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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.

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.

In Defense of Markets

Cap-and-trade has been demonized by conservatives as part of an effective strategy to stop climate legislation from moving forward in the U.S. Congress. As I wrote in my previous blog post (“Beware of Scorched-Earth Strategies in Climate Debates,” July 27, 2010), this unfortunate tarnishing of market-based instruments for environmental protection will come back to haunt conservatives and liberals alike when it becomes politically difficult to use the power of the marketplace to reduce business costs in the pursuit of a wide variety of environmental objectives.

Cap-and-trade has been vilified as a national energy tax, an elaborate Ponzi scheme, and a giveaway to corporate polluters. The fact that none of these attacks are factually correct has not seemed to reduce their political effectiveness. This is one element of the poisonous atmosphere which has come to dominate so much of national political discourse, at least in this election year.

When Senate leaders decided they could not assemble the sixty votes necessary to cut-off debate on meaningful climate legislation, they pulled nationwide, economy-wide cap-and-trade off the table, quite possibly until after a new Congress is seated in January of 2013. But when serious attention is again given to meaningful national climate policy, as it surely will be, consideration will inevitably include carbon-pricing, whether in the form of carbon taxes or cap-and-trade, because these approaches have tremendous advantages over the alternatives (“The Real Options for U.S. Climate Policy,” June 23rd, 2010).

Therefore, it is important to set the record straight, and respond to at least some of the attacks that have been made on cap-and-trade specifically and carbon-pricing broadly. That is the fundamental purpose of an Issue Brief Dr. Janet Peace and I have written. Our report, “In Brief: Meaningful and Cost Effective Climate Policy: The Case for Cap and Trade,” was published by the Pew Center on Global Climate Change in June, 2010. In today’s blog post, I will highlight just a few of our findings.

Questions and Concerns

While the justification for putting a price on carbon emissions seems straightforward to most policy analysts, some of the public and even some policy makers have questioned whether creating a market for greenhouse gas (GHG) reductions would be a cure worse than the disease itself:

Why employ market-based approaches to GHG emission reductions, when markets are subject to manipulation?
Would a market-based approach to reducing greenhouse gas emissions be a corporate handout?
Can markets be trusted to reduce emissions?
Will a market-based approach, such as cap-and-trade, be too costly?
Are other approaches likely to be more effective and less complicated?

In our Pew Center report, Janet Peace and I respond to all of these questions, but in today’s blog post I will highlight our response just to the first question. For the full and complete story, I urge readers to see the original report, which can be downloaded freely from the Pew Center’s web site.

Why create a market for GHG emissions, when markets – in general – are subject to manipulation and have failed terribly?

With the U.S. economy experiencing its worst recession since the Great Depression, amidst corporate scandals, pyramid schemes, and a series of government bailouts, some members of the public as well as elected officials have come to question the ability of markets to perform their basic functions. Despite the past successes of market mechanisms to address environmental problems such as acid rain, leaded gasoline, and stratospheric ozone depletion, this growing distrust of markets has led some to question whether market-based approaches are appropriate instruments to help tackle the exceptionally challenging problem of global climate change.

The storyline goes roughly like this: establishing a “carbon market” for greenhouse gas emissions opens the door for financial intermediaries – banks and brokers – to be involved. Since we know that they cannot be trusted, and only care about making profits (and not about reducing emissions), how could any approach that involves them be part of an effective solution?

In reality, of course, our recent economic turmoil does not mean that “markets” in any general sense do not work; only that markets require appropriate oversight. Our economy fundamentally is a market-based system, but oversight – including, where appropriate, effective rules and regulations – can be essential to ensure transparency and prevent manipulation.

With appropriate rules and oversight, markets have been shown to work exceptionally well to address environmental problems. They provide key flexibility to regulated entities to adopt least-cost approaches to emission reductions, while providing powerful incentives for technological innovation and diffusion, which serve to reduce costs over time. Real world experiences with using market-based instruments for environmental protection include CFC trading under the Montreal Protocol (to protect the ozone layer); SO₂ allowance trading under the U.S. Clean Air Act Amendments of 1990 (to curb acid rain); NO_x trading (to control regional smog in the eastern U.S.); and eliminating lead from gasoline in the 1980s.

Studies that have evaluated the performance of these market-based approaches to environmental protection have found that they have achieved their environmental objectives and have done so at lower cost than conventional, command-and-control approaches. Estimates of cost savings range from 7 percent to 96 percent, with more than half of studies showing that market-based programs cut the cost of regulation by well over 50% compared with command-and-control options. For example, the SO₂ allowance trading program resulted in 33 percent cost savings — on the order of $1 billion annually, while reducing power-sector emissions from 15.7 million tons in 1990 to 7.6 million tons million tons in 2008. The phase-down of leaded gasoline in the 1980s, which employed trading of environmental credits, was also successful in meeting its environmental targets, while yielding cost savings of about $250 million per year.

The evidence is incontrovertible – market-based approach to environmental protection can work, effectively achieving environmental targets and keeping costs to a minimum. These approaches are not deregulation, but reformed and improved regulation. And like all markets, these environmental markets need rules and oversight.

A Real and Pressing Problem

The fundamental reason why we face the threat of global climate change is that there is no price or cost for emitting greenhouse gases. In the absence of a price, the damages associated with a changing climate are not considered by companies or individuals when they make their energy choices. A cap-and-trade policy creates this price by establishing a limit on the amount of greenhouse gas emissions and allowing firms covered by the program the flexibility to trade allowances. The environmental integrity of the program is ensured by the “cap” on emissions, and the costs of the program are kept as low as possible through the creation of a market (where firms can buy and sell allowances).

Concern about financial markets and fraudulent investment scams has created an atmosphere of distrust regarding the functioning and effectiveness of markets. By extension, questions have been raised about the wisdom of creating a market with a cap-and-trade program for controlling greenhouse gases. In truth, appropriate oversight and regulation of carbon markets will be required. The problem has been the abuse of markets, not something fundamental about markets themselves.

Climate change is a real and pressing problem. Strong government actions are required, as well as enlightened political leadership at the national and international levels. Creation of a market for greenhouse gas emissions can work, but is contingent on government action to establish this policy. When the Congress decides to return to this issue – as it inevitably will – cap-and-trade policy specifically and carbon-pricing generally must be considered seriously and debated honestly, otherwise it will be fundamentally impossible to provide the right incentives to put the United States on a climate-friendly path of robust and sustainable economic growth.

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P.S. For those of you interested in the important climate policy developments that are occurring in the state of California, you may find of 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.