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Both Are Necessary, But Neither is Sufficient: Carbon-Pricing and Technology R&D Initiatives in a Meaningful National Climate Policy

For many years, there has been a great deal of discussion about carbon-pricing – whether carbon taxes or cap-and-trade – as an essential part of a meaningful national climate policy. It has long been recognized that although carbon-pricing will be necessary, it will not be sufficient. Economists and other policy analysts have noted that policies intended to foster climate-friendly technology research and development (R&D) will also be necessary, but likewise will not be sufficient on their own.

Some recent studies and press accounts, which I reference below, have identified these two approaches to addressing CO₂ emissions as substitutes, rather than complements. That is fundamentally inconsistent with decades of research, and so my purpose in this essay is to set the record straight.

Carbon Pricing: Necessary But Not Sufficient

First of all, why is there so much talk among policy analysts and policy makers – not simply among academics – about carbon‑pricing as the core of a meaningful strategy to reduce CO₂ emissions? Why, in fact, is this approach so overwhelmingly favored by the analytical community? The answer is simple and surprisingly pragmatic.

First, there is no other feasible approach that can provide meaningful emissions reductions, such as the 80 percent reduction in national CO₂ emissions by 2050 that was part of the legislation passed by the U.S. House of Representatives and proposed in the Senate and part of the Obama administration’s conditional pledge under the Copenhagen Accord. Because of the ubiquity and diversity of energy use in a modern economy, conventional regulatory approaches –standards of various kinds – simply cannot do the job. Only carbon pricing – either in the form of carbon taxes or cap-and-trade – can significantly tilt in a climate-friendly direction the millions of decentralized decisions that are made in our economy every day.

Second, carbon-pricing 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.

For these reasons, carbon-pricing is a necessary component of a truly meaningful national climate policy. [I’ve written about this in many previous blog posts, including on June 23, 2010, “The Real Options for U.S. Climate Policy.”] However, although it is a necessary policy component, carbon-pricing is not sufficient on its own. This is because there are other market failures that dilute the impacts of price signals on decision makers.

Technology R&D Policies: Also Necessary, Also Not Sufficient

The most important of these “other market failures” is the public good nature of information. Companies carrying out research and development (R&D) incur the full costs of their efforts, but they do not capture the full benefits. This is because even with a perfectly-enforced system of intellectual property rights (such as patents), there are tremendous spillover benefits to other firms. Decades of economic research – much of it by my former colleague and co-author, Professor Adam Jaffe, now Dean of Arts and Sciences at Brandeis University – has analyzed with empirical (econometric) analysis the remarkable degree to which inventions and innovations by one firm provide valuable information that leads to new inventions and innovations by other firms.

So, firms pay the costs of their R&D, but do not reap all the benefits. The existence of this positive externality of firms’ R&D – or put differently, the public-good nature of the information generated by R&D – means that the private sector will carry out less than the “efficient” amount of R&D of new climate-friendly technologies in response to given carbon prices. Hence, other public policies are needed to address this “R&D market failure.”

New path-breaking technologies will be needed to address climate change, and public support for private-sector or public-sector R&D will be crucial to meet this need. But, at the same time, to address the climate-change market failure itself (that is, the externality associated with greenhouse gas emissions), carbon pricing will be necessary, for all of the reasons I gave above. This is an application of an important and fundamental principle in economics: two market failures require the use of two policy instruments.

Empirical analyses have repeatedly verified this crucial point – that combining carbon-pricing with R&D support is more cost-effective than adopting either approach alone. Included in this set of studies are the following: Carolyn Fischer (Resources for the Future) and Richard Newell (U.S. Energy Information Administration, on leave from Duke University), “Environmental and Technology Policies for Climate Mitigation”; Stephen Schneider (late of Stanford University) and Lawrence Goulder (Stanford University), “Achieving Low-Cost Emissions Targets”; and Daren Acemoglu (MIT), Philippe Aghion, Leonardo Bursztyn, and David Hemous (Harvard University), “The Environment and Directed Technical Change.”

Complements, Not Substitutes

An interesting, recent column, “Next Step on Policy for Climate,” by David Leonhardt in the New York Times (October 13, 2010, p. B1) might give some people the mistaken impression that technology policies are an adequate, even sensible substitute for carbon-pricing. That was not the intended message of the column. In fact, Leonhardt – perhaps the leading economic journalist writing today in the United States – indicates clearly in his column that he is skeptical of the notion of thinking of technology subsidies as an adequate substitute for carbon-pricing (in particular, cap-and-trade). And in a follow-up post at the New York Times’ Economix, he makes clear that “these two policies are not mutually exclusive.”

Nevertheless, Leonhardt’s original column (which included a very nice profile of my colleague, Professor Michael Greenstone of MIT) focused attention on a recent report – a report that could give the false impression that technology policies would be a sensible substitute for serious carbon-pricing. The report in question – “Post-Partisan Power” – received significant coverage, primarily because of its sponsorship: a combination of a prominent Republican-oriented Washington think tank, the American Enterprise Institute (AEI), and an equally prominent Democratic-oriented Washington think tank, the Brooking Institution (and a third partner, the Breakthrough Institute, a California-based environmental think tank).

The report may well garner some bi-partisan political support, because it promises a free lunch of painless, win-win solutions, a promise that will resonate with many elected officials. Indeed, the report’s sub-title is “how a limited and direct approach to energy innovation can deliver clean, cheap energy, economic productivity, and national prosperity.” What’s not to like? And the authors are presumably smart and politically shrewd. I know that’s the case with the AEI author, Steven Hayward, who I debated last year in the pages of the Wall Street Journal.

To its credit, the report lays out a menu of policies intended to stimulate carbon-friendly technological change, ranging from $500 million of Federal government funding of K-12 curriculum development and teacher training to $25 billion annually of direct Federal funding of energy innovation.

For the reasons I explained above (the “R&D market failure” and the “carbon emissions externality”), both direct technology R&D policies and serious carbon-pricing are necessary, but neither is sufficient on its own. Unfortunately, this new report – and some of the press coverage surrounding it – makes the claim that such direct government funding of technology innovation is a sufficient and sensible substitute for meaningful carbon-pricing. That claim is both unfortunate and wrong, as it is supported neither by sound reasoning nor empirical research, as I have described above.

Again, many of the individual technology policy recommendations offered by the AEI-Brookings-BI report are worthy of serious consideration (as a complement, not a substitute for an economy-wide carbon-pricing policy). But the specifics – indeed, much of the meat – are missing. “Reform the nation’s morass of energy subsidies” – yes, but exactly which subsidies (all of which have important political constituencies behind them) will be eliminated? “Recognize the potential for nuclear power” – yes, and both the House and Senate carbon-pricing schemes would have provided tremendous incentives for nuclear power investment.

Overall, there should be concern about how all of this will be funded. Where will the $25 billion per year come from? The report appropriately states that this should not come from general revenues, and thus add to the Federal debt. “Phasing out current subsidies for wind, solar, ethanol, and fossil fuels” could be meritorious on its own, but how much does this generate, and does it even pass a political laugh-test? Interestingly, beyond this, despite considerable rhetoric about moving beyond debates about carbon-pricing, the report recommends that in order to avoid adding to the Federal debt, it would be necessary to impose new taxes, including increased royalties for oil and gas extraction, a tax on imported oil, a tax on electricity sales, and a “very small carbon price” (presumably from a modest carbon tax or unambitious cap-and-trade system).

The actual numbers would be helpful, and the political feasibility remains a serious question. The political challenges that emerged in the effort to pass cap-and-trade climate legislation will not magically disappear if there’s an attempt to induce Congress to approve $25 billion in funding. As Tom Friedman noted on October 12^th in the New York Times, Congress has not come close to fully funding the outstanding requests for about $4 billion for ARPA-E (energy) research.

More broadly, despite the attraction of the AEI-Brookings-BI proposal as a potential complement to carbon-pricing (and I am serious that the proposal is of value in that context), one has to be very careful about comparing proposed new policies in idealized form (for example, precisely the right subsidies eliminated and precisely the right new subsidies introduced) with real policies with all their warts (for example, the cap-and-trade bill that was passed by the House last year). Making such comparisons can lead to flawed analysis and misleading results.

This is not a new issue. Robert Hahn and I wrote about this generic problem nearly 20 years ago in an article (“Economic Incentives for Environmental Protection: Integrating Theory and Practice”) which appeared the American Economic Review Papers and Proceedings (May 1992). At the time, our concern was that this mistake was being made not by the opponents but by the supporters of cap-and-trade and other (then essentially untested) market-based instruments. We worried that “many analysts use highly stylized benchmarks for comparison that ignore likely political realities,” and suggested that an appropriate “comparison would be between actual command-and-control policies and either actual trading [cap-and-trade] programs … or a reasonably constrained theoretical … program.”

Likewise today, when carrying out comparisons of policy alternatives, it is fine to compare two theoretical, idealized alternatives, or to compare two real-world policies, but it is problematic and usually misleading to compare a theoretical, idealized policy of one type with a real-world example of another type of policy.

The Bottom Line

Carbon-pricing – whether carbon taxes or cap-and-trade – will be an essential part of any truly meaningful national climate policy. Likewise, to address the “R&D market failure,” direct technology innovation policies will also be required. Both are necessary. Neither is sufficient. These are complements, not substitutes.

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Postscript: Four years ago, the U.S. Congressional Budget Office (CBO) — widely recognized for its non-partisan, first-rate research — produced a study on the same topic as the AEI-Brookings-BI report, but did so with rigor and without ideology. The CBO report — Evaluating the Role of Prices and R&D in Reducing Carbon Dioxide Emissions (September 2006) — was prepared by Dr. Terry Dinan, a long-time, respected CBO economist, and was peer reviewed by an impressive set of academic and other experts. Sadly, the CBO paper received little press coverage, despite its high quality and its relevance. For anyone interested in the topic of this post, particularly those who disagree with my theme, I hope you will read the CBO report.

Also, a reader of this blog post sent me a paper by David Hart and Kadri Kallas (from MIT’s Energy Innovation working paper series) that examines “Alignment and Misalignment of Technology Push and Regulatory Pull.” It’s worth reading in the context of combining carbon pricing and technology R&D policies.

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.

Cap-and-Trade versus the Alternatives for U.S. Climate Policy

Let’s credit Senator Lisa Murkowski (R-Alaska) for raising questions in the National Journal about the viability of cap-and-trade versus other approaches for the United States to employ in addressing CO₂ and other greenhouse gas emissions linked with global climate change.

Senator Murkowski says that only one approach – cap-and-trade – has received significant attention in the Congress. Let’s put aside for the moment the fact that most of the 1,428 pages of H.R. 2454 – the American Clean Energy and Security Act of 2009 (otherwise known as the Waxman-Markey bill) – are not about cap-and-trade at all, but about a host of other regulatory approaches (several of which are highly problematic, as I’ve discussed in a previous post). We can also put aside the fact that both conventional regulatory approaches and carbon taxes have been discussed repeatedly in numerous House and Senate committees over the past decade, and received detailed attention from a succession of U.S. administrations.

So, let’s not quibble about the Senator’s claim that cap-and-trade is the only approach that has received serious attention. Instead, let’s address the key substantive questions which Senator Murkowski raises, because they are important questions: Is cap-and-trade the most effective way of addressing climate change? And are there other approaches capable of achieving the same results at lower cost? From my perspective, as a card-carrying environmental economist, these are indeed the key questions.

While political leaders in the European Union, Canada, Australia, New Zealand, Japan, and the United States (Congress) move toward cap-and-trade systems as their preferred approach for achieving meaningful reductions in emissions of CO₂ and other greenhouse gases, many people – including some of my fellow economists — have been critical of the cap-and-trade approach in the climate context and have endorsed the use of carbon taxes. The Senator is correct that we should reflect on the merits of that alternative approach.

But, first, what about conventional regulatory approaches, that is, performance standards and technology standards?

Conventional Regulatory Standards

In short, experience has shown that such standards cannot ensure achievement of emissions targets, create problematic unintended consequences, and are very costly for what they achieve.

Why can conventional standard not ensure achievement of reasonable emissions targets? First, standards typically focus on new emissions sources, and do not address emissions from existing sources. Think about greenhouse gas standards for new cars and new power plants, for example. Second, standards cannot possibly address all types of new sources, given the ubiquity of energy generation and use (and hence CO₂ emissions) in a modern economy. Third, emissions depend upon many factors that cannot be addressed by standards, such as: emissions from existing sources and unregulated new sources; how quickly the existing capital stock is replaced; the growth in the number of new emissions sources; and how intensively emissions-generating plants and equipment are utilized.

Next, what about those unintended consequences? First, by reducing operating costs, energy-efficiency standards – for example — can cause more intensive use of regulated equipment (for example, air conditioners are run more often), leading to offsetting increases in emissions — the “rebound effect.” Second, firms and households may delay replacing existing equipment if standards make new equipment more costly. This is the well-known problem with vintage-differentiated regulations or “New Source Review.” Third, standards may encourage counterproductive, unintended shifts among regulated activities (for example, from purchasing cars to purchasing SUVs under the CAFE program). All of these unintended consequences result from the problematic incentives that standards can create, compared with the efficient incentives created by a cap-and-trade system (or a carbon-tax, for that matter).

If you favor a regulatory approach, then you may welcome what’s coming from EPA as a result of the Supreme Court ruling of a few years ago combined with the Administration’s endangerment finding. For my part, I don’t welcome it; I worry about it, because the set of regulatory approaches that could be forthcoming will accomplish relatively little, do so at an unnecessarily high cost, and hence play into the hands of opponents of progressive climate policy. (More about that in some other, future post.)

Putting a Price on Carbon

To virtually all participants in the policy world, it has become increasingly clear that the only approach that can do the job and do it cost-effectively is one which involves at its core putting a price on carbon. That leaves cap-and-trade and carbon taxes. Let me take these in turn.

Cap-and-Trade

Let’s step back from the debate regarding the details of the Waxman-Markey House bill or the new Senate proposal by Senators Boxer and Kerry, and think about the essence of the cap-and-trade approach. (For some of those details, however, please see my previous posts, where I have commented on various aspects of Waxman-Markey and described a proposal I developed for The Hamilton Project of an up-stream, economy-wide CO₂ cap-and-trade system to cost-effectively achieve meaningful greenhouse gas emissions reductions.)

Here are the basics. First, aggregate emissions from regulated sources are capped, and the cap is enforced through a requirement for affected firms to hold emissions allowances. Importantly, allowance trading minimizes costs of meeting the cap. It does this because allowances migrate to the highest-valued uses, covering emissions that are the most costly to reduce. So, the emission reductions undertaken are those that are least costly to achieve. In essence, the uniform market price of allowances creates incentives for all covered sources to reduce all emissions, and do so cost-effectively.

A cap-and-trade system can be more environmentally-effective and more cost-effective than standards. First, in terms of environmental-effectiveness, a cap-and-trade system can ensure achievement of emissions targets. Cap-and-trade allows policymakers to set specific overall emissions targets. And a well-enforced system guarantees achievement of those targets, because emissions will not exceed available allowances. An economy-wide, upstream cap-and-trade system on the carbon content of fossil fuels can cover all fossil-fuel-related CO₂ emissions without needing to regulate each emissions source individually.

In terms of cost-effectiveness, a well-designed cap-and-trade system minimizes emission reduction costs. Unlike NO_x, SO₂, and other pollutants, GHG emission reductions have the same effect no matter how, where, or when they are achieved. This makes the climate change problem unique in the degree to which compliance flexibility can be used to lower costs without compromising environmental integrity. Hence, a cap-and-trade system can minimize costs while still meeting environmental objectives by offering three forms of flexibility: what flexibility; where flexibility; and when flexibility.

In regard to “what flexibility,” many types of actions offer low-cost emission reductions, and a cap-and-trade system allows emission reductions through whatever measures are least costly. By contrast, standards can target only certain identified emission reduction measures, leaving other cost-effective opportunities untapped. Furthermore, predictions of what measures are cost-effective may be wrong.

In regard to “where flexibility,” the costs of emission reductions vary widely across industries, across facilities, and even across users of the same equipment. A cap-and-trade system exploits this variation in costs by achieving reductions wherever they are least costly. By contrast, standards would only be cost-effective if they accounted for all of the variation in costs across sectors, technologies, and regulated entities — but it is completely infeasible for standards to do this. Emission reduction costs across sectors and technologies change over time, making the flexibility offered by a cap-and-trade system even more valuable. Also, lower-cost opportunities to reduce emissions may exist in other countries. Importantly, a cap-and-trade system creates a common currency (emissions allowances) that makes it possible to link with other systems.

A cap-and-trade system also minimizes costs through “when flexibility.” Costs can be reduced through flexibility in the timing of emission reductions by avoiding: premature retirement of capital stock or lock-in of existing technologies; and unnecessarily costly reductions in one year due to unusual circumstances when less-costly offsetting reductions can be achieved in other years. A cap-and-trade can incorporate “when flexibility”
without compromising cumulative emissions targets through: allowance banking and borrowing; and multi-year compliance periods.

Beyond such “static cost-effectiveness,” cap-and-trade creates incentives for technology innovation, and thereby lowers long-run costs. By rewarding any means of reducing emissions, a cap-and-trade system provides broad incentives for any innovations that lower the cost of achieving emissions targets. Although standards may encourage development of lower cost means of meeting the standards’ specific requirements, they do not encourage efforts to exceed those standards.

Several cap-and-trade systems have been successful at achieving environmental goals and cost savings: the phase-out of leaded gasoline in the 1980s; the phase-out of ozone depleting substances; and the Clean Air Act amendments of 1990 SO₂ allowance trading program to cut acid rain by 50%. Perceived shortcomings in other cap-and-trade systems reflect design choices, not problems with the policy instrument itself. This applies both to California’s RECLAIM program, and the pilot phase of the EU Emissions Trading Scheme (which is operating successfully in its real, Kyoto phase).

In summary, compared with conventional standards, a cap-and-trade system can be more environmentally-effective and more cost-effective. As with any policy instrument, however, careful design is important.

Taxing Carbon

As I mentioned, it is clear that the only approach that can do the job and do it cost-effectively is one that involves putting a price on carbon. So, what about the other carbon-pricing approach — a carbon tax?

I am by no means opposed to the notion of a carbon tax, having written about such approaches for more than twenty years. Indeed, both cap-and-trade and carbon taxes are good approaches to the problem; they have many similarities, some tradeoffs, and a few key differences. I am opposed, however, to the confused and misleading straw-man arguments that have sometimes been used against cap-and-trade by carbon-tax proponents.

While there are tradeoffs between these two principal market-based instruments targeting CO₂ emissions — a cap-and-trade system and a carbon tax – the best (and most likely) approach for the short to medium term in the United States is a cap-and-trade system. I say this based on three criteria: environmental effectiveness, cost effectiveness, and distributional equity. So, my position is not capitulation to politics. On the other hand, sound assessments of environmental effectiveness, cost effectiveness, and distributional equity should surely be made in the real-world political context.

The key merits of the cap-and-trade approach I have described above are, first, the program can provide cost-effectiveness, while achieving meaningful reductions in greenhouse gas emissions levels. Second, it offers an easy means of compensating for the inevitably unequal burdens imposed by a climate policy. Third, it provides a straightforward means to harmonize with other countries’ climate policies. Fourth, it avoids the current political aversion in the United States to taxes. Fifth, it is unlikely to be degraded – in terms of its environmental performance and cost effectiveness – by political forces. And sixth, this approach has a history of successful adoption and implementation in this country over the past two decades.

Having said this, there are some real differences between taxes and cap-and-trade that need to be recognized. First, environmental effectiveness: a tax does not guarantee achievement of an emissions target, but it does provides greater certainty regarding costs. This is a fundamental tradeoff. Taxes provide automatic temporal flexibility, which needs to be built into a cap-and-trade system through provision for banking, borrowing, and possibly a cost-containment mechanism. On the other hand, political economy forces strongly point to less severe targets if carbon taxes are used, rather than cap-and-trade – this is not a tradeoff, and this is why environmental NGOs are opposed to the carbon-tax approach.

In principle, both carbon taxes and cap-and-trade can achieve cost-effective reductions, and – depending upon design — the distributional consequences of the two approaches can be the same. But the key difference is that political pressures on a carbon tax system will most likely lead to exemptions of sectors and firms, which reduces environmental effectiveness and drives up costs, as some low-cost emission reduction opportunities are left off the table. But political pressures on a cap-and-trade system lead to different allocations of allowances, which affect distribution, but not environmental effectives, and not cost-effectiveness.

Proponents of carbon taxes worry about the propensity of political processes under a cap-and-trade system to compensate sectors through free allowance allocations, but a carbon tax is sensitive to the same political pressures, and may be expected to succumb in ways that are ultimately more harmful: reducing environmental achievement and driving up costs.

The Bottom Line

The Hamilton Project staff concluded in an overview paper (which I highly recommend) that a well-designed carbon tax and a well-designed cap-and-trade system would have similar economic effects. Hence, they said, the two primary questions to use in deciding between them should be: which is more politically feasible; and which is more likely to be well-designed?

The answer to the first question is obvious; and I have argued here that given real-world political forces, the answer to the second question also favors cap-and-trade. In other words, it is important to identify and design policy that will be “optimal in Washington,” not just from the perspective of Cambridge, New Haven, or Berkeley.

In “policy heaven,” the optimal instrument to address climate-change emissions may well be a carbon tax (largely because of its simplicity), but in the real world in which policy is developed and implemented, cap-and-trade is the best approach if one is serious about addressing the threat of climate change with meaningful, effective, and cost-effective policies.