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 Economics vs. global warming: Carbon tax vs. cap-and-trade!
POSTED 4 DECEMBER 2008

In this corner, cap-and-trade

A carbon dioxide cap-and-trade system creates permits that businesses need to legally release carbon dioxide. Permit owners can buy and sell ("trade") these permits as needed, searching for the cheapest carbon dioxide reductions, but the total number of permits is capped, and declines over time.

A cap is a limit that 'provides you with environmental certainty, which is very, very important.'

Cap-and-trade is today's favorite horse in the race against global warming: Europe is refining its existing system, California is setting up a new one, and President-elect Barack Obama apparently also favors the cap-and-trade mechanism.

These cap-and-trade systems are elaborations of a market mechanism introduced under the U.S. Clean Air Act Amendments of 1990 to control sulfur dioxide and nitrogen oxides made at electric power plants, and thereby protect Northeastern lakes from acid rain.

Although some mocked cap-and-trade as a "license to pollute," the system reduced the pollutants causing acid rain by 40 to 50 percent between 1995 and 2006 (see #i in the bibliography). During this period, fossil-fuel use by electric generators rose almost 40 percent.

A proper cap

According to Environmental Protection Agency regulators at the acid-rain program, a cap-and-trade system should:

Be based on "clear, comprehensive legislation" and be easy to administer

Be flexible, yet contain strong incentives for cutting pollution

Use a solid monitoring system that allows low-price transfer of data on current emission levels

Allow the free market to set the price of pollution permits

The acid rain program was an inspiration for the European Union's Emission Trading Scheme (ETS). Currently the largest economic effort to control global warming, ETS covers more than 10,000 energy and industrial installations that produce nearly half of the EU's total carbon dioxide pollution.

The results for the test phase of ETS, which concluded at the end of 2007, were mixed. In the first year, 362 million tons of carbon dioxide permits were traded. The price peaked in April, 2006 at about 30 euros per ton, but after word leaked that some countries were likely to set generous caps, the price had skidded to a tenth of a euro by September 2007. Carbon dioxide pollution increased during the test phase; the second phase is under way.

Weighing cap-and-trade: + and -

Cap: For saving the climate, the key benefit of cap-and-trade comes from that itty-bitty first word. Once you decide on a tolerable level of carbon dioxide, individual nations or an international group can set the cap accordingly. "A cap provides certainty with regard to emissions," says William Chameides, dean of the Nicholas School of Earth and Ocean Sciences at Duke University. "You can put in a carbon tax and hope the market responds appropriately, but with a cap, whatever happens, that says not more than X tons will be emitted. A cap provides you with environmental certainty, which is very, very important."

Market mechanism: A market can be a brilliant means for distributing goods at the lowest price, and proponents say cap-and-trade will seek the cheapest reductions in carbon dioxide emissions. An electric generator that switches to geothermal power could, for example, sell permits to another generator that remains reliant on coal, providing a market-based subsidy for the low-carbon source while penalizing the high-carbon source. If it proves more expensive to reduce carbon, the permit price rises, and likewise the subsidy for no-carbon electricity.

Broad coverage: Planting a forest that removes carbon dioxide from the atmosphere is a step against global warming that could be rewarded by cap-and-trade, but not by a carbon tax. Cap-and-trade systems could enable forest owners to sell permits, thereby subsidizing a climate-friendly activity. The market could also encourage a company that invents a low-carbon electric-generator, which would be more valuable to its customers because they would, in turn, be able to sell more carbon permits. According to Chameides and co-author Michael Oppenheimer (see #2 in the bibliography), "... the advantage of a market-based system is that it provides an incentive for innovation -- which can translate into inexpensive CO2 emission reductions."

Grove of dead branchless pine tree trunks.
Photo: NASA
A forest devastated by acid rain in the Jizera mountains, Czech Republic.

Cost-saving: The successful acid-rain program shows the potential to reduce costs, Chameides says. "Virtually every air pollution regulation we have put into place has turned out to be much less expensive than original estimates. As long as we put in appropriate goals, there is a good possibility that innovation will reach it without costing as much."

Profit motive: "With cap-and-trade, there is a pot of gold at the end of the rainbow," says Chameides. "If you can exceed the requirements, you can make a lot of money. I don't see the incentive being as strong with a carbon tax."

The name: Not having to call it a tax is probably the best benefit of all for cap-and-trade, says James Barrett, chair of the board of Redefining Progress, a Washington non-profit concerned with environment, social justice and the economy.

On the minus side

Verification: If I operate a supposedly low-carbon generating station, who will check that I am truthful about emissions, and not skimping on my permit purchase? "Because permits meant to be tradable, redeemable, and backed by the U.S. government, they will have to police the system, to make sure the reduction is valid," says Barrett. "Cap-and-trade can get unbelievably complicated because basically you have printed a new form of currency, and you have to create an entity to defend it."

Fudge factor: Many of the benefits of cap-and-trade emerge from the fact that permits can be traded, yet if businesses even slightly understate their emissions on permits that are sold and resold, the fudge factor can add up to sabotage the market.

As electricity generation has increased, emissions decline
EPA; see #1 in the bibliography.
Since 1995, the U.S. Acid Rain Program has overseen dramatic drops in pollution from sulfur dioxide and nitrogen oxides. The health and environmental benefits of this cap-and-trade program were less expensive than expected.

The safety valve: Some popular cap-and-trade proposals place a ceiling on the price of pollution permits, but this could further undermine the program, adds Barrett. "Politicians say, 'Let's create a safety valve so cap-and-trade does not go haywire.'" That may sound reasonable, but if prices reach the ceiling, the government could dump permits on the market, and "then you lose the benefit of a hard cap on emissions. If you sell all permits at the limit, economically, it's almost identical to a carbon tax."

Market manipulation: The very market that is supposed to bring benefits under cap-and-trade raises further caution flags, says Barrett. "One reason that California environmentalists opposed cap-and-trade comes from the whole Enron disaster and deregulation. We found that energy traders are technically and morally capable of doing terrible things." Even Chameides concedes cap-and-trade could turn sour: "It's really clear from the Wall Street meltdown that markets can go really bad. You have to be really careful that cap-and-trade is set up to avoid unnecessary speculation. We don't want to end up having this be a place to make money by saving 'paper carbon.'"

Birthing blues: To start cap-and-trade, the permits must be distributed fairly, or at least logically. Even at a "modest" $15 per ton of carbon, the system would be handling $80 to $85 billion today, "about 10 times larger than value of the permits in the sulfur dioxide program," says economics professor Gilbert Metcalf of Tufts University. "Who gets those permits? Do we give them to the energy sector, the energy-intensive industry sector... or to state and local governments?" Although this decision could spark massive meddling from interest groups and businesses, a second method, much preferred by economists, is gaining popularity. According to Jennifer Morris, a research assistant in the MIT Joint Program on the Science and Policy of Global Change, and an author of a recent analysis of greenhouse gas proposals, "We have seen a political shift toward auctions" in recent U.S. proposals. "In Europe, they gave permits away in the first phase of [the cap-and-trade system], but are moving to auctions now."

Fairness: A lot of money is at stake. Recently, the EPA estimated the cost of a particular cap-and-trade system between 2012 and 2050 at between $5 to $10 trillion. "If the government gave that away [by allocating free permits to existing polluters], it would be the largest transfer of wealth to the private sector since the Oklahoma land rush" of 1893, Barrett says. While revenue from carbon taxes can offset other taxes, in cap-and-trade, the money may stay with the businesses and speculators in the carbon market.

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Terry Devitt, editor; Nathan Hebert, project assistant; S.V. Medaris, designer/illustrator; David Tenenbaum, feature writer; Amy Toburen, content development executive

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