; and, after a three-decade hiatus, on NIMBY conflicts afflicting high speed rail right-of-way and nuclear waste disposal sites. He is also a regular writer on pedagogy, especially teaching in professional education, and co-edited the "Curriculum and Case Notes" section of the Journal of Policy Analysis and Management. Between faculty appointments at the MIT Department of Urban Studies and Planning and the John F. Kennedy School of Government at Harvard, he was director of policy analysis at the Massachusetts Executive Office of Environmental Affairs. He has had visiting appointments at Università Bocconi in Milan and the National University of Singapore and teaches regularly in the Goldman School's executive (mid-career) programs. At GSPP, O'Hare has taught a studio course in Program and Policy Design, Arts and Cultural Policy, Public Management, the pedagogy course for graduate student instructors, Quantitative Methods, Environmental Policy, and the introduction to public policy for its undergraduate minor, which he supervises. Generally, he considers himself the school's resident expert in any subject in which there is no such thing as real expertise (a recent project concerned the governance and design of California county fairs), but is secure in the distinction of being the only faculty member with a metal lathe in his basement and a 4×5 Ebony view camera. At the moment, he would rather be making something with his hands than writing this blurb.