With the apparent collapse last week of U.S. Senate consideration of a meaningful climate policy, it is important to reflect on what could be a very serious long-term casualty of these acrimonious climate policy debates, namely the demonizing of cap-and-trade and the related tarnishing of market-based approaches to environmental protection.
In an op-ed which appeared on July 27th in The Boston Globe (click here for link to the original op-ed), Richard Schmalensee and I commented on this unfortunate outcome of U.S. political debates and described the irony that the attack on cap-and-trade – and carbon-pricing, more broadly – has been led by conservatives, who should take pride as the creators of these cost-effective policy innovations in three Republican administrations.
Rather than summarize (or expand on) our op-ed, I simply re-produce it below as it was published by The Boston Globe, with some hyperlinks added for interested readers.
By the way, for anyone who is not familiar with Dick Schmalensee, let me note that he is the Howard W. Johnson Professor of Economics and Management at MIT, where he served as the Dean of the Sloan School of Management from 1998 to 2007. Also, he served as a Member of the Council of Economic Advisers in the George H. W. Bush administration from 1989 to 1991.
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The Power of Cap-and-Trade
by Richard Schmalensee and Robert Stavins
The Boston Globe, July 27, 2010
LAST WEEK, the Senate abandoned its latest attempt to pass climate legislation that would limit carbon dioxide emissions, putting off any action until the fall at the soonest. In the process, conservative Republicans dubbed the cap-and-trade system “cap-and-tax.’’ Regardless of what they think about climate change, however, they should resist demonizing market-based approaches to environmental protection and reverting to pre-1980s thinking that saddled business and consumers with needless costs.
In fact, market-based policies should be embraced, not condemned by Republicans (as well as Democrats). After all, these policies were innovations developed by conservatives in the Reagan, George H. W. Bush, and George W. Bush administrations (and once strongly condemned by liberals).
In the 1980s, President Ronald Reagan’s Environmental Protection Agency successfully put in place a cap-and-trade system to phase out leaded gasoline. The result was a more rapid elimination of leaded gasoline from the marketplace than anyone had anticipated, and at a savings of some $250 million per year, compared with a conventional no-trade, command-and-control approach.
In June 1989, President George H. W. Bush proposed the use of a cap-and-trade system to cut by half sulfur dioxide emissions from coal-fired power plants and consequent acid rain. An initially resistant Democratic Congress overwhelmingly endorsed the proposal. The landmark Clean Air Act amendments of 1990 passed the Senate 89 to 10 and the House 401 to 25. That cap-and-trade system has cut sulfur dioxide emissions by 50 percent, and has saved electricity companies — and hence shareholders and ratepayers — some $1 billion per year compared with a conventional, non-market approach.
In 2005, George W. Bush’s EPA issued the Clean Air Interstate Rule, aimed at achieving the largest reduction in air pollution in more than a decade, including reducing sulfur dioxide emissions by a further 70 percent from their 2003 levels. Cap-and-trade was again the policy instrument of choice in order to keep costs down and achieve the rapid reductions at minimum economic pain. (The rule was later invalidated by the courts, and is now being reformulated.)
To reject this legacy and embrace the failed 1970s policies of one-size-fits-all regulatory mandates would signify unilateral surrender of principled support for markets. If some conservatives oppose energy or climate policies because of disagreement about the threat of climate change or the costs of those policies, so be it. But in the process of debating risks and costs, there should be no tarnishing of market-based policy instruments. Such a scorched-earth approach will come back to haunt when future environmental policies will not be able to use the power of the marketplace to reduce business costs.
Virtually all economists agree on a market-based approach to reduce carbon dioxide emissions. Some favor carbon taxes combined with revenue-neutral cuts in distortionary taxes, whereas others support cap-and-trade mechanisms — or “cap-and-dividend,’’ with revenues from auctioned allowances refunded directly to citizens.
Conventional approaches advanced as “painless alternatives’’ — a plethora of standards, special-interest technology subsidies, and tax breaks — won’t do the job, and will be unnecessarily expensive. While we are struggling to revitalize the economy, we simply cannot afford to turn our backs on markets and impose unnecessary costs on businesses and consumers.
A price on carbon is the least costly way to provide meaningful incentives for technology innovation and diffusion, reduce emissions from fossil fuels, and drive energy efficiency. In the long run, it can reduce our use of oil and drive our transportation system toward alternative energy sources.
Market-based approaches to environmental protection – including cap-and-trade – should be lauded, not condemned, by political leaders, no matter what their party affiliation. Demonizing cap-and-trade in the short term will turn out to be a mistake with serious long-term consequences for the economy, for business, and for consumers.
Prof. Stavins,
I am curious as to your motivation for publishing this “Requiem for Cap and Trade (or Carbon Tax)”. Matters didn’t collapse because there was some misconception of the relative efficiency of C&T (or CT) to remedy global warming. And as such, should the political will ever return, these measures would return in a heartbeat.
The whole, sad current state of affairs has arisen, fundamentally, because Republicans want Obama and the congressional Democrats to fail politically – the terrible, prospective costs be damned. And in that context, the power of particular energy interests and the Club for Growth crowd, already formidable, became (or, perhaps more precisely, appeared to become) magnified.
Rather than a rehabilitation of the concept of C&T, I as an interested reader would like to be exposed to your thoughts on the next step: the relative effectiveness and efficiency of prospective EPA measures. Are some of these “bad” measures substantially better than others? And some political economy stories would also be of great interest. The EPA is now understood as a kind of cudgel to be wielded to get the relevant Republicans and coal-state Democrats back to the bargaining table. Are there specific measures that might be taken in this regard that might be particularly effective?
Best,
Steve
But the Republicans aren’t demonizing cap-and-trade in favor of pre-1980’s regulatory thinking. They would oppose any regulatory approach at least as strongly. They’re demonizing cap-and-trade because for them, short term political gain trumps everything else. Their long-term thinking extends no farther than November 2012.
Prof Stavins,
Thank you for another coherent (and compelling) piece on cap-and-trade. The ‘demonization’ – as you put it – always strikes me as quite bizarre given it’s track record and sound theoretical basis. Nevertheless, I share your concerns about design implementation. With that in mind, I’m curious as to your brief thoughts on the involvement of speculators and third-party access to carbon markets.
I understand that the argument FOR speculators is premised on an assumption that they create much-need liquidity. However, I remain somewhat sceptical. Surely all that is needed for trading to take place is a market platform and differing marginal abatement costs between polluting firms? (I.e. No “middle men” required…)
I raise this point as it seems that some opposition to cap-and-trade is based on the fear that it could spark a new derivatives market and create another speculative bubble. Similarly, I’ve seen criticism over the potential for powerful financial houses to make large sums of money from dealings in the carbon market at the expense of smaller firms actually engaged in the regulated industry.
Grant,
An issue brief I co-authored with Janet Peace was published last week by the Pew Center on Global Climate Change. In it we address the concerns you raise regarding market manipulation, etc. It can be accessed at: http://www.pewclimate.org/docUploads/case-for-cap-and-trade-paper.pdf
I plan to write about it soon at this blog. Stay tuned.
Rob Stavins
Thanks for the reply, Rob.
The market itself isn’t so much my concern (again, dependent on design), but rather who is granted access to the market. In a sense, my question is whether carbon markets “need” 3rd party participants/speculators, or can they function effectively (better?) when trading is limited to firms that fall under regulation.
With that in mind, I look forward to your upcoming blog post.
Grant
Professor Stavins says: “The result was a more rapid elimination of leaded gasoline from the marketplace than anyone had anticipated, and at a savings of some $250 million per year, compared with a conventional no-trade, command-and-control approach.”
This comment suggests that Prof Stavins completely limited analysis of the leaded gasoline phase out. The efficiency success of that initiative dervies from the product standard-type regulation that was introduced. The “cap and trade” lead quota regime that was added on top of the product standard introduced ineffciency and served one purpose only: trade protectionism.
In 1978 or so, both Canada and the US introduced close to identical new product standards for gasoline. The distributors of gasoline (not the producers) could not release more lead in gasoline in 1981 than they did in 1980. Their lead entitlements declined on a straight line basis to 0 in 1986. In both countries, any entity that did not use their full entitlement by 1986 could bank and use it through 1990. Thereafter, lead gasoline could only be sold to exempt, special markets.
The Canadian product standard regulation stipulated that any combination on distributors could “comply jointly”, which provision spawned lead trading. This provisio nin combination with the limited right to bank lead entitlements spawned a vibrant and real secondary market for lead…WITHOUT ANY GOVERNMENT QUOTA ALLOCATION,OR ANY GOVERNMENY-ADMINISTERED SETTLEMETN OR CLEARING FUNCTION. Lead disappeared from Canadian gasoline a full 3 years faster than in the US. Canadian refineres stopped making leaded gasoline before the end of 1986.
Instead of building the joint cmopliance option into the product standard, the US EPA stipulated that US obligated parties–gasoline distributors–were required to surrender a unit of US lead quota (called an “allowance”) to the EPA covering their legal lead releases. Quota was bankable and tradable.
Then the EPA freely allocated 100% of US lead quota to US refineries–not the distributors. This meant that the day after the US “cap and trade” regime was in place, any US distributor that imported leaded gasoline had to buy US quota from a US refinery. This rule discriminated unfairly against leaded fuel imports, creating a massive short-term subsidy for US refineries. Any similar rule would breach WTO, NAFTA trade law and, possibly, even US domestic law today.
By the way, while US cap and trade phased out demand for leaded gas in the US, it did not oblige US refineries to stop making leaded fuel. In fact, US refiners maintained high leaded gas production levels for 10 years after domestic sales were phased out. US refineries shifted leaded fuel sales from the US to South America. At one point in time leaded gasoline exports from the US equated to 15% of all US gasoline production. So the US law not only allowed, but encouraged the US refineries to simp;ly shift lead pollution to new markets, exporting the leaded fuel at high discounts because those lead exports were subsidized by the US distributors’ lead quota purchase obligations. US consumers paid higher pre-tax prices for unleaded fuel than Canadian consumers, while US refineries dumped highly polluting product on developing world markets. This is a success story only if one ignores these realities.
Both Canada and the US have long histories of cost-effectively driving the market to cleaner, safer products through product standards. The Canadian leaded gas product standard is an example of most cost-effective integration of market measures in a product standard. But the US leaded gasoline phase-out history–using quota allocation instead of a joint compliance provision–was not only less efficient but is a case history in US trade protectionism and pollution dumping.
It is too easy to blame partisan politics as the sole reason for the failure of cap-and-trade to pass through the US Congress.
The cap-and-trade system proposed by Obama/Waxman-Markey/Kerry-Lieberman was too big, and promoted bizarre allowance allocation schemes.
If the team had proposed a modest cap-and-trade system for large direct emitters, with a tight cap, free allocation of allowances to capped facilities, a lively offsets system and a vigilant, transparent registry, cap-and-trade would have succeeded.
Can everybody be persuaded to reduce emissions through cap-and-trade? No.
An effective cap-and-trade works well in reducing the emissions of large, direct emitters, facilities that will end up in court, if they do not retire allowances equal to their annual emissions. Cap-and-trade does not succeed in reducing indirect emissions, e.g. capping gasoline distributors for the emissions by their customers.
For non-large final emitters we must consider other policies and programs, e.g. regulations, standards, taxes, promotion and information, changing cultural values, and, above all, real leadership from governments.
I agree with your assessment that many environmental problems are problems associated with the allocation and consumption of commons. In Santa Barbara County, California a dramatic improvement in air quality over the last 40 years has been achieved solely by regulation. While market-based approaches may provide efficacious solutions to some commons related problems, it cannot be denied that the air quality regulatory effort has been one of the most successful public policy enterprises ever pursued.
With regard the negative effects of regulations on the economy, it is interesting to note that in 1970 when the Santa Barbara County Air Pollution Control District was established, there were about 250,000 residents in Santa Barbara County and about 90,000 jobs. Today, there are a little over 400,000 residents in the County and about 200,000 jobs. During that 40 period, the air quality improved from exceeding the health standards nearly 100 days a year to exceeding the standards on only 7 days in 2010. The regulations that are responsible for this dramatic improvement restricted neither population growth nor economic growth in the County.
Market-based approaches to environmental protection problems are all well and good; however, considering the successes that have been achieved by regulatory programs, I would caution against abandoning the regulatory approach altogether.
Terry Dressler, Director
Santa Barbara County Air Pollution Control District
Terry,
Thanks for your comment.
I agree that it’s an impressive accomplishment of “conventional regulatory approaches” to have reduced aggregate pollution during a period of population increase and employment increase, but that does not mean it’s cost-effective. The correct counter-factual is what would the aggregate pollution levels, population, and economic activity levels be instead if a more flexible, market-based instrument had been used. Obviously, that’s not an easy question to answer, but a considerable amount of economic research has gone into answering such questions. See the full article in the AER.
Thanks again,
Rob