environmental politics Archives - Page 25 of 43 - An Economic View of the Environment

Two Notable Events Prompt Examination of an Important Property of Cap-and-Trade

In December of 2010, a group of economists and legal scholars gathered at the University of Chicago to celebrate two notable events. One was the fiftieth anniversary of the publication of Ronald Coase’s “The Problem of Social Cost” (Coase 1960). The other was Professor Coase’s 100^th birthday. The conference resulted in a special issue of The Journal of Law and Economics, which has just been published (although it is dated November 2011).

My frequent co-author, Robert Hahn (of the University of Oxford), and I were privileged to participate in the conference (a video of our presentation is available here). We recognized that the fiftieth anniversary of the publication of Coase’s landmark study provided an opportunity for us to examine one of that study’s key implications, which is of great importance not only for economics but for public policy as well, in particular, for environmental policy.

The Coase Theorem and the Independence Property

In our just-published article, “The Effect of Allowance Allocations on Cap-and-Trade System Performance,” Hahn and I took as our starting point a well-known result from Coase’s work, namely, that bilateral negotiation between the generator and the recipient of an externality will lead to the same efficient outcome regardless of the initial assignment of property rights, in the absence of transaction costs, income effects, and third party impacts. This result, or a variation of it, has come to be known as the Coase Theorem.

We focused on an idea that is closely related to the Coase theorem, namely, that the market equilibrium in a cap-and-trade system will be cost-effective and independent of the initial allocation of tradable rights (typically referred to as permits or allowances). That is, the overall cost of achieving a given emission reduction will be minimized, and the final allocation of permits will be independent of the initial allocation, under certain conditions (conditional upon the permits being allocated freely, i.e., not auctioned). We call this the independence property. It is closely related to a core principle of general equilibrium theory (Arrow and Debreu 1954), namely, that when markets are complete, outcomes remain efficient even after lump-sum transfers among agents.

The Practical Political Importance of the Independence Property

We were interested in the independence property because of its great political importance. The reason why this property is of such great relevance to the practical development of public policy is that it allows equity and efficiency concerns to be separated. In particular, a government can set an overall cap of pollutant emissions (a pollution reduction goal) and leave it up to a legislature to construct a constituency in support of the program by allocating shares of the allowances to various interests, such as sectors and geographic regions, without affecting either the environmental performance of the system or its aggregate social costs. Indeed, this property is a key reason why cap-and-trade systems have been employed and have evolved as the preferred instrument in a variety of environmental policy settings.

In Theory, Does the Property Always Hold?

Because of the importance of this property, we examined the conditions under which it is more or less likely to hold — both in theory and in practice. In short, we found that in theory, a number of factors can lead to the independence property being violated. These are particular types of transaction costs in cap-and-trade markets; significant market power in the allowance market; uncertainty regarding the future price of allowances; conditional allowance allocations, such as output-based updating-allocation mechanisms; non-cost-minimizing behavior by firms; and specific kinds of regulatory treatment of participants in a cap-and-trade market.

In Reality, Has the Property Held?

Of course, the fact that these factors can lead to the violation of the independence property does not mean that in practice they do so in quantitatively significant ways. Therefore, Hahn and I also carried out an empirical assessment of the independence property in past and current cap-and-trade systems: lead trading; chlorofluorocarbons (CFCs) under the Montreal Protocol; the sulfur dioxide (SO₂) allowance trading program; the Regional Clean Air Incentives Market (RECLAIM) in Southern California; eastern nitrogen oxides (NO_X) markets; the European Union Emission Trading Scheme (EU ETS); and Article 17 of the Kyoto Protocol.

I encourage you to read our article, but, a quick summary of our assessment is that we found modest support for the independence property in the seven cases we examined (but also recognized that it would surely be useful to have more empirical research in this realm).

Politicians Have Had it Right

That the independence property appears to be broadly validated provides support for the efficacy of past political judgments regarding constituency building through legislatures’ allowance allocations in cap-and-trade systems. Governments have repeatedly set the overall emissions cap and then left it up to the political process to allocate the available number of allowances among sources to build support for an initiative without reducing the system’s environmental performance or driving up its cost.

This success with environmental cap-and-trade systems should be contrasted with many other public policy proposals for which the normal course of events is that the political bargaining that is necessary to develop support reduces the effectiveness of the policy or drives up its overall cost. So, the independence property of well-designed and implemented cap-and-trade systems is hardly something to be taken for granted. It is of real political importance and remarkable social value.

Can Market Forces Really be Employed to Address Climate Change?

Debate continues in the United States, Europe, and throughout the world about whether the forces of the marketplace can be harnessed in the interest of environmental protection, in particular, to address the threat of global climate change. In an essay that appears in the Spring 2012 issue of Daedalus, the journal of the American Academy of Arts and Sciences, my colleague, Joseph Aldy, and I take on this question. In the article – “Using the Market to Address Climate Change: Insights from Theory & Experience” – we investigate the technical, economic, and political feasibility of market-based climate policies, and examine alternative designs of carbon taxes, cap-and-trade, and clean energy standards.

The Premise

Virtually all aspects of economic activity – individual consumption, business investment, and government spending – affect greenhouse gas emissions and, therefore, the global climate. In essence, an effective climate change policy must change the nature of decisions regarding these activities in order to promote more efficient generation and use of energy, lower carbon-intensity of energy, and a more carbon-lean economy.

Basically, there are three possible ways to accomplish this: (1) mandate that businesses and individuals change their behavior; (2) subsidize business and individual investment; or (3) price the greenhouse gas externality proportional to the harms that these emissions cause.

Harnessing Market Forces by Pricing Externalities

The pricing of externalities can promote cost-effective abatement, deliver efficient innovation incentives, avoid picking technology winners, and ameliorate, not exacerbate, government fiscal conditions.

By pricing carbon emissions (or, equivalently, the carbon content of the three fossil fuels – coal, petroleum, and natural gas), the government provides incentives for firms and individuals to identify and exploit the lowest-cost ways to reduce emissions and to invest in the development of new technologies, processes, and ideas that can mitigate future emissions. A fairly wide variety of policy approaches fall within the concept of externality pricing in the climate-policy context, including carbon taxes, cap-and-trade, and clean energy standards.

What About Conventional Regulatory Approaches?

In contrast, conventional approaches to environmental protection typically employ uniform mandates to protect environmental quality. Although uniform technology and performance standards have been effective in achieving some established environmental goals and standards, they tend to lead to non-cost-effective outcomes in which some firms use unduly expensive means to control pollution.

In addition, conventional technology or performance standards do not provide dynamic incentives for the development, adoption, and diffusion of environmentally and economically superior control technologies. Once a firm satisfies a performance standard, it has little incentive to develop or adopt cleaner technology. Indeed, regulated firms may fear that if they adopt a superior technology, the government will tighten the standard.

Given the ubiquitous nature of greenhouse gas emissions from diverse sources, it is virtually inconceivable that a standards-based approach could form the centerpiece of a truly meaningful climate policy. The substantially higher cost of a standards-based policy may undermine support for such an approach, and securing political support may require weakening standards and lowering environmental benefits.

How About Technology Subsidies?

Government support for lower-emitting technologies often takes the form of investment or performance subsidies. Providing subsidies for targeting climate-friendly technologies entails revenues raised by taxing other economic activities. Given the tight fiscal environment throughout the developed world, it is difficult to justify increasing (or even continuing) the subsidies that would be necessary to change significantly the emissions intensity of economic activity.

Furthermore, by lowering the cost of energy, climate-oriented technology subsidies can actually lead to excessive levels of energy supply and consumption. Thus, subsidies can undermine incentives for efficiency and conservation, and impose higher costs per ton abated than cost-effective policy alternatives.

In practice, subsidies are typically designed to be technology specific. By designating technology winners, such approaches yield special-interest constituencies focused on maintaining subsidies beyond what would be socially desirable. They also provide little incentive for the development of novel, game-changing technologies.

That said, there is still a role for direct technology policies in combination with externality pricing, as I have argued in a previous essay at this blog. This is because in addition to the environmental market failure (appropriately addressed by externality pricing) there exists another market failure in the climate change context, namely, the public-good nature of information produced by research and development. I addressed this in my essay, “Both Are Necessary, But Neither is Sufficient: Carbon-Pricing and Technology R&D Initiatives in a Meaningful National Climate Policy.”

Back to Markets, and Some Real-World Experience

Empirical analysis drawing on actual experience has demonstrated the power of markets to drive profound changes in the investment and use of emission-intensive technologies.

The run-up in gasoline prices in 2008 increased consumer demand for more fuel-efficient new cars and trucks, while also reducing vehicle miles traveled by the existing fleet. Likewise, electricity generators responded to the dramatic decline in natural gas prices in 2009 and 2010 by dispatching more electricity from gas plants, resulting in lower CO₂ emissions.

Longer-term evaluations of the impacts of energy prices on markets have found that higher prices have induced more innovation – measured by frequency and importance of patents – and increased the commercial availability of more energy-efficient products, especially among energy-intensive goods such as air conditioners and water heaters.

Experience with Externality Pricing

Real-world experience with policies that price externalities has illustrated the effectiveness of market-based instruments. Congestion charges in London, Singapore, and Stockholm have reduced traffic congestion in busy urban centers, lowered air pollution, and delivered net social benefits. Likewise, the British Columbia carbon tax has reduced carbon dioxide emissions since 2008.

More prominently, the U.S. sulfur dioxide (SO₂) cap-and-trade program has cut SO₂ emissions from U.S. power plants by more than 50 percent since 1990, resulting in compliance costs one-half of what they would have been under conventional regulatory mandates.

The success of the SO₂ allowance trading program motivated the design and implementation of the European Union’s Emissions Trading Scheme (EU ETS), the world’s largest cap-and-trade program, focused on cutting CO₂ emissions from power plants and large manufacturing facilities throughout Europe.

And the 1980s phasedown of lead in gasoline, which reduced the lead content per gallon of fuel, served as an early, effective example of a tradable performance standard.

These positive experiences have provided ample reason to consider market-based instruments – carbon taxes, cap-and-trade, and clean energy standards – as potential approaches to mitigating greenhouse gas emissions.

The Rubber Hits the Road

The U.S. political response to possible market-based approaches to climate policy has been and will continue to be largely a function of issues and structural factors that transcend the scope of environmental and climate policy. Because a truly meaningful climate policy – whether market-based or conventional in design – will have significant impacts on economic activity in a wide variety of sectors and in every region of the country, it is not surprising that proposals for such policies bring forth significant opposition, particularly during difficult economic times.

In addition, U.S. political polarization – which began some four decades ago and accelerated during the economic downturn – has decimated what had long been the key political constituency in Congress for environmental (and energy) action: namely, the middle, including both moderate Republicans and moderate Democrats. Whereas congressional debates about environmental and energy policy have long featured regional politics, they are now largely partisan. In this political maelstrom, the failure of cap-and-trade climate policy in the Senate in 2010 was collateral damage in a much larger political war.

Better economic times may reduce the pace – if not the direction – of political polarization. And the ongoing challenge of large federal budgetary deficits may at some point increase the political feasibility of new sources of revenue. When and if this happens, consumption taxes – as opposed to traditional taxes on income and investment – could receive heightened attention; primary among these might be energy taxes, which, depending on their design, can function as significant climate policy instruments.

Many environmental advocates would respond that a mobilizing event will surely precipitate U.S. climate policy action. But the nature of the climate change problem itself helps explain much of the relative apathy among the U.S. public and suggests that any such mobilizing events may come “too late.”

Nearly all our major environmental laws have been passed in the wake of highly publicized environmental events or “disasters,” including the spontaneous combustion of the Cuyahoga River in Cleveland, Ohio, in 1969, and the discovery of toxic substances at Love Canal in Niagara Falls, New York, in the mid-1970s. But note that the day after the Cuyahoga River caught on fire, no article in The Cleveland Plain Dealer commented that the cause was uncertain, that rivers periodically catch on fire from natural causes. On the contrary, it was immediately apparent that the cause was waste dumped into the river by adjacent industries. A direct consequence of the observed “disaster” was, of course, the Clean Water Act of 1972.

But climate change is distinctly different. Unlike the environmental threats addressed successfully in past U.S. legislation, climate change is essentially unobservable to the general population. We observe the weather, not the climate. Until there is an obvious and sudden event – such as a loss of part of the Antarctic ice sheet leading to a dramatic sea-level rise – it is unlikely that public opinion in the United States will provide the bottom-up demand for action that inspired previous congressional action on the environment over the past forty years.

A Half-Full Glass of Water?

Despite this rather bleak assessment of the politics of climate change policy in the United States, it is really much too soon to speculate on what the future will hold for the use of market-based policy instruments, whether for climate change or other environmental problems.

On the one hand, it is conceivable that two decades (1988–2008) of high receptivity in U.S. politics to cap-and-trade and offset mechanisms will turn out to be no more than a relatively brief departure from a long-term trend of reliance on conventional means of regulation.

On the other hand, it is also possible that the recent tarnishing of cap-and-trade in national political dialogue will itself turn out to be a temporary departure from a long-term trend of increasing reliance on market-based environmental policy instruments. Perhaps the ongoing interest in these policy mechanisms in California (Assembly Bill 32), the Northeast (Regional Greenhouse Gas Initiative), Europe, and other countries will eventually provide a bridge to a changed political climate in Washington.

Low Prices a Problem? Making Sense of Misleading Talk about Cap-and-Trade in Europe and the USA

Some press accounts and various advocates have labeled the Regional Greenhouse Gas Initiative (RGGI) as near “the brink of failure” because of the recent trend of very low auction prices. Likewise, commentators have recently characterized the European Union Emission Trading Scheme (EU ETS) as possibly “sinking into oblivion” because of low allowance prices. Since when are low prices (which in this case reflect low marginal abatement costs) considered to be a problem? To understand what’s going on, we need to remind ourselves of the purpose (and promise) of a cap-and-trade regime, and then look at what’s been happening in the respective markets.

The Purpose and Promise of Cap-and-Trade

A cap-and-trade system– if well designed, implemented, and enforced – will limit total emissions of the regulated pollutant to the desired level (the cap), and will do this (if the cap is binding) in a cost-effective manner, by leading regulated sources to each make reductions until they are all experiencing the same marginal abatement cost (the allowance price). Thus, the sources that initially face the highest abatement costs, reduce less, and those sources that face the lowest abatement costs, reduce more, achieving system-wide minimum costs, that is, cost effectiveness. So, the purpose and promise, in a nutshell, is to achieve the targeted level of aggregate pollution control, and – if the cap is binding – do this at the lowest possible cost.

RGGI Allowance Prices

The Regional Greenhouse Gas Initiative (RGGI) – a downstream cap-and-trade system for CO₂ emissions from the power sector in 10 northeast states (Connecticut, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, and Vermont, with New Jersey now in the process of withdrawing from the coalition), was launched with relatively unambitious targets, principally in order to keep prices down to prevent severe leakage of electricity demand and hence leakage of CO₂ emissions from the RGGI region to states and provinces outside of the region (mainly from New York to Pennsylvania).

Emissions are capped from 2012 to 2014, and then, starting in 2015, the cap decreases 2.5% per year until it is down by 10% in 2019. This would represent a level of emissions 13% below the 1990 level of emissions. It was originally thought that this would be some 35% below the Business-as-Usual (BAU) level in 2019. Sounds good. What happened is not that the system performed other than designed, but that “business was not as usual.” That is, what happened is that unregulated power-sector (BAU) emissions in the northeast fell significantly. (See the graph below of the RGGI cap and historical emissions.)

For source, please click here.

So, Why Did Emissions Fall in the RGGI States?

This happened for three reasons. First, because of increasing supplies in the United States of low-cost, unconventional sources of natural gas, prices for this fuel have fallen dramatically since 2008. (See the graph below of natural gas and coal prices.) That has meant greater dispatch of electricity from gas-fueled power plants (relative to coal-fired plants), more investment in new gas-fired generating plants, less investment in coal-fired generating capacity, and retirement of existing coal-fired capacity, all of which has contributed to lower CO₂ emissions.

For source, please click here.

Second, the worst economic recession since the Great Depression hit the United States in 2008, causing dramatic reductions in electricity demand in the industrial and commercial sectors, reducing emissions. (See the graph below of quarterly percentage change in U.S. GDP, 2007-2009.)

For source, please click here.

Third and finally, moderate northeast temperatures have kept down CO₂ emissions linked with both heating and cooling.

Low Emissions, Low Allowance Demand, Low Allowance Prices

So, for the three reasons above, BAU CO₂ emissions from the power sector in the RGGI states are dramatically below what was originally (and quite reasonably) anticipated. The supply of RGGI CO₂ allowances made available at auction is – by law – unchanged, but demand for these allowances has fallen dramatically, hence the fall in RGGI allowance prices. (See the graph below of RGGI allowance prices, 2008-2010.)

For source, please click here.

Given that emissions are below the RGGI cap and – due to expectations regarding future natural gas prices – are likely to remain below the cap, there is no scarcity of allowances. Shouldn’t the price fall to zero? In theory, yes, except that the system has an auction reservation price of $1.86 per ton built in, thereby creating a price floor of precisely this amount.

Is RGGI a Failure?

So, the cap put in place by the RGGI system is being achieved, but it is not binding. RGGI may not be particularly relevant, but it is not thereby a flawed system; surely it is not a failure. Rather, a great environmental success has been achieved by the “fortunate coincidence” of low natural gas prices, economic recession, and mild weather. This is hardly something to be lamented.

True enough, the RGGI system does have flaws (such as its narrow scope limited to electricity generation, and its lack of a simple safety valve, as I have written about in the past). But the low allowance prices are evidence of a success outside of the RGGI market, not evidence of failure within the RGGI market.

If the RGGI states have the desire and the political will to tighten the cap in the future, then the system can again become binding, environmentally relevant, and cost-effective. That’s an ongoing political debate.

To be fair, I should note that the same outcome I have described here can be spun – perhaps for political purposes – quite differently. Recently, a self-described “free-market energy blog” commentator claimed – not without some justification – that RGGI is irrelevant or worse: “Bottom line, the program has raised electricity prices, created a slush fund for each of the member states, and has had virtually no impact on emissions or on global climate change.”

Phrased differently, due to exogenous circumstances (I’ve described above), the RGGI program is non-binding, and so has no direct effect on emissions, but its relatively low auction reservation price does lead to very small impacts on electricity prices, and produces revenues for participating states, revenues which those states would surely claim are of value for state-level energy-efficiency and other programs that indirectly do affect CO2 emissions. So, the real bottom line is that low RGGI allowance prices are not a consequence of poor system design or a fatal flaw of cap-and-trade systems in general, but rather a consequence of what are in reality some exogenous coincidences that have turned out to be good news for the environment.

Now, let’s turn to the European Union Emissions Trading Scheme (EU ETS).

EU ETS Allowance Prices

Unlike RGGI, the EU ETS has not been irrelevant. It has successfully capped European CO₂ emissions, achieved significant emissions reductions, and it has done so — more or less — cost-effectively. (More about this hedging on cost-effectiveness below). Not surprisingly, like RGGI, the EU ETS has some design flaws (principally, its limited scope – electricity generation and large-scale manufacturing – and lack of a safety-valve), but as with RGGI, its low allowance prices should not be taken as bad news, but to some degree as good news, and certainly not as a sign of failure of the EU ETS.

Hand-wringing in Europe over Low Allowance Prices

There has been much hand-wringing in Europe over the “failure of the system” because of low allowance prices. Indeed, Danish Energy Minister Martin Lidegaard said earlier this month that low carbon prices threaten the EU ETS.

Of course, he’s correct that EU ETS allowance prices are “low.” They are down from their historic average of about $20 per ton of CO₂ to about $9 per ton currently (having reached an all-time low of $7.88 in early April). Here’s a graph of EU ETS allowance prices (EUAs) over the crucial period of change, January 2007 to January 2009.

For source, please click here.

At this point in this essay, I probably don’t need to say that this pattern is partly explained by the global recession, which has hit Europe particularly hard (and now threatens a double-dip recession in a number of European nations). Lower European – and global – demand has meant decreased economic activity in Europe, hence lower energy demand, lower CO₂ emissions, and therefore lower demand and lower prices for EU ETS allowances.

Even if we assume a growth rate of European CO₂ emissions 1 percent less than the growth rate of GDP (represented by the dotted “counterfactual” BAU line in the graph below, which estimates what emissions would have been from 2005 to 2010 without the introduction of the EU’s Emissions Trading System), the evidence makes clear that the EU ETS has succeeded in reducing emissions significantly below what would be expected from the recession alone.

For source, please click here.

This is where an important caveat needs to be introduced. Also feeding into this allowance price depression has been a set of national and regional energy policies, such as those promoting use of renewables, which have served to reduce emissions, demand for allowances, and hence allowance prices (while rendering the overall CO2 program less cost-effective by ensuring that marginal abatement costs remain heterogeneous). So, to the degree that the low allowance prices are due to so-called complimentary policies, the low prices are bad news about public policy (in cost-effectiveness terms), not good news. But this refers to misguided complimentary policies (which fail to bring about any incremental emissions reductions — under the cap-and-trade umbrella — and drive up aggregate cost), not to any design flaw in the EU ETS itself.

Multiple Goals Typically Require Multiple Policy Instruments

No doubt, Minister Lidegaard is aware of the allowance price impacts of the recession, and I hope he’s aware of the allowance price consequences of these other energy and environmental policies. The problem arises, however, because he sees the fundamental purpose of the EU ETS as somewhat broader than what I described at the beginning of this essay (namely, achieving emissions consistent with some cap, and doing so cost-effectively – if the cap is binding). For him – and many other European observers – “the purpose of the ETS was to cap CO₂ emissions in the E.U. and ensure clear economic incentives for investment in renewables.” So, the hand-wringing is not about a failure to achieve emissions reductions cost-effectively, but to have prices high enough to achieve other goals – in this case, greater use of renewable sources of energy. For others, the “other goals” have involved allowance prices high enough to bring about some targeted amount of technology innovation.

As I have written at this blog in the past, having multiple policy goals typically necessitates multiple policy instruments. For example, if the goal is a combination of reducing emissions cost-effectively and having prices maintained at some minimum (whether to bring about greater use of renewable energy sources or to inspire more technology innovation), then two policy instruments are needed to do the job: a cap-and-trade system for the first goal in combination with a carbon tax in the form of a price floor (as in RGGI) for the second goal.

Don’t Throw Out the Baby with the Bath Water

In other words, the EU ETS has not failed, but the design was inadequate (that is, incomplete) for what politicians now seem to want. If the Europeans want a price floor in their system (or better yet, a price collar, which would combine a price floor with a safety valve, i.e., price ceiling), then this is certainly feasible technically and economically. Likewise, if the EU member states have the desire and the political will to tighten the cap in the future, there are a variety of ways in which they can accomplish this, rendering the program more stringent and increasing allowances prices. But, in any event, the European Commission’s Energy division, Environment division, and Climate division should sort out the real effects of the “complimentary policies” that have contaminated the EU ETS, and which fail to bring about additional emissions reductions but drive up costs. Whether any of this is feasible politically is a question that my European colleagues and friends can best address.