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Cap and Trade: An Unserious Policy Framework for Humanity’s Most Serious Challenge – Part 1 December 12, 2009

Posted by Michael Hoexter in Energy Policy, Sustainable Thinking.
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In a few days in Copenhagen, world leaders will debate and, we hope, agree upon aggressive targets for humanity’s greatest challenge to date:  to avert devastating man-made climate change by transforming our economies’ use of energy and of land while maintaining and improving social welfare for the world’s peoples.  We have in the past 250 years proceeded on a course of development which has used fossil energy to replace human and animal muscle power with mechanical energy.  Economic development has almost become defined by application of this “exosomatic” energy, 85% of which comes from fossil sources worldwide.  Emissions from fossil energy as well as changes in land use, have dramatically increased the concentration of warming gases in the atmosphere, leading to increases in average annual temperature.  Furthermore, preferences for eating meat, in particular beef and bovine products like milk, have contributed massive amounts of warming potential to the atmosphere.  Finally, combustion of biomass and many fossil fuels has produced black carbon which has contributed substantially to warming.  Balancing the living standards of human beings with the health of the planet has become an unenviably massive set of tasks.

The potential economic and ecological catastrophes from a warmer planet are starting to become clear to us.  The retreat and eventual disappearance of glaciers seems now highly likely, reducing fresh water supplies for billions of earth’s people.  Rising sea levels from the melting of polar ice caps will swamp hundreds of millions more who live in low-lying coastal areas.  Changes in temperature are already disrupting fragile ecosystems with, for instance in North America, the pine beetle now surviving what once were frigid winters and devastating the forests of the Western US and Canada.  Many of the species with which our species has co-evolved will die off in a warmer world.

However, when compared to the magnitude of the threat and the measures needed to meet or exceed intended targets, the instrument chosen during the 1990’s to transform our economies, cap and trade (also known as emissions trading), has proved to be marginally effective to ineffective and extremely cumbersome to implement.  It is as if you, with great fanfare and concern, pointed out that there was a drowning swimmer 100 feet away from you but chose to throw a rubber duck instead of a lifebuoy to save them.  With time running low, it would be a disaster if government ministers and world leaders lock themselves into the cap and trade instrument as the main means to achieve emissions reductions targets.  Cap and trade or emissions trading, has had unimpressive results when compared with more traditional “command and control” regulation in the area of acid-rain forming pollution (SOx) and seems to have been selected as a means to control greenhouse gases largely because it appeared at the time politically expedient to the then-Clinton Administration.  This was humanity’s “first go” at a climate policy and the instrument has shown more weakness than strength.

There was within the Clinton Administration, which has had an outsized influence upon the shape of our first climate policy framework, an openness and vulnerability to the anti-regulatory and anti-tax rhetoric issuing from the Republican Party post-Ronald Reagan, so cap and trade seemed like an elegant domestic political solution.  Clinton, with apparent enthusiasm, declared in 1996 that “the era of Big Government is over,” yet government action and government regulation of markets, as it turns out, are going to be the pivotal institutions in transforming our economies to radically cut emissions (and managing our way out of the Great Recession).  Furthermore the Clinton Administration had more generally a fascination with financial innovation via expanding the influence and reach of financial trading markets and loosening regulations upon them.

However, in its capacity of creating a politically acceptable alternative to direct government action in the economy or to the levying of Pigovian (“sin”) taxation on carbon emissions, the proposal to use cap and trade to regulate greenhouse gas emissions has been, in the United States, a miserable political failure.  Opponents of action on climate change have seen through or willfully misinterpreted cap and trade’s “soft” regulatory image.  They are reinforced in their belief that “government is bad” by the effort by their political opponents to hide or make indirect government’s role via cap and trade.  “Fancy footwork” was unfortunately a hallmark of the Clinton Administration’s major policy efforts and cap and trade’s application to global warming is no exception.

I have elsewhere outlined two policy frameworks that with greater certainty would cut emissions more rapidly, based on more robust, reality-based economic and social scientific principles.  Firstly, a carbon tax or fee will function as a much clearer, more consistent incentive to invest in mitigation because of its predictability and clearer price signal to investors and consumers.  If paired with a series of targeted incentives for clean energy (feed in tariffs or other performance-based clean energy incentives) and investment in energy and transport infrastructure (electric transmission, electrified rail, electric vehicle infrastructure), we will see measurable emissions reductions and the emergence of real market choices upon which carbon prices will act.  The combination of incentives, disincentives and public investment might be called a “Comprehensive Climate and Energy Policy”.  Alternatively, a series of 20 to 50 large scale regional and global emissions cutting projects can form the basis for determining what would be the unifying national and international policy instruments, most likely including a carbon tax of some form.  Projects would need to represent certain emissions reductions using existing or emerging technologies within a timeframe or directly enable emissions reductions (transmission to renewable energy zones, electrified rail).

An alternate “meta-economic” framework for effective climate policy is Keynesianism, which after 3 decades of disregard has once again been recognized as the vital guide to economic policy at times of crisis.  What I call “Climate Keynesianism” recognizes the key role of government in leading an economy in crisis, in this case one with both a traditional worldwide economic slump in combination with an ecological crisis of unprecedented proportions.  Most commentators calling for a WWII style mobilization to catalyze economic growth and a greening of our society (a “Green New Deal”) are working with assumptions based on the work of John Maynard Keynes, though not all acknowledge his contribution.  Within a Keynesian framework government planning can supplement and support markets rather than remain invisible in our guiding economic theory or remain foolishly dismissed, as it has been over the past 30 years.  I have recently ventured the hypothesis that most intentional emissions reductions or increases in the efficient use of polluting resources that have occurred in our history have been the product of the implementation of government programs inclusive of the design of tax policy.

Furthermore, as I have argued here, cap and trade shields polluters and government from the ethical pressure of concerned citizens and concerned scientists, which are, in the end, the prime motive forces of climate action.   The new property rights to pollute that are the basis of emissions trading are fairly non-transparent and insulate polluters from the need to maximize emissions cuts sooner rather than later.  Cap and trade, in its implementation rather than in the ideal terms in which some advocates discuss it, sends out “go slow” or inconsistent signals via its complexity, reliance on offsets of often poor quality, soft targets, introduction of non-essential players into the domain of emissions reductions, and the contract not to cut emissions to zero contained within a pollution permit.

Seriousness and Unseriousness

I have above sketched out in broad terms why cap and trade is ineffective and incommensurate to the task of carbon mitigation (elsewhere I have gone into more detail with supporting documentation about why cap and trade is ineffective and resists strengthening).  However these criticisms that I have made are not particularly arcane or difficult to arrive at…why is it that these views are not shared more widely?  If we leave aside self-interested calculation for the time being, I believe there is what might be described as a “reality-orientation” among policymakers and important economic actors, within which cap and trade appears to be a quite acceptable solution despite its “Rube Goldberg” nature and inappropriateness to the task.  This reality orientation shapes perceptions of what is the nature of the challenges facing us and what are acceptable solutions to those challenges.  I would contend that it is possible to judge with some accuracy that some solutions are “serious” and others “unserious”.

On its simplest level, seriousness is an orientation of mind, either temporary or longer term, where we clear away irrelevant facts, irrelevant emotional states, and irrelevant impulses from consideration because of the need to take action.  Seriousness means focusing on only the relevant information for a particular moment or challenge and allowing in new information that is also relevant.  Seriousness means being able to screen information based on its appropriateness to what needs to be done now or very soon; it means understanding the links between an action and its ultimate purpose.

Despite the immediacy-of-action requirement in serious situations, seriousness however might also involve engaging in long-term planning, considering many factors and facts, but nesting and ranking them as to their relative importance, even though first actions are very important.  The observation from the study of complex systems called “sensitivity to initial conditions” a.k.a.  “the Butterfly Effect” explains to some degree why first steps are important even though the road may be long.  The planning and building of large physical structures requires seriousness from the outset to the end of the building process and beyond.  Seriousness most often involves the use of rational thought processes to come to solutions based on the relevant information, though intuitive, “Blink” type, reactions in extremis may yield good results as well.

Another way to look at seriousness from a more biological perspective, is that it is the “fight or flight response” brought under the control of the prefrontal cortex, the center of our brains that is associated with impulse control, deliberation and planning.  The fight or flight response is our basic physical and emotional response to threats, which has analogues across multiple species and has evolved over hundreds of millions of years.  In serious states of mind, the anxieties and dangers that trigger that response are anticipated, and planning is initiated that will reduce the likelihood of our encountering those threatening situations.

Unseriousness by contrast is allowing extraneous concerns and facts into that emergency or near-emergency situation or relying largely on non-rational decision-making processes when time would allow for rational ones.  As seriousness is judged by context and we all have multiple commitments in our lives, some people argue over whether people are “truly” committed to the issue at hand or are using it to further their “other agenda” to which it is assumed they are more committed.   As an example, deniers of climate change or action on climate change are in effect accusing those who are concerned about climate change of unseriousness because they believe them to have invented climate change science  as part of a pre-existing political agenda.  For these people, the pre-existing political conflict (between Left and Right) is the serious part while the science, to them, is unserious.  In this dispute there is a disagreement about which here is the fundamental context upon which to establish true “seriousness”:  the physical world as observed by science or the political and subjective world of human beings.

As “unseriousness” carries with it a pejorative tone, it is not the same thing as “lack of seriousness” in most domains of life where humor and levity is highly valued.   To break up the repetition in this piece I will use “lack of seriousness” to mean “unseriousness” because of the context.  However “to fiddle while Rome burns” can rightfully be called unserious, with all pejorative meanings intended.

To judge someone or something as “serious” or “unserious” appears at first to be a subjective task.  What are extraneous or irrelevant concerns and impulses?  What are rational thought processes?  For instance, I could be deciding at this moment for personal reasons of my own to declare cap and trade to be “unserious” and carbon taxation, a Comprehensive Climate and Energy Policy, and Climate Keynesianism to be “serious”.  Or seriousness could just be a state of mind that comes and goes; I might have a personal preference for serious people or a mood of seriousness (as it turns out this is the not the case).  If one looks or sounds a certain way, one might think, one is or is not taken as “serious”.

However I believe that most readers will be able to agree that certain facts and events in the world are “serious” without reference to the accompanying facial expressions or tones of voice.  What do we mean by “serious” or when something “gets serious”?  When something is “serious” we realize that we have either very little or no choice in an important matter; when something “gets serious” options have been removed and, yet action on our part is required that will have substantial repercussions for us and/or for others.  What most people would consider “necessities of life” are almost by definition “serious” while wants are not necessarily “serious”.  Government is often though not always involved in “serious” life and death situations: fire departments, police departments, courts, national defense etc.  Climate change is one of those serious issues:  we cannot escape the world en masse and we are degrading the biosphere irreversibly through our activity.  I am not making up its seriousness nor am I exaggerating it:  it is matter of humanity being able to live decently or the potential for a much reduced existence for humans and coevolved species in the future.

Also, many people, though perhaps a lesser number, will be able to identify unseriousness in the response to a serious situation.  You might become impatient if you recognize a serious predicament but are being offered information or solutions that are in some way irrelevant to its resolution.  If we are led to believe that we are in an emergency, yet are then offered a solution that is not effective or seems to be an answer to a different question, we need some very strong reasons to pair “Question and Answer A” with “Question and Answer B”.  However, as noted above, in some serious matters there are disputes about what is the “ultimate ground” or context against which acts are judged as more or less relevant: are politics and human relations or is the biophysical world “the ultimate ground”?

Seriousness or unseriousness is also an orientation with regard to the representation of facts and ideas.  In science, only “seriousness” is appropriate in the actual communication of data and their interpretation; there is supposed to be no ambiguity with regard to what something means.  In business or culture, “unseriousness” has its place, as ambiguity is allowed or encouraged.  Given the science-dependent nature of climate and energy policy and the very late hour we are facing these issues, “seriousness” is the only appropriate means to deal with the basic outlines of policies that are supposed to “save the world”.

Unseriousness at the wrong time or in the wrong people can have very real and serious consequences.   Unserious leaders of governments and large corporations can do enormous damage to their organizations or the parts of society that are affected by their actions.

Cap and Trade for Greenhouse Gas Emissions is Unserious Policy

Cap and trade via its adoption in the Kyoto Protocol and elsewhere has morphed into a sizeable set of institutions and worldwide: there are tens of thousands whose work is fed or feeds into its framework; it already has had serious real impacts on some people’s lives.  However despite its institutional massiveness and the grave nature of the climate change challenge it remains at its heart an “unserious” policy.  The frivolousness at the heart of the policy is a frightening irony and potential tragedy given the consequences of failure involved, the seriousness of the work done by many workers in the field as well as the fact of their employ in instituting such a policy.  But unfortunately, we and they have been saddled with a policy that is at odds with its fundamental task as well as the personal intents of many though not all of its supporters and functionaries.

The lack of seriousness of cap and trade can, in part, be traced back to its overreliance on trading and market mechanisms.  Markets, while they have serious consequences in the world, function in part via the lack of commitment of actors within markets to each other or to the goals of society as a whole.  Markets, to function, have to represent a degree of non-compulsion; they are never entirely “free” as some ideologues would like us to believe, but they attempt to be non-deterministic in terms of the outcome of the “play” of relationships and transactions within the market space.

The non-deterministic bent of markets leaves room for participants, in particular participants with sufficient financial resources, to have multiple choices with regard to the satisfaction of their wants.  For some this area of choice becomes a type of game, where players attempt to receive more benefits for less sacrifice of resources.  Offers can be played off against other offers so the costs for items will become more affordable for the buyers, though not necessarily advantageous for the sellers.  In playing one offer off against another there often will be an element of unseriousness or deception, as false commitments or false show of disinterest may lead sellers to increase the favorability of their offer.  To approach markets with total seriousness is often to lose out on opportunities or to be taken advantage of.  Playing games well in markets then becomes for each individual actor a competitive advantage in claiming more of the overall benefit for themselves.

There has been a certain hagiography of markets that has emerged in the last 30 years which has portrayed this scenario of market actors moving fluidly between offers on a market as the sole paradigm of economic activity.  All economic activity has been supposed to strive to emulate markets with the idea being promoted that individual buyers choosing between multiple offers is the almost exclusive foundation of economic progress and efficiency.  However this view of markets is focused on the internals of market functioning and ignores the supporting institutions for the smooth functioning of markets as well as the externalities (the damages and benefits to those not involved in the transaction) they create.  A well-functioning market is a product of (a lot of) work by non-market actors like government officials as well as those who work in economic roles and sectors which do not necessarily function well in the ideal market format.  Furthermore there are a number of economic functions that do not lend themselves well to market functioning, many of which are “natural monopolies” or oligopolies like electricity and transportation infrastructure.

Markets tend to work better the more “discretionary” or flexible a given type of human wish is, as well as where buyers can accurately evaluate the value and likely results of a transaction with their own knowledge base.  We tend to see “ideal” market behavior in areas of life where we are dealing more with luxuries than necessities:  in health care, cosmetic surgeons and dentists can sell their services to a (wealthier) consumer market on an out of pocket basis while in the area of basic medical care there is more likely to be subsidies or public and private insurance schemes.  Thus the “playfulness” of markets fits with things we can literally “do without” or hold out for, i.e. demand is “elastic”.  In those areas of life where demand is high but relatively “inelastic” we tend to see more regulation and/or subsidies by government or the direct provision of goods and services by government.

In the era of the idealization of markets we were supposed to trim all economic activity to the Procrustean bed of a competitive, unregulated market.  As Adam Brandenburger and Barry Nalebuff pointed out in their book Coopetition, cooperative interaction in the business world has been under-theorized while competition has been over-theorized and over-celebrated.  Economic planning, both within firms and in society as a whole, became taboo, as competition through the market was supposed to do almost everything for everybody.  In practice this has meant that certain economic activities that we are now recognizing are crucial (energy and transport) were neglected or subject to a series of exercises in deregulation or “marketization” with mixed but sometimes disastrous outcomes.  This has left, especially in the United States which has been the epicenter of the idealization of markets, energy infrastructure and transportation projects at the margins of high-level economic policy discussions.

Formulated during a period of financial deregulation and a mushrooming of the financial services industry, cap and trade is an offspring of the idealization of markets, a baroque monument to a belief in the market mechanism and financial trading in particular as the self-sufficient and predominant function in economic life.  Cap and trade has a “double decker” market, with the carbon permit market, with its variable price outcomes, regulating the real market for global warming solutions.  It would have been easier and more effective to simply drive the, “lower” level of that stack of markets, the real market for global warming solutions, with a tax but the policy designers were swept up in their belief in competitive markets and feared the appearance of exercising governmental authority via either taxation or direct regulation.  That the Clinton Administration was unsuccessful in 1993 in instituting an non-greenhouse gas related energy tax has shaped international climate policy in measures far beyond the value of that historical moment.

Proponents of cap and trade tend to argue that emissions trading and taxation are equivalent in terms of their usefulness but these assertions are based on an inadequate confrontation with some basic weaknesses in the cap and trade system.  Beyond the problem of offsets and their quality, which is a very large problem, the two most problematic assertions about almost all configurations of cap and trade are:

Assertion #1 –  Cap and trade’s price signal is equivalent as that of a carbon tax” –  This is not true because auctioning and permit trading yield a variable price signal and investment uncertainty.  A variable price signal is much less useful to investors in emissions reducing measures because these investments will pay for themselves in most cases over a period of years.  The value of the investment is then in question with a variable signal.  The economic modeling of this issue ignores the multi-year perspective from the point of view of individual economic actors.  I call this cap and trade’s “faulty microeconomics”.  There are ways to patch this up with price floors and ceilings and a very narrow trading range but then the elaborate structure of cap and trade is no longer necessary.  Cap and trade then becomes a more cumbersome tax with permits and market games attached.

Assertion #2 – “Cap and trade delivers certainty about quantities of emissions reductions (while taxation gives you price certainty).” If “1” is false (which it is without losing many of its trading attributes) then this statement is unlikely to be the case because carbon reducing investments will be less likely under carbon price uncertainty.   The point of carbon pricing (cap and trade or tax) is to stimulate investment in carbon reducing technologies rather than issue fiat regulations that controls amounts of emissions.  However the uncertainty in the price signal will interfere with emissions reductions until the point where regulators will step in and “pull the plug” on either malevolent, ignorant or unlucky losers on the carbon permit markets.  So certainty will be achieved, with an ambitious cap, when regulators will step in with arbitrary-seeming harsh measures.  Neither instrument will give anyone total “certainty” of quantity without the use of direct regulation, though a carbon tax would be easier to calibrate to achieve approximate goals.  Advocates of cap and trade omit the simple fact that carbon price rates can be adjusted perhaps every 3 years to achieve an emissions goal (though not so frequently as to make price projections arbitrary and useless for businesses).  Even with these adjustments the carbon price signal will remain clearer than with cap and trade.

Besides these questionable assertions that are always treated as established fact, invisible in the discussions by cap and trade advocates is the introduction of what is essentially an extraneous element into the process of pricing carbon, the trading markets, which seems to serve no other purpose than to lay at the feet of the market abstraction that the last couple generations of economists have idealized, the most important policy instrument that the world has ever seen.

As individuals, the designers and advocates of cap and trade are sometimes believers in more general financial market reform yet refuse to see how carbon finance pulls financial markets away from reform and towards speculative excess once again, via the insertion of price variability and trading.  Other than personal corruption, which may be the case for some, I do not see how these otherwise smart people continue to exempt cap and trade from what they otherwise would apply to the trading, for instance, of bundled sub-prime mortgages or other shady securities.

If we turn to our definition of “serious” vs. “unserious”, we see in cap and trade the introduction of an extraneous institution (the permit markets), set of concerns (the profit motive via trading of paper and not via producing or financing emissions cuts), and stakeholders (powerful financial groups interested in expansion of derivatives).  These extraneous institutions do not simply remain “quiet” but end up co-steering the course of the policy and interfering with its purpose.  Political and economic favoritism as well as intellectual hobbyhorses are being served instead of the world’s most important set of tasks and investments.

If we accept that our relationship with the biophysical world is the “ultimate ground” of climate policy, introducing an over-elaborate set of political and economic ideas and interest groups that are inessential to the policy’s goals and divert energy and funds to their ends adds a lot of unnecessary risk to the carbon mitigation enterprise.  If we furthermore acknowledge that the state and rate of our degradation of the biophysical world is very serious and approaching dire, the risks are multiplied.

Therefore cap and trade is unserious policy.



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