linkage of cap-and-trade systems Archives - Page 15 of 17

AB 32, RGGI, and Climate Change: The National Context of State Policies for a Global Commons Problem

Why should anyone be interested in the national context of a state policy? In the case of California’s Global Warming Solutions Act (AB 32), the answer flows directly from the very nature of the problem — global climate change, the ultimate global commons problem. Greenhouse gases (GHGs) uniformly mix in the atmosphere. Therefore, any jurisdiction taking action — whether a nation, a state, or a city — will incur the costs of its actions, but the benefits of its actions (reduced risk of climate change damages) will be distributed globally. Hence, for virtually any jurisdiction, the benefits it reaps from its climate‑policy actions will be less than the cost it incurs. This is despite the fact that the global benefits of action may well be greater — possibly much greater — than global costs.

This presents a classic free-rider problem, in which it is in the interest of each jurisdiction to wait for others to take action, and benefit from their actions (that is, free-ride). This is the fundamental reason why the highest levels of effective government should be involved, that is, sovereign states (nations). And this is why international, if not global, cooperation is essential. [See the extensive work in this area of the Harvard Project on International Climate Agreements.]

Despite this fundamental reality, there can still be a valuable role for sub-national climate policies. Indeed, my purpose in this essay is to explore the potential for such state and regional policies — both in the presence of Federal climate policy and in the absence of such policy. I begin by describing the national climate policy context, and then turn to sub-national policies, such as California’s AB 32 and the Regional Greenhouse Gas Initiative (RGGI) in the northeast. My focus is on how these sub-national policies will interact with a Federal climate policy. It turns out that some of the interactions will be problematic, others will be benign, and still others could be positive. I also examine the role that could be played by sub-national policies in the absence of a meaningful Federal policy, with the conclusion that — like it or not — we may find that Sacramento comes to take the place of Washington as the center of national climate policy.

The (Long-Term) National Context: Carbon-Pricing

I need not tell readers of this blog that virtually all economists and most other policy analysts favor a national carbon‑pricing policy (whether carbon tax or cap-and-trade) as the core of any meaningful climate policy action in the United States. Why is this approach so overwhelmingly favored by the analytical community?

First, no other feasible approach can provide truly meaningful emissions reductions (such as an 80% cut in national CO₂ emissions by mid-century). Second, it is the least costly approach in the short term, because abatement costs are exceptionally heterogeneous across sources. Only carbon-pricing provides strong incentives that push all sources to control at the same marginal abatement cost, thereby achieving a given aggregate target at the lowest possible cost. Third, it is the least costly approach in the long term, because it provides incentives for carbon-friendly technological change, which brings down costs over time. Fourth, although carbon pricing is not sufficient on its own (because of other market failures that reduce the impact of price signals — more about this below), it is a necessary component of a sensible climate policy, because of factors 1 through 3, above. [I’ve written about carbon-pricing in many previous blog posts, including on June 23, 2010, “The Real Options for U.S. Climate Policy.”]

But carbon-pricing is a hot-button political issue. This is primarily because it makes the costs of the policy transparent, unlike conventional policy instruments, such as performance and technology standards, which tend to hide costs. Carbon-pricing is easily associated with the dreaded T-word. Indeed, in Washington, cap-and-trade has been successfully demonized as “cap-and-tax.” As a result, the political reality now appears to be that a national, economy-wide carbon-pricing policy is unlikely to be enacted before 2013. Does this mean that there will be no Federal climate policy in the meantime? No, not at all.

The (Short-Term) National Context: Federal Regulations on the Way or Already in Place

Regulations of various kinds may soon be forthcoming — and in some cases, will definitely be forthcoming — as a result of the U.S. Supreme Court decision in Massachusetts v. EPA and the Obama administration’s subsequent “endangerment finding” that emissions of carbon dioxide and other greenhouse gases endanger public health and welfare. This triggered mobile source standards earlier this year, the promulgation of which identified carbon dioxide as a pollutant under the Clean Air Act, thereby initiating a process of using the Clean Air Act for stationary sources as well.

Those new standards are scheduled to begin on January 2, 2011, with or without the so‑called “tailoring rule” that would exempt smaller sources. Among the possible types of regulation that could be forthcoming for stationary sources under the Clean Air Act are: new source performance standards; performance standards for existing sources (Section 111(d)); and New Source Review with Best Available Control Technology standards under Section 165.

The merits that have been suggested of such regulatory action are that it would be effective in some sectors, and that the threat of such regulation will spur Congress to take action with a more sensible approach, namely, an economy-wide cap‑and‑trade system. However, regulatory action on carbon dioxide under the Clean Air Act will accomplish relatively little and do so at relatively high cost, compared with carbon pricing. Also, it is not clear that this threat will force the hand of Congress; it clearly has not yet done so. Indeed, it is reasonable to ask whether this is a credible threat, or will instead turn out to be counter‑productive (when stories about the implementation of inflexible, high‑cost regulatory approaches lend ammunition to the staunchest opponents of climate policy).

It’s also possible that air pollution policies for non‑greenhouse gas pollutants, the emissions of some of which are highly correlated with CO₂ emissions, may play an important role. For example, three‑pollutant legislation focused on SO_x, NO_x, and mercury could have profound impacts on the construction and operation of coal‑fired electricity plants, without any direct CO₂ requirements. Without any new legislation, a set of rules which could have significant impacts on coal-fired power plants are now making their way through the regulatory process — including regulations affecting ambient ozone, SO₂/NO₂, particulates, ash, hazardous air pollutants (mercury), and effluent water.

There is also the possibility of new energy policies (not targeted exclusively at climate change) having significant impacts on CO₂ emissions. The possible components of such an approach that would be relevant in the context of climate change include: a national renewable electricity standard; Federal financing for clean energy projects: energy efficiency measures (building, appliance, and industrial efficiency standards; home retrofit subsidies; and smart grid standards, subsidies, and dynamic pricing policies); and new Federal electricity‑transmission siting authority.

Even without action by the Congress or by the Administration, legal action on climate policy is likely to take place within the judicial realm. Public nuisance litigation will no doubt continue, with a diverse set of lawsuits being filed across the country in pursuit of injunctive relief and/or damages. Due to recent court decisions, the pace, the promise, and the problems of this approach remain uncertain.

Beyond the well‑defined area of public nuisance litigation, other interventions which are intended to block permits for new fossil energy investments, including both power plants and transmission lines will continue. Some of these interventions will be of the conventional NIMBY character, but others will no doubt be more strategic.

But with political stalemate in Washington on carbon-pricing or national climate policy, attention is inevitably turning to regional, state, and even local policies intended to address climate change.

Sub-National Climate Policies

The Regional Greenhouse Gas Initiative (RGGI) in the Northeast has created a cap‑and‑trade system among electricity generators. More striking, California’s Global Warming Solutions Act (Assembly Bill 32, or AB 32) will likely lead to the creation of a very ambitious set of climate initiatives, including a statewide cap‑and‑trade system (unless it’s stopped by ballot initiative — Proposition 23 — or a new Governor, depending on the outcome of the November 2010 elections). The California system is likely to be linked with systems in other states and Canadian provinces under the Western Climate Initiative. Currently, more than half of the 50 states are contemplating, developing, or implementing climate policies.

In the presence of a Federal policy, will such state efforts achieve their objectives? Will the efforts be cost-effective? The answer is that the interactions of state policies with Federal policy can be problematic, benign, or positive, depending upon their relative scope and stringency, and depending upon the specific policy instruments used. This is the topic of a paper which Professor Lawrence Goulder (Stanford University) and I have written, “Interactions Between State and Federal Climate Change Policies” (National Bureau of Economic Research Working Paper 16123, June 2010).

Problematic Interactions

Let’s start with the case of a Federal policy which limits emission quantities (as with cap-and-trade) or uses nationwide averaging of performance (as with some proposals for a national renewable portfolio standard). In this case, emission reductions accomplished by a “green state” with a more stringent policy than the Federal policy — for example, AB 32 combined with Waxman-Markey/H.R. 2454 — will reduce pressure on other states, thereby freeing, indeed encouraging (through lower allowance prices) emission increases in the other states. The result would be 100% leakage, no gain in environmental protection from the green state’s added activity, and a national loss of cost-effectiveness.

Potential examples of this — depending upon the details of the regulations — include: first, AB 32 cap-and-trade combined with Federal cap-and-trade (H.R. 2454) or combined with some U.S. Clean Air Act performance standards; second, state limits on GHGs/mile combined with Federal CAFE standards; and third, state renewable fuels standards combined with a Federal RFS, or state renewable portfolio standards combined with a Federal RPS. A partial solution would be for these Federal programs to allow states to opt out of the Federal policy if they had an equally or more stringent state policy. Such a partial solution would not, however, be cost-effective.

Benign Interactions

One example of benign interactions of state and Federal climate policy is the case of the Regional Greenhouse Gas Initiative (RGGI) in the northeast. In this case, the state policies are less stringent than an assumed Federal policy (such as H.R. 2454). The result is that the state policies become non-binding and hence largely irrelevant.

A second example — that warms the hearts of economists, but appears to be politically irrelevant for the time being — is the case of a Federal policy that sets price, not quantity, i.e., a carbon tax, or a binding safety-valve or price collar in a cap-and-trade system. In this case, more stringent actions in green states do not lead to offsetting emissions in other states induced by a changing carbon price. It should be noted, however, that there will be different marginal abatement costs across states, and so aggregate reductions would not be achieved cost-effectively.

Positive Interactions

Three scenarios suggest the possibility of positive interactions of state and Federal climate policies. First, states can — in principle — address market failures not addressed by a Federal carbon-pricing policy. A prime example is the principal‑agent problem of insufficient energy‑efficiency investments in renter‑occupied properties, even in the face of high energy prices. This is a problem that is best addressed at the state or even local level, such as through building codes and zoning.

Second, state and regional authorities frequently argue that states can serve as valuable “laboratories” for policy design, and thereby provide useful information for the development of Federal policy. However, it is reasonable to ask whether state authorities will allow their “laboratory” to be closed after the experiment has been completed, the information delivered, and a Federal policy put in place. Pronouncements from some state leaders should cause concern in this regard.

Third, states can create pressure for more stringent Federal policies. A timely example is provided by California’s Pavley I motor-vehicle fuel-efficiency standards and the subsequent change in Federal CAFE requirements. There is historical validation of this effect, with California repeatedly having increased the stringency of its local air pollution standards, followed by parallel Federal action under the Clean Air Act. This linkage is desirable if the previous Federal policy is insufficiently stringent, but whether that is the case is an empirical question.

Thus, in the presence of Federal climate policy, interactions with sub-national policies can be problematic, benign, or positive, depending upon the relative scope and stringency of the sub-national and national policies, as well as the particular policy instruments employed at both levels. [For a more rigorous derivation of the findings above, as well as an examination of a larger set of examples, please see my paper with Stanford Professor Lawrence Goulder, referenced above.]

But comprehensive Federal carbon-pricing policy appears to be delayed until 2013, at the earliest. And it is possible that pending Federal regulatory action under the Clean Air Act will be curtailed or significantly delayed either by the new Congress or by litigation. Therefore, it is important to consider the role of state and regional climate policies in the absence of Federal action.

Sub-National Climate Policies in the Absence of Federal Action

In brief, in the absence of meaningful Federal action, sub‑national climate policies could well become the core of national action. Problems will no doubt arise, including legal obstacles such as possible Federal preemption or litigation associated with the so‑called Dormant Commerce Clause.

Also, even a large portfolio of state and regional policies will not be comprehensive of the entire nation, that is, not truly national in scope (for a quick approximation of likely coverage, check out a recent map of blue states and red states).

And even if the state and regional policies were nationally comprehensive, there would be different policies of different stringency in different parts of the country, and so carbon shadow‑prices would by no means be equivalent, meaning that the overall policy objectives would be achieved at excessive social cost.

Is there a solution (if only a partial one)? Yes. If the primary policy instrument employed in the state and regional policies is cap-and-trade, then the respective carbon markets can be linked. Such linkage occurs through bilateral recognition of allowances, which results in reduced costs, reduced price volatility, reduced leakage, and reduced market power. Good news all around.

Such bottom‑up linkage of state and regional cap‑and‑trade systems could be an important part or perhaps even the core of future of U.S. climate policy, at least until there is meaningful action at the Federal level. In the meantime, it is at least conceivable — and perhaps likely — that linkage of state‑level cap‑and‑trade systems will become the (interim) de facto national climate policy architecture.

In this way, Sacramento would take the place of Washington as the center of national climate policy deliberations and action. No doubt, this possibility will please some, and frighten others.

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P.S. For those of you interested in the topic of this blog post, you may also find of particular interest a conference organized by the University of California, taking place in Sacramento on October 4th, “California’s Climate Change Policy: The Economic and Environmental Impacts of AB 32.” You can learn more about it by clicking on this link.

The Real Options for U.S. Climate Policy

The time has not yet come to throw in the towel regarding the possible enactment in 2010 of meaningful economy-wide climate change policy (such as that found in the Waxman-Markey legislation passed by the U.S. House of Representatives in June, 2009, or the more recent Kerry-Lieberman proposal in the Senate). Meaningful action of some kind is still possible, or at least conceivable. But with debates regarding national climate change policy becoming more acrimonious in Washington as midterm elections approach, it is important to ask, what are the real options for climate policy in the United States – not only in 2010, but in 2011 and beyond. That’s the purpose of this essay.

Federal Policy Options

Let’s begin my considering Federal policy options under two distinct categories: pricing instruments and other approaches. Carbon-pricing instruments could take the form of caps on the quantity of emissions (cap-and-trade, cap-and-dividend, or baseline-and-credit), or approaches that directly put carbon prices in place (carbon taxes or subsidies). Beyond pricing instruments, the other approaches include regulation under the Clean Air Act, energy policies not targeted exclusively at climate change, public nuisance litigation, and NIMBY and other public interventions to block permits for new fossil-fuel related investments. I will discuss each of these in turn.

Quantity-Based Carbon Pricing

I’ve frequently written about cap-and-trade in the past (See, for example: Here We Go Again: A Closer Look at the Kerry-Lieberman Cap-and-Trade Proposal; Eyes on the Prize: Federal Climate Policy Should Preempt State and Regional Initiatives; Any Hope for Meaningful U.S. Climate Policy? You be the Judge; Confusion in the Senate Regarding Allowance Allocation?; Cap-and-Trade versus the Alternatives for U.S. Climate Policy; Can Countries Cut Carbon Emissions Without Hurting Economic Growth?; Cap-and-Trade: A Fly in the Ointment? Not Really; National Climate Change Policy: A Quick Look Back at Waxman-Markey and the Road Ahead; Worried About International Competitiveness? Another Look at the Waxman-Markey Cap-and-Trade Proposal; The Wonderful Politics of Cap-and-Trade: A Closer Look at Waxman-Markey; The Making of a Conventional Wisdom), and so I will be very brief on this instrument in this essay.

A Quick Reminder about Cap-and-Trade

In brief, there are four principal merits of the cap-and-trade approach to achieving significant reductions of carbon dioxide (CO₂) emissions. First, this approach achieves overall targets at minimum aggregate cost, that is, it is cost-effective, both in the short term by allocating responsibility among sources, and in the long term, by providing price signals that will drive technological innovation and diffusion of carbon-friendly technologies. Second, the allowance allocation under a cap-and-trade system can be used to build a constituency of political support across sectors and geographic areas without driving up the cost of the program or reducing its environmental performance. Third, we have significant experience in the United States with the use of this approach, including during the 1980s to phase out leaded gasoline from the marketplace, and since the 1990s to cut acid rain by 50 percent. Fourth, and of great importance, a domestic cap-and-trade system can be linked directly and cost-effectively with cap-and-trade systems and emission-reduction-credit systems in other parts of the world to keep costs down domestically.

Three principal concerns have been voiced about cap-and-trade systems in U.S. debates. First, while a cap-and-trade system constrains the quantity of emissions, the costs of control are left uncertain (although such cost uncertainty can be limited — if not eliminated — through the use of safety valves, price collars, or related mechanisms). Second, in the wake of concerns regarding the roll that financial markets played in the global recession, there have been many fears about the possibilities of market manipulation in a cap-and-trade system. A third concern – in a political context – is that this cost-effective approach to environmental protection, pioneered by the Republican administration of President George H. W. Bush, has – ironically — been demonized by conservatives in current debates.

That said, a variety of pending design issues will need to be addressed in the development of any cap-and-trade system, including: ambition, scope (suddenly important because of a renewed focus in Washington on the possibility of a utility-only cap), point of regulation in the economy, allowance allocation, the role of offsets, cost-containment mechanisms, international competition protection, and regulatory oversight. (I’ve written about all of these design issues in previous essays at this blog and elsewhere.)

A Design-Change for Cap-and-Trade?

Does the current political climate call for a design change — or at least a name change — for cap-and-trade? Both stepwise and sectoral approaches are being considered. A stepwise approach of beginning with one or a few sectors of the economy and subsequently expanding gradually to an economy-wide program was embodied in both the Waxman-Markey legislation and in the Kerry-Lieberman proposal. Under a sectoral approach, cap-and-trade would be used for some sectors, but other approaches would be used for other parts of the economy. To some degree, the Kerry-Lieberman proposal embodies this approach. The current focus in Washington is on the possibility of using cap-and-trade for the electricity sector only.

Although the politics may argue for a stepwise or sectoral approach, it should be recognized that neither is likely to be cost-effective, because it is highly unlikely that marginal abatement costs will be equated across all sectors of the economy without the use of a single (implicit) price on carbon.

So the potential approach now receiving much attention in Washington of employing a cap-and-trade system in the electricity sector only would — in all likelihood — achieve less in terms of overall emissions reductions, and would not be cost-effective (due to the exclusion of other sectors). However, it is at least conceivable that will prove to be the best among politically-feasible paths to a better future policy. That is, of course, a political — not an economic — question.

A Populist Approach?

Populism has emerged as a major theme in recent electoral politics in the United States, both from the left and from the right. What might be characterized as a populist approach would be a cap-and-trade system with 100% of the allowances auctioned and the auction revenue returned directly “to the people.” Although this is a standard variant of cap-and-trade design, contemporary politics — with its demonization of the phrase “cap-and-trade” — might well argue for a name change: how about “cap-and-dividend?”

This approach is embodied in the CLEAR Act of Senators Maria Cantwell (D-Washington) and Susan Collins (R-Maine). The merits of this approach include its simplicity, appearance of fairness, and related appeal to the populist mood. Concerns, however, include the proposal’s relatively modest environmental achievements (according to an analysis by the World Resources Institute), its overall cost due to restrictions on trading, and its apparent political infeasibility, given its lack of visible support in the Congress.

Other Trading Mechanisms

In addition to cap-and-trade, the other major type of tradable permit system is an emission-reduction-credit system, or baseline-and-credit system. Because such approaches lack caps, they raise some well-known concerns, in particular the necessity of comparing actual emissions with what emissions would have been in the absence of the policy. In such a system, the latter is fundamentally unobserved and unobservable. This is the problem of “additionality,” which comes up in spades in the case of the Clean Development Mechanism (CDM), but also in the context of most other offset programs.

A related trading mechanism is found in the Clean Energy Standards approach, embodied in Senator Richard Lugar’s (R-Indiana) legislative proposal. This mechanism is similar to a Renewable Portfolio Standard (RPS), but allows for a broader set of qualified sources; not only renewables, but also nuclear power, fossil fuel power with carbon capture and storage (CCS), and – in principle — efficient natural gas. If the clean energy credits are denominated in units of carbon free megawatt hours and are tradable, then the merits of this approach include the flexibility that is provided through trading. The concerns include the lack of an emissions cap, and the difficulty of expanding this approach to other sectors or linking it with a cap-and-trade system. However, if the clean energy credits are denominated in emissions per megawatt hour, then the program can more easily be converted to or linked with a cap-and-trade system.

Direct Carbon Pricing

A carbon tax system would be similar in design to an upstream cap-and-trade approach. There is some real interest in this approach, mainly from academics, and there is also what I would characterize as “strategic interest,” principally from those who recognize that once the focus is on carbon taxes rather than other instruments, political debates will inevitably result in less ambitious targets or, in fact, no policy at all.

Carbon Taxes in Brief

Having said this, the merits of a carbon tax approach compared with cap-and-trade include the fact that cost uncertainty is eliminated with the tax approach (although, of course, there is quantity uncertainty, that is, no emissions cap). And, I mentioned earlier, the cost uncertainty inherent in a cap-and-trade system can be reduced, if not eliminated, with cost-containment mechanisms such as a price collar.

Another merit of the carbon tax approach is that it would generate substantial revenues (as would a cap-and-trade system in which the allowances are auctioned). These revenues can be used – in principle – for a variety of worthwhile public purposes, including reducing distortionary taxes, which would serve to lower the overall social cost of the policy. Third, the tax approach is (at least perceived to be) much simpler than the allowance market that would be generated by a cap-and-trade scheme.

Major concerns regarding carbon taxes are fourfold. First, despite their social cost-effectiveness, pollution taxes can be more costly to the regulated sector than even a non-cost-effective command-and-control instrument. Second, unlike cap-and-trade, the tax approach lacks a benign mechanism for building political constituency, and is likely to lead to requests for tax exemptions, and hence a less ambitious policy and possibly a more costly one. Third, although it is not impossible to link such as system internationally (for purposes of cost containment), it is more challenging to do so than with the quantity based cap-and-trade alternative. A fourth and final concern is the apparent political infeasibility of this approach, at least currently in the United States.

In this regard, it is important to note that what has frequently been interpreted as hostility to cap-and-trade in the U.S. Senate is actually – on closer inspection — broader hostility to the very notion of carbon pricing (or any climate change policy). Surely, the political reception to a carbon tax would be even less enthusiastic than the reception that has greeted recent cap-and-trade proposals.

Subsidies: The Good, the Bad, and the Ugly

If it’s so politically difficult to tax “bad behavior,” how about subsidizing “good behavior?” The mirror image of a tax is indeed a subsidy, and two potential price-based approaches to achieving greenhouse gas emission reductions are the use of climate-friendly subsidies and the elimination of problematic subsidies that exacerbate the climate problem.

In thinking about climate-friendly subsidies, we should first keep in mind that the Obama economic stimulus package enacted by the Congress includes significant subsidies (and tax credits) for renewables and efficiency upgrades — to the tune of about $80 billion. A major problem has been that the administration (in particular, the Department of Energy) has been finding it difficult to spend the money fast enough. Also, some would consider subsidies for biofuels, such as ethanol, as falling within this category of climate-friendly subsidies, but clearly that is a matter of considerable controversy.

Principal among the problematic subsidies – and hence major candidates for reduction or elimination – are subsidies for the development and use of fossil fuels. According to the Environmental Law Institute, U.S. fossil-fuel subsidies and tax breaks currently amount to $8-$10 billon per year. At the global level, the International Energy Agency has estimated that such fossil-fuel subsidies now amount to $550 billion annually! President Obama proposed at the G20 meeting in Pittsburgh in November, 2009, that such subsidies be phased out around the world, and there seemed at the time to be broad-based support for this proposal. However, it should not be surprising that less than a year later, it now appears that the commitment may be watered down somewhat at the G20 meeting in Toronto this June.

The merit of trying to use climate-friendly subsidies is based on the fact that subsidies affect relative prices, much like taxes do, but are much more politically attractive, since politicians prefer to give out benefits rather than costs to their constituents. And eliminating problematic subsidies can be economically efficient.

But a major concern of using climate-friendly subsidies is that the funds go not only to marginal units that otherwise would not be taking specific actions, but also to infra-marginal units that are pleased to accept the funds, but whose behavior is unaffected by them. This means that this approach is relatively costly to the government (and to society at large) for what is accomplished. And a concern of removing fossil fuel subsidies – particularly in the current political climate of worries about oil imports – is that this can work against so-called “energy security” (some have therefore suggested the addition of an “oil import fee”).

Climate Change Regulation under the Clean Air Act

Regulations of various kinds may soon be forthcoming – and in some cases, will definitely be forthcoming – as a result of the U.S. Supreme Court decision in Massachusetts v. EPA and the Obama administration’s subsequent “endangerment finding” that emissions of carbon dioxide and other greenhouse gases endanger public health and welfare. This triggered mobile source standards earlier this year, the promulgation of which identified carbon dioxide as a pollutant under the Clean Air Act, thereby initiating a process of using the Clean Air Act for stationary sources as well.

Those new standards are scheduled to begin on January 1, 2011, with or without the so-called “tailoring rule” that would exempt smaller sources. Among the possible types of regulation that could be forthcoming for stationary sources under the Clean Air Act include: new source performance standards; performance standards for existing sources (Section 111(d)); and New Source Review with Best Available Control Technology standards under Section 165.

The merits that have been suggested of such regulatory action are that it would be effective in some sectors, and that the threat of such regulation will spur Congress to take action with a more sensible approach, namely, an economy wide cap-and-trade system.

However, regulatory action on carbon dioxide under the Clean Air Act will accomplish relatively little and do so at relatively high cost, compared with carbon pricing. Also, it is not clear that this threat will force the hand of Congress. Indeed it is reasonable to ask whether this is a credible threat, or will instead turn out to be counter-productive (when stories about the implementation of inflexible, high-cost regulatory approaches lend ammunition to the staunchest opponents of climate policy).

Furthermore, there is the question of possible preemption. Although Senator Lisa Murkowski’s (R-Alaska) resolution was defeated in the Senate, Senator Jay Rockefeller’s (D-West Virginia) proposal of a two-year delay of Clean Air Act regulatory action is still pending; and depending upon the outcome of the November elections, there may be a series of further Congressional actions to tie the hands of EPA in this regard.

Regulation of Conventional Pollutants under the Clean Air Act

It’s also possible that air pollution policies for non-greenhouse gas pollutants, the emissions of some of which are highly correlated with CO₂ emissions, may play an important role. For example, the three-pollutant legislation co-sponsored by Senator Thomas Carper (D-Delaware) and Senator Lamar Alexander (R-Tennessee), focused on SO_x, NO_x, and mercury, could have profound impacts on the construction and operation of coal-fired electricity plants, without any direct CO₂ requirements. Beyond this, there are also possibilities of policies for the non-CO₂ greenhouse gases.

Important, Unanswered Questions

An important pending question regarding EPA’s use of the Clean Air Act is whether EPA may legally create CO₂ cap-and-trade or offset markets under existing Clean Air Act authority. The answer appears to be “probably yes.” There is positive precedent from EPA’s emissions trading program of the 1970s, and it’s a leaded gasoline phase-down of the 1980s, although recent court decisions regarding the Bush administration’s Clean Air Interstate Rule may cause concern in this regard.

The more important question, however, may turn out to be whether EPA can politically create significant CO₂ markets in the face of Congressional opposition. The answer to this is considerably less clear.

Energy Policies Not Targeted Exclusively at Climate Change

The “positive politics” generated by the Gulf oil spill, combined with the “negative politics” of addressing climate change explicitly, may well increase the likelihood of so-called “energy-only” legislation being enacted this year. Senator Jeff Bingaman’s (D-New Mexico) bill from the Environment and Natural Resources Committee and perhaps Senator Richard Lugar’s bill will feature centrally in any bipartisan initiative.

The possible components of such an approach which would be relevant in the context of climate change include: a national renewable electricity standard; Federal financing for clean energy projects: energy efficiency measures (building, appliance, and industrial efficiency standards; home retrofit subsidies; and smart grid standards, subsidies, and dynamic pricing policies); and new Federal electricity-transmission siting authority.

Other Legal Mechanisms

Even without action by the Congress or by the Administration, legal action on climate policy is likely to take place within the judicial realm. Public nuisance litigation will no doubt continue, with a diverse set of lawsuits being filed across the country in pursuit of injunctive relief and/or damages. Due to recent court decisions, the pace, the promise, and the problems of this approach remain uncertain.

Beyond the well-defined area of public nuisance litigation, other interventions which are intended to block permits for new fossil energy investments, including both power plants and transmission lines will continue. Some of these interventions will be of the conventional NIMBY character, but others will no doubt be more strategic.

Does the Road to National Climate Policy Need to Go through Washington?

With political stalemate in Washington, attention may increasingly turn to regional, state, and even local policies intended to address climate change. The Regional Greenhouse Gas Initiative (RGGI) in the Northeast has created a cap-and-trade system among electricity generators. More striking, California’s Global Warming Solutions Act (Assembly Bill 32, or AB 32) will likely lead to the creation of a very ambitious set of climate initiatives, including a statewide cap-and-trade system (unless it’s stopped by ballot initiative or a new Governor, depending on the outcome of the November 2010 elections). The California system is likely to be linked with systems in other states and Canadian provinces under the Western Climate Initiative.

These sub-national policies will interact in a variety of ways – some good, some bad — with Federal policy when and if Federal policy is enacted. As Professor Lawrence Goulder (Stanford University) and I have written in a new paper for the National Bureau of Economic Research (NBER), some of these interactions could be problematic, such as the interaction between a Federal cap-and-trade system and a more ambitious cap-and-trade system in California under AB 32, while other interactions would be benign, such as RGGI becoming somewhat irrelevant in the face of a Federal cap-and-trade system that was both more stringent and broader in scope.

An important question is whether there can be sensible sub-national policies even in the presence of an economy-wide Federal carbon-pricing regime? The answer is surely yes, partly because other market failures will continue to exist that are not addressed by carbon pricing. A prime example is the principal-agent problem of insufficient energy-efficiency investments in renter-occupied properties, even in the face of high energy prices. This is a problem that is best addressed at the state or even local level, such as through building codes and zoning.

In the meantime, in the absence of meaningful Federal action, sub-national climate policies could well become the core of national action. Problems will no doubt arise, including legal obstacles such as possible Federal preemption or litigation associated with the so-called Dormant Commerce Clause. Also, even a large portfolio of state and regional policies will not be comprehensive of the entire nation, that is, not truly national in scope. And even if they are nationally comprehensive, with different policies of different stringency in different parts of the country, carbon shadow-prices will by no means be equivalent, and so overall policy objectives will be achieved at excessive social cost.

Is there a solution, if only a partial one? Yes, state and regional carbon markets can be linked. Such linkage occurs as a result of bilateral recognition of allowances, which results in reduced costs, price volatility, leakage, and market power. Such bottom-up linkage of state and regional cap-and-trade systems may be an important part or perhaps the core of future of U.S. climate policy, at least until there is meaningful action at the Federal level. In the meantime, it is at least conceivable that linkage of state-level cap-and-trade systems across the United States will become the de facto post-2012 national climate policy architecture.

The Path Ahead

Conventional politics clearly disfavors market-based (pricing) environmental policy approaches that render costs obvious or at least somewhat transparent, despite the fact that the costs of these same policies are actually less than those of alternative approaches. Instead, conventional politics favors approaches to environmental protection that render costs less obvious (or better yet invisible), such as renewable portfolio standards, and — for that matter — all sorts of command-and-control performance and technology standards.

But carbon pricing will be necessary to address the diverse economy-wide sources of CO₂ emissions effectively and at sensible cost, whether the carbon pricing comes about through an economy-wide Federal cap-and-trade system or through a Federal carbon tax. It is inconceivable that truly meaningful reductions in CO₂ emissions could be achieved through purely regulatory approaches, and it remains true that whatever would be achieved, would be accomplished at excessively high cost.

So, although it is true – as I have sought to explain in this essay – that there are a diverse set of options for future climate policy in the United States, the best available alternative to an economy-wide cap-and-trade system enacted in 2010 may be an economy-wide cap-and-trade system enacted in 2011. But ultimately, the question of what is the best alternative this year to an economy-wide cap-and-trade system is a political, not an economic question.

Defining Success for Climate Negotiations in Copenhagen

The fact that President Obama has decided to attend the United Nations climate change negotiations in Copenhagen at the end of the two-week meetings on December 18th, rather than during the previous week on his way to Oslo to receive the Nobel Peace Prize, is important, because it increases – in my mind – the likelihood of a significant outcome from the negotiations. However, my reasoning – as I explained in a blog post for the Financial Times – is not what most people may think. It is a matter of what is called “endogeneity” in economics, that is, there is causality in both directions. That’s a bit cryptic, so let me explain.

[Before I proceed, I should explain that I have agreed to blog periodically from Copenhagen for the Financial Times, analyzing some of the issues before the negotiators in response to questions from the Financial Times‘ editors and reporters. Those posts can be viewed at the Financial Times energy-source web site.]

Although it is true that President Obama’s presence on the concluding day of the negotiations (when – taking Kyoto in 1997 as an example – some of the key deals are finally struck) can have some influence, it is even more true that this decision by the White House signals that the Administration has reason to believe that there will be a visibly successful outcome of the Copenhagen talks.

His initial decision to visit the negotiations the previous week would have shielded the President – to a considerable degree — from any embarrassment and bad publicity if the negotiations were to fall apart. (The President does not need to fly back from Copenhagen a second time having failed on his mission; his attempt to bring the Olympic games to Chicago is still fresh in the minds of the international press.)

Therefore, the fact that the White House has decided to send the President to Copenhagen for the final day, where he will assemble with some 90 other world leaders, and participate in closing statements (not to mention photo opportunities), indicates that the Administration is relatively confident that the talks will not collapse in a logjam of disagreement between the industrialized world and the developing countries, but rather that there will be a successful outcome.

The key outstanding question is whether the outcome will be one that provides a sound foundation for meaningful, long-term global action, not simply some notion of immediate, albeit highly visible triumph. This is a subject on which I wrote in the Boston Globe (“A Silver Lining in the Climate Talks Cloud”) on Sunday, December 6, 2009, and it is my major focus here.

The gloom and doom predictions we’ve been hearing about the global climate negotiations taking place in Copenhagen this week and next are fundamentally misguided. The picture is much brighter than it might seem for this international conference aimed at coming up with a successor for the Kyoto Protocol, which essentially sunsets in 2012.

The best goal for the Copenhagen climate talks is to make real progress on a sound foundation for meaningful, long-term global action, not some notion of immediate triumph. This is because of some basic scientific and economic realities.

First, the focus of scientists (and policy makers) is and should be on stabilizing concentrations at acceptable levels by 2050 and beyond, because it is the accumulated stock of greenhouse gas emissions — not the flow of emissions in any year — that are linked with climate consequences.

Second, the cost-effective path for stabilizing concentrations involves a gradual ramp-up in target severity, to avoid rendering large parts of the capital stock prematurely obsolete.

Third, long-term technological change is the key to the needed transition from reliance on carbon-intensive fossil fuels to more climate-friendly energy sources.

Fourth, the creation of long-lasting international institutions is central to addressing this global challenge.

Indeed, it would be easy, but unfortunate, for countries to achieve what some people wish to define as “success” in Copenhagen: a signed international agreement, glowing press releases, and related photo opportunities for national leaders. Such an agreement could only be the Kyoto Protocol on steroids: more stringent targets for the industrialized countries and no meaningful commitments by the key rapidly-growing emerging economies of China, India, Brazil, Korea, Mexico, and South Africa (let alone by the numerous developing countries of the world).

Such an agreement could — in principle — be signed, but it would not reduce global emissions and it would not be ratified by the U.S. Senate (just like Kyoto). Hence, there would be no real progress on climate change.

If it’s not reasonable to expect that a comprehensive post-Kyoto policy architecture will be identified in Copenhagen, what would constitute real progress? One important step forward would be a constructive joint-communiqué from major countries (just seventeen industrialized and emerging economies account for about 90% of annual emissions).

Such a joint-communiqué could lay out key progressive principles to underlie a future climate agreement, such as making the United Nations notion of “common but differentiated responsibilities” meaningful through a the dual principles that: all countries recognize their historic emissions (read, the industrialized world); and all countries are responsible for their future emissions (think of those rapidly-growing emerging economies).

This would represent a great leap beyond what has become the “QWERTY keyboard” (that is, unproductive path dependence) of international climate policy: the distinction in the Kyoto Protocol between the small set of Annex I countries with quantitative targets, and the majority of countries in the world with no responsibilities. Various policy architectures could subsequently build on these dual principles and make them operational, beginning to bridge the massive political divide which exists between the industrialized and the developing world.

In addition, a mid-term agreement could be reached on an approach involving an international portfolio of domestic commitments, whereby each nation would commit and register to abide by its domestic climate commitments, whether those are in the form of laws and regulations or multi-year development plans. Support for such an approach has been voiced by a remarkably diverse set of countries, including Australia, India, and the United States.

The key question is not what this approach would accomplish in the short-term, but whether it would put the world in a better position two, five, and ten years from now in regard to a long-term path of action.

Consistent with this portfolio approach, President Obama recently announced that the United States would put a target on the table in Copenhagen to reduce emissions 17 percent below 2005 levels by 2020 (in line with climate legislation in the U.S. Congress). In response, China announced that it would reduce its carbon intensity (emissions per unit of economic activity) 40 percent below 2005 levels over the same period of time. Subsequently, India announced similar targets. Given these countries rapid rates of economic growth, the announced targets won’t cut emissions in absolute terms, but they are promising starting points for negotiations.

So, despite the multitude of negative pronouncements about the slow pace of international climate negotiations, there are positive developments and promising paths forward. It is fortunate that a few key nations, including the United States, appear to be more interested in real progress than symbolic action.