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Cap and Trade: A Tangled Web of Good Intentions and Bad Policy – Part 1 October 26, 2009

Posted by Michael Hoexter in Efficiency/Conservation, Energy Policy, Green Transport, Renewable Energy.
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I favor some of the more aggressive actions to avert climate catastrophe, actions which nevertheless do not compromise the continuity of human life and well-being. The climate which enabled our evolution as a species and the societies upon which we depend has almost no price attached to it. Averting this calamity, if we can, is the moral equivalent of war. As such it deserves the investment and political priorities that are accorded the military during a war, though the necessary moral and climate-science arguments for this level of investment have not been made clearly by leaders, especially in the US.   In our Great Recession, a forward-looking policy to counter climate change would have much needed economic benefits and lay the foundation of the new economy that we are supposed to be building.

Unfortunately, the mental “real estate” of climate activists and politicians has been captured by a monumentally bad idea, a misapplication of an environmental regulatory system that encourages delay and irresponsibility in climate action rather than changing the course of our society’s use of energy and land. Whatever urgency is felt popularly or by leaders, the institutions that will arise from the cap and trade policy framework have a good chance of actually blocking more effective action on climate (more straightforward system of rules, incentives, disincentives, and direct investment), which makes the work of exposing its flaws not simply the matter of my or someone else’s political or economic preferences but one of life and death for future generations and the ecosystems upon which we depend. An unquestioning herd mentality has taken over and encouraged even some of our best social scientific minds, including Nobelist Paul Krugman, to issue statements of support for a policy inspired by an outdated political and economic fashion of which Krugman is himself one of the leading critics.

Somehow a connection is not being made between the monumental collapse of our financial systems over 13 months ago and the design of the twenty-year-old policy instrument to which so much unearned credence has been given. Fundamental to cap and trade is the hand-off of key responsibilities and agency (the ability to act) for cutting carbon emissions to a carbon derivatives trading market, an unnecessary gift to the hyper-caffeinated and overgrown trading sector of finance. Just this week, critics of the Obama Administration’s earlier weaker financial regulatory efforts are now feeling somewhat vindicated in seeing that the Administration is now stepping up its efforts to rein in financial engineering and trading-dominated finance. It is utterly baffling that people who are intelligent enough to design or just understand an over-complicated policy instrument like cap-and-trade have not made the connection between the origins of cap and trade and the vagaries of our financial system. For them, the cap and trade instrument is still wrapped in the mystique of trading-based markets, which outside the climate community have lost much of their appeal.

It is an open secret among people who actually work now in cutting emissions by implementing energy efficiency and renewable energy projects that cap and trade is at best a holding pattern if not a monumental roadblock to pushing ahead with deployment, investment and research in emissions reductions themselves. These voices, generally excluded from the political discussion, contradict the “line” that, for instance, the upcoming legislation from the US Congress centered around cap and trade is a “clean energy jobs bill” and is the very heart of a green economy. While cap and trade is complex, these criticisms come not from a lack of economic or even political understanding but from a realistic appraisal of how actual lower-carbon technology implementation decisions get made, an elementary business process which seems to have escaped study by the policy’s designers. Cap and trade is not too stringent or too effective but not nearly effective enough.

The fundamental problem with cap and trade is that it placates government leaders and activists with manifest good intentions while undermining the effectiveness of the only instruments which could realize those good intentions. Cap and trade inserts a layer of obfuscation and indirection into governments’ ability to make rules, implement programs, build public works, and levy taxes in a fair and transparent manner.   On another level, it has a faulty microeconomics, inserting uncertainty about the value of emissions reductions to the businesses that will actually cut emissions via responding to the policy.  While working with ineffectual or superficially “P.C.” policy instruments might be acceptable in other matters, in climate policy the massive open-air experiment that has been cap and trade over the past 15 years is an unfolding catastrophe. It is not unlike the Trojan Horse, in that cap and trade appears as a gift, yet gives the vandals or just climate do-nothings command of the citadel. Tragically, the barrage of criticism and invective from the loony political Right or from professional contrarians who have lost a sense of proportion, distracts well-intentioned lawmakers and their supporters from seeing the flaws of their chosen policy.

Cap and Trade in Summary

Briefly, the cap and trade systems under discussion are permit trading systems that attempt to limit emissions of greenhouse gases by allowing polluters to emit greenhouse gases to the amount for which they possess permits. Permits are either given away or auctioned off up to the amount of a society-wide or economic sector-wide “cap” determined by regulators, which is supposed to be “tightened” (meaning reduced) over the years, leading to the decades long equivalent of a game of musical chairs. Regulators, as is planned, will in the future remove “chairs” by reducing the number of permits available to the point where by 2050 there would only be permits for 20% of 1990 greenhouse gas emissions. The “trade” part happens when companies have excess permits, because of having polluted less or owning unneeded permits. They can sell these excess permits for a profit to companies that pollute more than the amount of permits that they own. There have been various attempts to re-brand cap and trade with a name that sounds somewhat less shady, like “market-based cap” etc..

Derived from the speculations of the economists Ronald Coase (1960) and Martin Weitzman (1974), cap and trade, also called emissions trading, was invented in the US in the late 1980’s and early 1990’s during the first Bush Administration as a way to avoid issuing  so-called “command-and-control” environmental regulation by government (telling industry exactly what to do and monitoring it) or direct monetary penalties like pollution taxes. The original cap and trade system for acid rain pollution which is still in place in the US, has been declared responsible for reducing by 40% sulfur emissions (SOx) by coal-burning power plants in the period 1990-2004. However, during the same time period, European and Japanese regulators have been markedly more successful using traditional regulations in cutting the emissions of these same pollutants (65%) from power plants, revealing the cap and trade system to be the equivalent of a regulatory stunt: “See! Look Ma…no hands!”  In a 2007 review of  the results of emissions trading, Gar Lipow has led the way in calling into question the sales pitch for cap and trade.

As an example, the highly coal-dependent, heavily industrial Czech Republic went from in 1990 emitting two times the amount of SOx per capita as the US to in 2004 emitting approximately one-half the amount of SOx per capita as the US (UNECE report page 68).  While most post-Communist societies have decreased all types of emissions substantially due de-industrialization, economic hard times, or adoption of modern emissions controls, the Czech Republic had in 2006 twice as much industry as a percentage of GDP and uses as a percentage of total energy supply twice as much coal as the US, revealing the US to be far from a leader in reducing acid rain pollution.   Furthermore, the cap and trade system’s success has been aided in America by the accessibility of low-sulfur coal at an equivalent price to coal with higher sulfur content; Wyoming’s Powder River Basin coal deposits have been the “wind beneath the wings” of the US anti-acid rain program such as it is.   From the perspective of these results, holding out the SOx regulatory system of the US as the pivotal policy to save the planet stretches credulity.

Cap and Trade and Greenhouse Gases

The road to applying cap and trade to climate change had a number of twists and turns. Before implementing a climate policy, in 1993 the newly-formed Clinton Administration had attempted to institute a BTU energy tax as a means of raising revenue but was rebuffed by Congress. The Administration considered this experience along with its frustrated health care reform effort a major early defeat that shaped later thoughts on policy and political strategy; these fateful events 16 years ago unfortunately have had inordinate effect on US and world climate policy since then.

The Clinton Administration subsequently in the negotiations surrounding the Kyoto treaty to limit greenhouse gas (GHG) emissions favored “flexibility” and helped engineer a consensus in favor of cap and trade and cross-border emissions swaps.   While a “wonky” intellectual interest in emissions trading may have played a role, the Clinton Administration also thought that this policy would have domestic political benefits as a means to circumvent a policy that had the “tax” label or appeared to tell industry what exactly to do (direct regulation).   Using cap and trade also was an effort to “reach across the aisle” as the first cap and trade system had been implemented under the Presidency of the first George Bush.  In other areas of the economy, in tune with economic fashion of the 1980’s and 90’s, the Clinton Administration was as fascinated by markets as its Republican predecessors and, additionally, had a penchant for policy complexity, within which the notion of using a market to regulate other markets seemed almost commonsensical.

In 1998, despite pressing for cap and trade as the international GHG regulating instrument, the Clinton Administration compromised with an intransigent US Congress by not ratifying the Kyoto treaty, insisting that the developing world must be included in the regulation of greenhouse gases.  The elaborate political ploy in using cap and trade failed as far as US politics were concerned.  Other industrialized nations, most notably Europe and Japan, and the relevant UN bureaucracies continued developing the carbon market and cap and trade concept without direct US involvement during the later Clinton and Bush years.  The Protocol went into effect in most industrial countries in 2005 after a lengthy period of negotiation and set-up.

While emissions have been cut in some countries, the experience of the first four years of international carbon regulation via cap and trade have not shown the instrument to be particularly capable of effecting meaningful reductions in carbon emissions. In the European Union Emissions Trading Scheme (EU ETS), affiliated with Kyoto, the effects of the economic downturn or a future upturn are making any evaluation of the effect of cap and trade on emissions a near impossibility.   The use of carbon offsets originating in developing countries will further cloud the data.    In its initial 3 year period (2005-2007), GHG emissions in the EU ETS went up by 1.9% with wide nation by nation variation ranging from Sweden (-20%) to Finland (+28.5%).   Multiple reasons are possible for the wide span between countries and more generally many self-issued excuses are rampant because of the acknowledged complexity of the system; this was a “run-in period” etc.  In 2008 there is missing data but it appears that a combination of the economic downturn and high energy prices (not necessarily attributable to a carbon price) led to a fall of GHG emissions of 3% from 2007 in the EU, which the managers of the EU-ETS attributed to the carbon “price signal”  generated by the trading scheme.   In the same period (2007-2008) without a national GHG cap and trade system, US emissions fell 2.8% for similar reasons, contradicting the claims of EU ETS managers that cap and trade had an effect in 2008.   The net contribution of carbon trading to emissions reductions is still, 12 years after Kyoto, indistinguishable from “noise” in the data.

While it is universally agreed that “errors” were made in giving away too many permits in the initial round of Kyoto/EU-ETS, it is a strange repeat of these supposed errors that the now proposed US cap and trade system being debated in Congress will as of this writing also give away most of its permits for about the next decade. Furthermore the use of offsets, the (supposed) emissions cuts by others that are purchased on an international market because they are cheaper than internal investments, has been controversial both in design and in implementation.  Whatever one’s view on carbon arbitrage (shopping around for the cheapest reductions around the world), it is universally agreed that offsets reduce pressure on the biggest polluters to take action now in reducing their own emissions. The notion of cap and trade being a system of indulgences for fossil fueled economies is further reinforced by this disturbing propensity of real-existing, as opposed to theoretical-ideal, GHG cap and trade systems to undermine themselves or soften their impact on the biggest sources of emissions.

In Copenhagen in December at COP15, the successor to the Kyoto process (2005-2012) is to be designed and most of the climate community is moving towards a new cap and trade-based treaty that activists hope will be more vigorous than the previous one. Yet the trenchant criticisms of cap and trade systems that emerge from economists, most notably William Nordhaus, and concerned economic actors on the ground are brushed aside by those congregated at these events who seem to feel that their good intentions can substitute for conscientious analysis. For instance, almost every economist, including cap and trade supporter Sir Nicholas Stern, has had to agree at one point or another that carbon taxation is more efficient than the baroque emissions trading systems we have built.

Furthermore, we in the US are put in the difficult position of being a laggard in a process that is based upon our own bad idea, and upon which we really never followed through in its original form. In a way, the Obama Administration is, as it may be doing with its Afghanistan policy, put in the position of fighting the last Democratic President’s war rather than designing a more future-looking policy; having defined the political choice as cap and trade or, as the Republican opposition to Obama would have it, no strong action on climate change, the Democrats and Obama should instead be looking for the way to a more effective climate policy. The cap and trade framework, a product of some tortured political logic from the Bush and Clinton years, has “captured” the discussion, limiting thought and discourse on what are the available instruments to avert this catastrophe.

In its defense, permit trading may be appropriate as a distribution mechanism though not a magical cure-all in certain environmental arenas, most particularly the regulation of fisheries. In many nations now “catch-shares” are allocated to fishers who can trade these shares with other fishers. However, the ultimate success of even this appropriate use is achieved by the government setting limits on the fishing industry, not by yielding to some invisible hand of a fabricated market: the total amount of the permits allowed would need to be determined beforehand with reference to study of the fishery by biologists unaffiliated with industry and fishing limits would need to be enforced by government regulators, albeit according to the number of permits that the fisher owns. The appropriateness of permit trading as a distributional mechanism in this instance is that

  1. one is trying to calibrate exploitation of a natural resource at a particular level rather than reduce it in one direction (lower is almost always going to be better with GHG emissions for the foreseeable future.
  2. The permit trading is a just a new layer inside an existing historical market for fish which have an intrinsic positive economic value for people but are not arbitrarily created by people (it’s “inelastic”).  Pollution permits are on the other hand entirely an arbitrary creation of government(s), so the determination of a pollution price via the market is similar to playing a game of “guess what’s on my mind.”
  3. A simple intuitive equation can be made by all fishing market participants between a permit and a tradable object of recognized economic value, i.e. the fish.

All types of permit trading, whether of emissions or other, have provoked ethical controversy with regard to the selling of ownership shares to a public or natural common good. Despite these reservations, in the case of fisheries, fishers already have a longstanding tradition of claiming ownership of what they catch so permit trading represents not much of an innovation in resource ownership in fishing.

Why Cap and Trade is Bad News for Our Climate’s Future

There are a number of fundamental problems with cap and trade systems that are deeply embedded within the policy or its likely implementations, which suggest that working towards alternatives, even if they too are imperfect, is preferable. Remember, we do not have as many shots as we would like to deal with this problem, perhaps only one or one and a half, so a decades-long experiment with third-best policies is a foolish game. As Bill McKibben points out in a recent article, we cannot negotiate with non-human nature, unlike some other areas of policy.  So we need to put in policies that are either “right” or that do not install roadblocks that would stand in the way of better solutions.

  1. Cap and trade puts a newly formed financial derivatives market (the carbon permit market) with all its potential for boom and bust cycles and manipulation by powerful and unaccountable players, in a position to distort the real market for low-carbon technology and land-use changes; the stimulation of this real market is the reason for its existence in the first place. Within the fabricated permit market, the profit-seeking activities of permit traders from the financial markets and industry will be able to exert a substantial amount of unintentional control over the real technology choices and solutions implemented to curb our emission and sequester carbon. These traders, as do all traders, have a vested interest in opacity, price variability, and information asymmetries that would enable them to achieve the highest profit levels for their firms. Permit trading may offer some of the highest returns on investment in a cap and trade-dominated climate action world, so financial players will defend these profit streams with all the considerable means at their disposal. These are the most likely candidates for the “Greek raiding party” in the belly of the Trojan Horse, though climate activists and bureaucrats wedded to cap-and-trade are co-responsible for opening up the “citadel”.
  2. As trading looks to be one of the more profitable areas of the carbon business but in itself does not cut emissions, the incentives in the policy are misaligned: the most profitable business within a carbon policy framework should be those lines of business that cut the most emissions either through selling new technologies or processes or implementing them. An unfortunate echo of the go-go 90’s in which it was conceived, activity of trading is given a role far beyond any real value it offers.  On the level of businesses with real polluting assets, cap and trade will also reward those economic actors who are better permit-buying “game-payers” rather than those companies that invest most in emissions reductions.  This type of reward structure has no place in climate policy.
  3. Non-cap-and-trade policies that determine a fixed price for carbon have the advantage of having as an “output” an acknowledged decision-making tool (a monetary amount) that is already historically integrated into every economic transaction.  In permit trading, permit prices are only applicable to large economic actors and have only a “reflected” (and variable) monetary price after the net costs of the cap and trade outcome for that economic actor have been integrated into the pricing of their goods and services.
  4. A variable, uncertain carbon price that arises from market fluctuations and artifacts of the permit auctioning and trading system is not a clear, easily quantifiable incentive for firms and other real economic actors to make the long-term investments in capital equipment required to cut carbon emissions. A predictable carbon price (in the form of a tax or fee) over the long-term, albeit steeply increasing, would provide a much better incentive to make long-term investments that pay off over years. The “net present value” calculations that are the bedrock of investment decision-making depend on the projection of costs and benefits out into the future, which is nearly impossible using the rapid fluctuations and uncertainties of a carbon market.
  5. The salespeople of cap-and-trade claim falsely that the system gives policymakers “certainty” in terms of the amount emitted as compared to a price instrument like a tax/fee.  As the study of  existing cap and trade systems shows this certainty is illusory and gives leaders a false sense of security.  To get this type of certainty in a cap and trade system, regulators would have to engage in some very harsh and disruptive administrative actions, like shutting down a power plant during the last 3 months of a year if its owners ran out of permits.  Alternatively, the owners of the power plant could “borrow” permits from the next year’s allotment, only to create a direr threat for the next year, but the cap for the current year would have been broken.  Again this is punishing players for not playing the permit “game” as smartly as others though not necessarily being the gravest offenders in terms of carbon-inefficiency or overall emissions.
  6. Buying permits from other firms at a higher cost will impose an undue burden on companies or organizations that need to scale up their operations and increase their emissions in the middle of a year in response to an increased demand for their products.  A carbon tax will have no such punitive effects for unplanned growth as its cost will remain constant throughout the year and per unit produced.
  7. The carbon market does not differentiate between upstream and downstream emissions mitigation. “Upstream” means at the source of emissions, while “downstream” means either increasing efficiency of carbon-emitting energy use or absorbing emissions via land use changes. The efforts to make carbon emissions reductions appear as cheap as possible have tended to emphasize downstream solutions or projects in developing countries. However ultimately the main solution to slowing global warming is to eliminate emissions upstream which is currently more expensive, though downstream mitigation is always going to be necessary as well. A carbon policy that addresses upstream emissions immediately is preferable to one that waves a hand of resignation at business as usual in power generation and transport fuels because of initial cost issues.
  8. Cap and trade, because of its complexity, indirection and somewhat mystical faith in markets, has become the lingua franca of the climate action community and in so doing has shut down that community’s ability to critically examine the instrument itself or alternative, more effective instruments. The collective mental bandwidth that this instrument occupies has helped it to “suck in” many of the good intentions and attentions of politicians and activists, drawing their efforts away from other measures.
  9. Cap and trade obscures the vital role of government leadership, responsibility, regulation and direct investment from the public, the climate action community, and the leaders of government themselves. The successes of cap and trade systems such as they are, depend on either external factors independent of policy (economic downturns, low-sulfur coal deposits) or governmental actors setting stringent targets, operating the permit auction and trading system, and enforcing emissions goals. Yet, cap and trade’s sponsors and advocates continue to promote the fallacy that government is only playing an indirect role in its workings, as if this were a strength of the program. According to most of the expectations that have developed about government over the past millennium or so, there’s nothing wrong with governments taking a leading role in averting one of the greatest calamities we have ever faced. Government is the only institution that can represent and press for the realization of our society’s intention to save itself and the climate via implementation of low-carbon technologies and abstaining as a society from using up fossil fuels all at once. Attempts to hide the role of government paradoxically reinforce the position of advocates of a smaller government who can then point to the attempt soft-pedal as supporting evidence for their claims that government, especially “Big Government”, is “bad”. An honest assumption of responsibility by government would enable clearer, more transparent and more decisive policy moves and educational efforts about the dangers and opportunities for taking a sustainable path to economic development associated with climate change
  10. Instituting a cap and trade system because we, pro forma, must put a policy called a climate policy in place now or by December’s Copenhagen climate conference is worse than delaying a few months or a year to put in a better policy once our leaders have examined the alternatives with a more complete understanding of where they are going. The cap and trade systems now and soon to be developed already create considerable institutional and bureaucratic inertia and their own set of interest groups which are not so much incentivized to cut carbon emissions but to manage and justify the cumbersome system.

Any policy will have its strengths and weaknesses but cap and trade creates an economic, social scientific and political lattice-work at a distance from or interfering with the actual climate tasks ahead of us while blocking the way to better climate policy.

[In part 2 I will highlight what I think is the “fundamental challenge” of climate and energy politics and policy, look at the generic tasks that climate and energy policy is supposed to accomplish and suggest alternate route(s) that are more practical and will be infinitely more effective than cap and trade]

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