Thursday, June 5, 2008

The Economics of Cap and Trade

What a week, the press is abuzz with two new pieces of legislation being introduced to the Senate. The first is the Consumers First Energy Act, but by far the bigger news was the Lieberman-Warner Climate Security Act of 2008. This bill proposes a new cap and trade scheme to regulate carbon emissions.

The idea behind cap and trade is that a limited number of permits would be distributed to American industry to emit carbon emissions. Companies could then buy and sell excess permits creating an incentive to reduce emissions and automatically allocating the permits to where they are most needed. Each year the number of permits would be gradually reduced increasing the cost of pollution. In theory a cap and trade system seems like a very elegant solution to the carbon emissions problem, but things are not as clean in reality and this proposed cap and trade system is generating a lot of criticism from all sides.

As a result, it’s no surprise that the Lieberman-Warner bill is unlikely to pass this year, not the least because Bush has indicated his intention to veto any such plan that comes his way. However, both McCain and Obama have said they favor some kind of cap and trade solution, so we will likely see movement on it in the next few years.

The first criticism centers on how to distribute the permits to American businesses. Conservatives generally support gifting out the permits on some sort of ad-hoc basis, at least up to a certain level, and then auctioning off the remaining permits. This would have the benefit of minimizing impact on the economy, but would also create adverse incentives for companies. Their goal would become to inflate their perceived need and maximize their gift, since any extra permits could the be used or sold if not needed.

The alternative approach is to auction off all of the permits. This greatly increases the “cost” to the economy, but it would encourage companies to minimize how many permits they acquire from the get-go. Auctioning off the permits would do a better job of capturing the true cost of climate change externalities by transferring it directly to the producers which would reduce the total number of permits granted and have the greatest impact on reducing emissions. The downside is that charging for all of the permits would make the bill far more difficult to pass.

Either way, the cap and trade will generate huge sums of money over the years to come. This begs the question, what do we do with all this newly raised money? The natural inclination for most people when faced with this dilemma is to suggest investing in alternative energy sources and new clean technologies. Unfortunately this is far more complicated in practice than theory. The Warner-Lieberman bill attempts to dole out the funds to appropriate parties, but with so much cash at stake, it has turned into a giant pork barrel fest with every organization, legitimate or otherwise, trying to lobby for their share of the cash.

Robert Reich offered a far more elegant solution in the Wall Street Journal, where he suggested that this payday bonanza be paid out to taxpayers as a carbon dividend. His idea is take the total pile of earnings divide by the number of US citizens and send out the checks. It easy, fast, and offers the benefit of helping to offset the likely increase in energy costs that American’s would be facing in the years to come. However my one concern would be that it might prove a disincentive to politicians to keep ratcheting down the permit levels if they have to face a simultaneous cut in carbon dividends. Once the American public becomes used to the idea of getting regular checks, what congressman would dare suggest taking that away just for the sake of reducing total emissions.

Perhaps a better approach is to take the carbon emission earnings and use it as an offset to the income tax. This way we can help people save money, but without mailing them a check that they will come to expect every year. In time, as emissions are further reduced to the point where the earnings from the cap and trade system become nil, the income taxes would gradually increase to make up the difference.

Another concern about cap and trade is how it will affect the global trade dynamic. On Marketplace yesterday, they brought up a provision that is buried deep in the Warner-Lieberman bill that would impose a tariff on nations that do not have a carbon emissions cap in place. This is supposed to help to level the playing field between manufacturers based in the states and others based abroad. The fear is that once this system goes into place, every heavily polluting industry will pack up and move to China taking with them the countless American jobs they employ. Instituting a cap and trade system will greatly increase the costs faced by American companies and it will be hard for them to compete with cheap international imports if their products do not also include the cost of reducing climate change.

However, it is unclear whether the World Trade Organization would even allow such a tariff. All the same, this issue does further highlight the fact that combating climate change is an important global issue that cannot be fully addressed in isolation. Our decisions on this issue will have reverberations across the planet and likely drive negotiations surrounding the eventual replacement to the Kyoto Protocol. Similarly, the actions of our neighbors (or lack of action) will impact us as well. It is important that our leadership remain engaged with the UN and other international organizations as they begin confronting climate change.

Debate will likely continue surrounding the Lieberman-Warner bill and it is unlikely to be resolved anytime soon. Whatever solution is eventually adopted, I can only hope that the politicians remain focused on the economic incentives at play.

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