Waxman-Markey legislation Archives - Page 4 of 14 - An Economic View of the Environment

The Second Term of the Obama Administration

In his inaugural address on January 21^st, President Obama surprised many people – including me – by the intensity and the length of his comments on global climate change. Since then, there has been a great deal of discussion in the press and in the blogosphere about what climate policy initiatives will be forthcoming from the administration in its second term.

Given all the excitement, let’s first take a look at the transcript of what the President actually said on this topic:

We will respond to the threat of climate change, knowing that the failure to do so would betray our children and future generations. Some may still deny the overwhelming judgment of science, but none can avoid the devastating impact of raging fires, and crippling drought, and more powerful storms. The path towards sustainable energy sources will be long and sometimes difficult. But American cannot resist this transition. We must lead it. We cannot cede to other nations the technology that will power new jobs and new industries. We must claim its promise. That’s how we will maintain our economic vitality and our national treasure, our forests and waterways, our crop lands and snow capped peaks. That is how we will preserve our planet, commanded to our care by God.

Strong and plentiful words. Although I was certainly surprised by the strength and length of what the President said in his address, I confess that it did not change my thinking about what we should expect from the second term. Indeed, I will stand by an interview that was published by the Harvard Kennedy School on its website five days before the inauguration (plus something I wrote in a previous essay at this blog in December, 2012). Here it is, with a bit of editing to clarify things, and some hyperlinks inserted to help readers.

The Second Term: Robert Stavins on Energy and Environmental Policy

January 16, 2013

By Doug Gavel, Harvard Kennedy School Communications

President Obama’s second term in office began on Inauguration Day, January 21st, and the list of policy challenges facing his administration is daunting. Aside from the difficult task of addressing the nation’s economic woes, the president and his administration will also deal with the increasing complexities of global climate change, a rapidly changing energy market, entitlement and tax reform, healthcare reform, and the repercussions from the still simmering “Arab Spring.” Throughout this month, we will solicit the viewpoints of a variety of HKS faculty members to provide a range of perspectives on the promise and pitfalls of The Second Term.

We spoke with Robert Stavins, Albert Pratt Professor of Business and Government, and Director of the Harvard Environmental Economics Program, about energy and environmental policy issues the president will face in the next four years.

Q: What are the top priorities for a second Obama administration in energy and environmental policy?

A: The Obama administration faces a number of impending challenges in the energy and environmental policy realm in its second term, which I would characterize – in very general terms – as finding balance among three competing factors: (1) demands from some constituencies for more aggressive environmental policies; (2) demands from other constituencies – principally in the Congress – for progress on so-called “energy security;” and (3) recognition that nothing meaningful is likely to happen if the country’s economic problems are not addressed.

Q: What will be the potential challenges/roadblocks in the way of implementing those top priorities?

A: The key challenge the administration faces in its second term as it attempts to achieve some balance among these three competing objectives is the reality of a very high degree of political polarization in the two houses of Congress.

The numbers are dramatic. For example, when the Clean Air Act Amendments of 1990 that established the landmark SO₂ allowance trading system were being considered in the U.S. Congress, political support was not divided on partisan lines. Indeed, environmental and energy debates from the 1970s through much of the 1990s typically broke along geographic lines, rather than partisan lines, with key parameters being degree of urbanization and reliance on specific fuel types, such as coal versus natural gas. The Clean Air Act Amendments of 1990 passed the U.S. Senate by a vote of 89-11 with 87 percent of Republican members and 91 percent of Democrats voting yea, and the legislation passed the House of Representatives by a vote of 401-21 with 87 percent of Republicans and 96 percent of Democrats voting in support.

But, 20 years later when climate change legislation was receiving serious consideration in Washington, environmental politics had changed dramatically, with Congressional support for environmental legislation coming mainly to reflect partisan divisions. In 2009, the U.S. House of Representatives passed the American Clean Energy and Security Act of 2009 (H.R. 2454), often known as the Waxman-Markey bill, that included an economy-wide cap-and-trade system to cut carbon dioxide (CO₂) emissions. The Waxman-Markey bill passed by a narrow margin of 219-212, with support from 83 percent of Democrats, but only 4 percent of Republicans. (In July 2010, the U.S. Senate abandoned its attempt to pass companion legislation.) Political polarization in the Congress (and the country) has implications far beyond energy and environmental policy, but it is particularly striking in this realm.

Q: In the Obama administration’s second term, are there openings/possibilities for compromises in those areas?

A: It is conceivable – but in my view, unlikely – that there may be an opening for implicit (not explicit) “climate policy” through a carbon tax. At a minimum, we should ask whether the defeat of cap-and-trade in the U.S. Congress, the virtual unwillingness over the past 18 months of the Obama White House to utter the phrase “cap-and-trade” in public, and the defeat of Republican Presidential candidate Mitt Romney indicate that there is a new opening for serious consideration of a carbon-tax approach to meaningful CO₂ emissions reductions in the United States.

First of all, there surely is such an opening in the policy wonk world. Economists and others in academia, including important Republican economists such as Harvard’s Greg Mankiw and Columbia’s Glenn Hubbard, remain enthusiastic supporters of a national carbon tax. And a much-publicized meeting in July, 2012, at the American Enterprise Institute in Washington, D.C. brought together a broad spectrum of Washington groups – ranging from Public Citizen to the R Street Institute – to talk about alternative paths forward for national climate policy. Reportedly, much of the discussion focused on carbon taxes.

Clearly, this “opening” is being embraced with enthusiasm in the policy wonk world. But what about in the real political world? The good news is that a carbon tax is not “cap-and-trade.” That presumably helps with the political messaging! But if conservatives were able to tarnish cap-and-trade as “cap-and-tax,” it surely will be considerably easier to label a tax – as a tax! Also, note that President Obama’s silence extends beyond disdain for cap-and-trade per se. Rather, it covers all carbon-pricing regimes.

So as a possible new front in the climate policy wars, I remain very skeptical that an explicit carbon tax proposal will gain favor in Washington. Note that the only election outcome that could have lead to an aggressive and successful move to a meaningful nationwide carbon pricing regime would have been: the Democrats took back control of the House of Representatives, the Democrats achieved a 60+ vote margin in the Senate, and the President was reelected. Only the last of these happened. It’s not enough.

A more promising possibility – though still unlikely – is that if Republicans and Democrats join to cooperate with the Obama White House to work constructively to address the short-term and long-term budgetary deficits the U.S. government faces, and if as part of this they decide to include not only cuts in government expenditures, but also some significant “revenue enhancements” (the t-word is not allowed), and if (I know, this is getting to be a lot of “ifs”) it turns out to be easier politically to eschew increases in taxes on labor and investment and turn to taxes on consumption, then there could be a political opening for new energy taxes, even a carbon tax.

Such a carbon tax – if intended to help alleviate budget deficits – could not be the economist’s favorite, a revenue-neutral tax swap of cutting distortionary taxes in exchange for implementing a carbon tax. Rather, as a revenue-raising mechanism – like the Obama administration’s February 2009 budget for a 100%-auction of allowances in a cap-and-trade scheme – it would be a new tax, pure and simple. Those who recall the 1993 failure of the Clinton administration’s BTU-tax proposal – with a less polarized and more cooperative Congress than today’s – will not be optimistic.

Nor is it clear that a carbon tax would enjoy more support in budget talks than a value added tax (VAT) or a Federal sales tax. The key question is whether the phrases “climate policy” and “carbon tax” are likely to expand or narrow the coalition of support for an already tough budgetary reconciliation measure. The key group to bring on board will presumably be conservative Republicans, and it is difficult to picture them being more willing to break their Grover Norquist pledges because it’s for a carbon tax.

What remains most likely to happen is what I’ve been saying for several years, namely that despite the apparent inaction by the Federal government, the official U.S. international commitment — a 17 percent reduction of CO₂ emissions below 2005 levels by the year 2020 – is nevertheless likely to be achieved! The reason is the combination of CO₂ regulations which are now in place because of the Supreme Court decision [freeing the EPA to treat CO₂ like other pollutants under the Clean Air Act], together with five other regulations or rules on SOX [sulfur compounds], NOX [nitrogen compounds], coal fly ash, particulates, and cooling water withdrawals. All of these will have profound effects on retirement of existing coal-fired electrical generation capacity, investment in new coal, and dispatch of such electricity.

Combined with that is Assembly Bill 32 (AB 32) in the state of California, which includes a CO₂ cap-and-trade system that is more ambitious in percentage terms than Waxman-Markey was in the U.S. Congress, and which became binding on January 1, 2013. Add to that the recent economic recession, which reduced emissions. And more important than any of those are the effects of developing new, unconventional sources of natural gas in the United States on the supply, price, and price trajectory of natural gas, and the consequent dramatic movement that has occurred from coal to natural gas for generating electricity. In other words, there will be actions having significant implications for climate, but most will not be called “climate policy,” and all will be within the regulatory and executive order domain, not new legislation.

Q: Are there lessons that a second Obama administration can draw upon from the first administration, or from history, when constructing its energy & environmental policy over the next four years?

A: It will take a great deal of dedicated effort and profound luck to find political openings that can bridge the wide partisan divide that exists on climate change policy and other environmental issues. Think about the following. Nearly all our major environmental laws were passed in the wake of highly publicized environmental events or “disasters,” including the spontaneous combustion of the Cuyahoga River in Cleveland, Ohio, in 1969, and the discovery of toxic substances at Love Canal in Niagara Falls, New York, in the mid-1970s. But note that the day after the Cuyahoga River caught on fire, no article in The Cleveland Plain Dealer commented that the cause was uncertain, that rivers periodically catch on fire from natural causes. On the contrary, it was immediately apparent that the cause was waste dumped into the river by adjacent industries. A direct consequence of the observed “disaster” was, of course, the Clean Water Act of 1972.

But climate change is distinctly different. Unlike the environmental threats addressed successfully in past U.S. legislation, climate change is essentially unobservable to the general population. We observe the weather, not the climate. Notwithstanding last year’s experience with Super Storm Sandy, it remains true that until there is an obvious, sudden, and perhaps cataclysmic event – such as a loss of part of the Antarctic ice sheet leading to a dramatic sea-level rise – it is unlikely that public opinion in the United States will provide the tremendous bottom-up demand that inspired previous congressional action on the environment over the past forty years.

That need not mean that there can be no truly meaningful, economy-wide climate policy (such as carbon-pricing) until disaster has struck. But it does mean that bottom-up popular demand may not come in time, and that instead what will be required is inspired leadership at the highest level that can somehow bridge the debilitating partisan political divide.

Postscript: Please note that the Kennedy School series on the second term of the Obama administration also includes an interview with my colleague, Professor Joseph Aldy, offering his own views on potential environmental policy developments in the next four years.

Cap-and-Trade, Carbon Taxes, and My Neighbor’s Lovely Lawn

The recent demise of serious political consideration of an economy-wide U.S. CO₂ cap-and-trade system and the even more recent resurgence in interest among policy wonks in a U.S. carbon tax should prompt reflection on where we’ve been, where we are, and where we may be going.

Lessons

Almost fifteen years ago, in an article that appeared in 1998 in the Journal of Economic Perspectives, “What Can We Learn from the Grand Policy Experiment? Lessons from SO₂ Allowance Trading,” I examined the implications of what was then the very new emissions trading program set up by the Clean Air Act Amendments of 1990 to cut acid rain by half over the succeeding decade. In that article, I attempted to offer some guidance regarding the conditions under which cap-and-trade (then known as “tradable permits”) was likely to work well, or not so well. Here’s a brief summary of what I wrote at the time:

(1) SO₂ trading was a case where the cost of abating pollution differed widely among sources, and where a market-based system was therefore likely to have greater gains, relative to conventional, command-and-control regulations (Newell and Stavins 2003). It was clear early on that SO₂ abatement cost heterogeneity was great, because of differences in ages of plants and their proximity to sources of low-sulfur coal. But where abatement costs are more uniform across sources, the political costs of enacting an allowance trading approach are less likely to be justifiable.

(2) The greater the degree to which pollutants mix in the receiving airshed or watershed, the more attractive a cap-and-trade (or emission tax) system will be, relative to a conventional uniform standard. This is because taxes or cap-and-trade can – in principle – lead to localized “hot spots” with relatively high levels of ambient pollution. Some states (in particular, New York) tried unsuccessfully to erect barriers to trades they thought might increase deposition within their borders. This is a significant distributional issue. It can also be an efficiency issue if damages are nonlinearly related to pollutant concentrations.

(3) The efficiency of a cap-and-trade system will depend on the pattern of costs and benefits. If uncertainty about marginal abatement costs is significant, and if marginal abatement costs are quite flat and marginal benefits of abatement fall relatively quickly, then a quantity instrument, such as cap-and-trade, will be more efficient than a price instrument, such as an emission tax (Weitzman 1974). With a stock pollutant (such as CO₂), this argument favors a price instrument (Newell and Pizer 2003). However, when there is also uncertainty about marginal benefits, and marginal benefits are positively correlated with marginal costs (which, it turns out, is a relatively common occurrence for a variety of pollution problems), then there is an additional argument in favor of the relative efficiency of quantity instruments (Stavins 1996).

(4) Cap-and-trade will work best when transaction costs are low (Stavins 1995), and the S0₂ experiment showed that if properly designed, private markets will tend to render transaction costs minimal.

5) Considerations of political feasibility point to the wisdom of proposing trading instruments when they can be used to facilitate emissions reductions, as was done with SO₂ allowances and lead rights trading, less so for the purpose of reallocating existing emissions abatement responsibility (Revesz and Stavins 2007).

(6) National policy instruments that appear impeccable from the vantage point of Cambridge, Massachusetts, Berkeley, California, or Madison, Wisconsin, but consistently prove infeasible in Washington, D.C., can hardly be considered “optimal.”

Implications for CO₂ Policy

In the same article, I noted that many of these issues could be illuminated by considering a concrete example: the “current interest” in applying cap-and-trade to the task of cutting CO₂ emissions to reduce the risk of global climate change. Some of the points I made in this regard in my 1998 article were:

(a) The number of sources of CO₂ emissions are vastly greater than in the case of SO₂ emissions as a precursor of acid rain, where the focus could be placed on a few hundred electric utility plants. Feasibility considerations alone argue for market-based instruments (cap-and-trade or taxes) to achieve meaningful reductions of CO₂ emissions.

(b) The diversity of sources of CO₂ in a modern economy and the consequent heterogeneity of emission reduction costs bolster the case for using cost-effective market-based instruments.

(c) As the ultimate global-commons problem, CO₂ is a truly uniformly-mixed pollutant. With no concern for hot spots, market-based instruments present none of the problems that can arise in the case of localized environmental threats.

(d) Any pollution-control program must face the possibility of emissions leakage from regulated to unregulated sources. This would be a severe problem for an international CO₂ program, where emissions would tend to increase in nonparticipant countries. Furthermore, it raises concerns for the emission-reduction-credit (not cap-and-trade) system in the Kyoto Protocol known as the Clean Development Mechanism (CDM). Such an offset system can lower aggregate costs by substituting low-cost for high-cost control, but may also have the unintended effect of increasing aggregate emissions beyond what they would otherwise have been, because there is an incentive for adverse selection: sources in developing countries that would reduce their emissions, opt in, and receive credit for actions they would have taken anyway.

(e) Although any trading program could potentially serve as a model for the case of global climate change, I argued that the trading system that accomplished the U.S. phaseout of leaded gasoline in the 1980s merited particular attention. The currency of that system was not lead oxide emissions from motor vehicles, but the lead content of gasoline. So too, in the case of global climate, great savings in monitoring and enforcement costs could be had by adopting input trading linked with the carbon content of fossil fuels. This is reasonable in the climate case, since – unlike in the SO₂ case – CO₂ emissions are roughly proportional to the carbon content of fossil fuels and scrubbing alternatives are largely unavailable, at least at present.

(f) Natural sequestration of CO₂ from the atmosphere by expanding forested areas is available (even in the United States) at reasonable cost (Stavins 1999). Hence, it could be valuable to combine any carbon trading (or carbon tax) program with a carbon sequestration program, although this will raise significant challenges in regard to monitoring and enforcement.

(g) In regard to carbon permit allocation mechanisms, auctions would have the advantage that revenues could be used to finance reductions in distortionary taxes. Free allocation could increase regulatory costs enough that the sign of the efficiency impact could conceivably be reversed from positive to negative net benefits (Parry, Williams, and Goulder 1999). On the other hand, free allocation of carbon permits would meet with much less political resistance.

The Necessity of Market-Based Instruments: Cap-and-Trade or Carbon Taxes

I concluded that developing a cap-and-trade system for climate change would bring forth an entirely new set of economic, political, and institutional challenges. At the same time, I recognized that the diversity of sources of CO₂ emissions and the magnitude of likely abatement costs made it equally clear that only a market-based instrument – some form of carbon rights trading or (probably revenue-neutral) carbon taxes – would be capable of achieving the domestic targets that might eventually be forthcoming.

In other words, my conclusion in 1998 strongly favored a market-based carbon policy, but was somewhat neutral between carbon taxes and cap-and-trade. Indeed, at that time and for the subsequent eight years or so, I remained agnostic regarding what I viewed as the trade-offs between cap-and-trade and carbon taxes. What happened to change that? Three words: The Hamilton Project.

The Making of an Advocate

For those of you who don’t know, the Hamilton Project is an initiative based at the Brookings Institution that – according to its web site – “offers a strategic vision and produces innovative policy proposals on how to create a growing economy that benefits more Americans.”

In 2007, the Project’s leadership asked me to write a paper proposing a U.S. CO₂ cap-and-trade system. I responded that I would prefer to write a paper proposing the use of a market-based CO₂ policy, describing the two alternatives of cap-and-trade and carbon taxes. I explained that I was by no means opposed to the notion of a carbon tax, having written about such approaches for more than twenty years. Indeed, I noted, both cap-and-trade and carbon taxes would be good approaches to the problem; they have many similarities, some tradeoffs, and a few key differences.

The Hamilton Project leaders said no, they wanted me to make the best case I could for cap-and-trade, not a balanced investigation of the two policy instruments. Someone else would be commissioned to write a proposal for a carbon tax. (That turned out to be Professor Gilbert Metcalf of Tufts University – now on leave at the U.S. Department of the Treasury – who did a splendid job!) Thus, I was made into an advocate for cap-and-trade. It’s as simple as that.

Giving It My Best Shot

I argued in my Hamilton Project paper (which you can read here) that despite the tradeoffs between the two principal market-based instruments that could target CO₂ emissions, the best (and most likely) approach for the short to medium term in the United States was a cap-and-trade system, based on three criteria: environmental effectiveness, cost effectiveness, and distributional equity. Although my position was not simple capitulation to politics, I argued that sound assessments of environmental effectiveness, cost effectiveness, and distributional equity should be made in a real-world political context.

I said that the key merits of the cap-and-trade approach were, first, the program could provide cost-effectiveness, while achieving meaningful reductions in greenhouse gas emissions levels. Second, it offered an easy means of compensating for the inevitably unequal burdens imposed by a climate policy. Third, it provided a straightforward means to link with other countries’ climate policies. Fourth, it avoided the political aversion in the United States to taxes. Fifth, it was unlikely to be degraded – in terms of its environmental performance and cost effectiveness – by political forces. And sixth, this approach had a history of successful adoption and implementation in this country over the past two decades.

I recognized that there were some real differences between taxes and cap-and-trade that needed to be recognized. First, environmental effectiveness: a tax does not guarantee achievement of an emissions target, but it does provide 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 cost-containment mechanisms. 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 is why virtually no environmental NGOs have favored 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 the free allowances, which affect distribution, but not environmental effectiveness, and not cost-effectiveness.

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

Of course, such positive political economy arguments look much less compelling in the wake of the defeat of cap-and-trade legislation in the U.S. Congress and its successful demonization by conservatives as “cap-and-tax.”

A Political Opening for Carbon Taxes?

Does the defeat of cap-and-trade in the U.S. Congress, the obvious unwillingness of the Obama White House to utter the phrase in public, and the outspoken opposition to cap-and-trade by Republican Presidential candidate Mitt Romney indicate that there is a new opening for serious consideration of a carbon-tax approach to meaningful CO₂ emissions reductions?

First of all, there surely is such an opening in the policy wonk world. Economists and others in academia, including important Republican economists such as Harvard’s Greg Mankiw and Columbia’s Glenn Hubbard, remain enthusiastic supporters of a national carbon tax. And a much-publicized meeting in July at the American Enterprise Institute in Washington, D.C. brought together a broad spectrum of Washington groups – ranging from Public Citizen to the R Street Institute – to talk about alternative paths forward for national climate policy. Reportedly, much of the discussion focused on carbon taxes.

Clearly, this “opening” is being embraced with enthusiasm in the policy wonk world. But what about in the real political world? The good news is that a carbon tax is not “cap-and-trade.” That presumably helps with the political messaging! But if conservatives were able to tarnish cap-and-trade as “cap-and-tax,” it surely will be considerably easier to label a tax – as a tax! Also, note that Romney’s stated opposition and Obama’s silence extend beyond disdain for cap-and-trade per se. Rather, they cover all carbon-pricing regimes.

So as a possible new front in the climate policy wars, I remain very skeptical that an explicit carbon tax proposal will gain favor in Washington, no matter what the outcome of the election. Note that the only election outcome that could lead to an aggressive and successful move to a meaningful nationwide carbon pricing regime would be: the Democrats take back control of the House of Representatives, and the Democrats achieve a 60+ vote margin in the Senate, and the President is reelected. A quick check at Five Thirty Eight (Nate Silver’s superb election forecast website at the New York Times) and other polling web sites makes it abundantly clear that the probability of such Democratic control of the White House and Congress is so small that it’s hardly worth discussing.

What About Fiscal Policy Reform?

A more promising possibility – though still unlikely – is that if Republicans and Democrats join to cooperate with either a Romney or Obama White House to work together constructively to address not only the short-term fiscal cliff at the end of this calendar year, but also the longer-term budgetary deficits the U.S. government faces, and if as part of this they decide to include not only cuts in government expenditures, but also some significant “revenue enhancements” (the t-word is not allowed), and if (I know, this is getting to be a lot of “if’s”) it turns out to be easier politically to eschew increases in taxes on labor and investment and therefore turn to taxes on consumption, then there could be a political opening for new energy taxes, in particular, (drum roll ….) a carbon tax.

Nor is it clear that a carbon tax would enjoy more support in budget talks than a value added tax (VAT) or a Federal sales tax. The key question is whether the phrases “climate policy” or “carbon tax” are likely to expand or narrow the coalition of support for an already tough budgetary reconciliation measure. The key group to bring on board will presumably be conservative Tea Party Republicans, and it is difficult to picture them being more willing to break their Grover Norquist pledges because it’s for a carbon tax.

Research

Even if the much-ballyhooed political opening for carbon taxes is largely illusory, the opening for policy wonks is real. And here is where action is happening, and should continue to happen. At some point the politics will change, and it’s important to be ready. This is why economic research on carbon taxes is very much needed, particularly in the context of broader fiscal challenges, and it is why I’m pleased to see it happening at Resources for the Future, Harvard University, and elsewhere.

Bottom Line

I would personally be delighted if a carbon tax were politically feasible in the United States, or were to become politically feasible in the future. But I’m forced to conclude that much of the current enthusiasm about carbon taxes in the academic and broader policy-wonk community in the wake of the defeat of cap-and-trade is – for the time being, at least – largely a manifestation of the grass looking greener across the street.

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

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

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

The Coase Theorem and the Independence Property

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

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

The Practical Political Importance of the Independence Property

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

In Theory, Does the Property Always Hold?

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

In Reality, Has the Property Held?

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

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

Politicians Have Had it Right

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

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