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2. Cap and Trade: A Tangled Web of Good Intentions and Bad Policy

In the first part of this post I identified 10 features of cap and trade, the favored climate policy of many policy elites at this point in time, that make the policy ineffectual. I outlined how cap and trade was sold to America and the world based on faulty assumptions as well as its superficial political appeal to the then Clinton Administration. Contrary to the story told in climate activist and sympathetic policy circles, cap and trade has been comparatively ineffective as a means to reduce emissions of either SOx or GHGs. I argue that this is a structural problem with cap and trade, not a mistake in implementation.

The Gulf Between Gutlessness and “All the Guts in the World”

fishgamewardens

A permit system requires its enforcement arm, like these fish and game wardens. The actions of whatever "enforcers" are instituted via a cap and trade system would tend to seem arbitrary given the way the auction and trading system works. These enforcers would have to compound the misery of actors that will already have "lost" on the permit markets (Photo: Debra Hamilton)

Cap and trade is a hybrid policy, the mixture of a price mechanism and permit regulation. In theory, the three “motors” of cap and trade are the economic pain caused by having to buy permits (or the anticipation thereof), the profit gained by market participants in exploiting the permit and pollution troubles of others, or the prospect of running out of permits and being subject to some penalty inclusive of actual “police action” on the part of regulators. As with any permitting system, permits are meaningless without the threat of, potentially, monetary and criminal penalties. For instance, fish and game wardens need to be able to stop hunters and fishermen from taking animals for which they do not have permits.

However, cap and trade systems hide and, it appears infinitely, postpone the moment where regulators would have to essentially shut down the operations of various industrial or power generation facilities because they no longer possess permits to pollute (which they would have to do to operate using their current technology). For instance if a financially troubled power utility or plant operator ran out of permits on November 5, to meet the cap regulators would have to shut down one or more power plants until January 1. This might mean blackouts and brownouts to homes, businesses and, of course, hospitals. It would therefore take “all the guts in the world” for a regulator or government to enforce the cap, standing down the cries of people who will have to live with no or extremely unreliable electricity. Yes the notions of “banking and borrowing” permits are meant to reassure system users that this day of reckoning will never come. Yet this process undermines the power of the permits and the firmness of the cap.

Furthermore, at the point when this theoretical moment of enforcement might occur, the net effect would actually show the regulators/government in a very negative light because punishment might come as a consequence of a lack of “clever” permit-market behavior on the part of the power plant operators. Their power plants may be no more carbon intensive than the next but they may simply have been outfoxed by other permit buyers or various manipulators of the permit market. In this case, the punishment will seem arbitrary.

So we can now understand the design and behavior of the designers of real existing cap and trade systems a little better by recognizing this disjuncture between the lax disbursement of permits (Kyoto/EU-ETS and current Congressional bills), the various softening and smoothing mechanisms (banking and borrowing) and the need for some kind of real enforcement of the cap. It would subvert the politics of the policy to actually meet the cap through the harsh regulation that would almost certainly never happen or would be largely meaningless within the cap and trade framework.

While regulatory and political guts will be required to meet the climate change challenge, the imposition of harsh measures should be seen far in advance to allow adequate time for polluters to take action to cut emissions. Cap and trade’s framework does not allow for this type of lead-time before administrative measures are taken.

True Belief in Markets vs. a Baroque Policy Mess

As you might glean from how I write about these matters, I am no market absolutist nor believer in the efficient market hypothesis (EMH) which assumes exclusively rational information processing by market participants in aggregate. I think it is more reasonable to assume that people can be both economically rational and economically irrational or can alternate between the two at different times or in different contexts. Economists are also coming around to realizing how central irrationality is in our economic behavior: there has now been about a decade of behavioral economic research as well as the coming to grips with the fact that our recent crash was in part caused by a belief in the almost total predominance of rational, utility-maximizing economic behavior.

price_tag_pic

In economic theory, people are thought to use price as the key decision criterion for making purchases. From these price tags for vodka, consumers probably will be using the differences in prices as a guide to the quality or social status value of the vodka or its ability to be wet and alcoholic at little sacrifice to them, or some compromise between price and product attributes. (Photo: Jayd Tags)

Whatever the balance of rationality and irrationality in human economic behavior, cap and trade (or carbon taxation/fees) with good justification attempts to mobilize the economic rationality of individual market actors in the service of climate protection by introducing a carbon price that will influence procurement and operations decisions. Rational economic man (or woman), according to the theory, only needs the information of price to make rational, optimal decisions. In cap and trade, the carbon price and market is supposed to be the link between merely pro-forma climate action in the form of permit giveaways/postponement of action by regulators and the theoretical, never-to-be-activated harsh punishments for exceeding the cap. Polluters are supposed to know that they are in trouble when they start paying more and more for polluting, sending to them a signal, the price signal that they need to change their operations. Rather than the impingement of some set of rules upon the company’s operations, the price is going to tell that economic actor “how much” it will be worth it for them to do something, so they can make an rational choice among a range of options.

The most productive use of a price signal will be if firms anticipate the economic pain caused by the signal before it gets expensive for them; once they are in trouble and overpaying for permits they will have less of an ability to make expensive long-term investments, especially if they are an emission-intensive business like power generation or cement making. With cap and trade, there may be sudden surprises in the carbon markets which will put firms into trouble even with adequate planning.

louis-xiv-furniture

The Baroque visual style emphasized curves and flourishes, like this side table. In the area of climate policy, too many curves and flourishes in policy leave hiding places for footdragging, corruption, and unearned profits, weighing down policy when it needs to be fleet and effective. Our stylistic preferences are secondary to getting the job done.

I’ve already outlined how flawed cap and trade is in generating the price signal due to the variability of the carbon price that results both via auctioning and via permit trading. In both cases there will be a lot of market “noise” related to how much people think something is worth rather than what it is worth fundamentally in terms of the climate. The “how much” will be almost impossible to calculate accurately under cap and trade as conceived and as urged by climate action groups that believe in cap and trade with all permits auctioned off as the gold standard of climate regulation. This will make investment decision making tools like net present value difficult to use as you cannot calculate the negative cash flows into the future that are attributable to the carbon price. This is not because net present value (NPV) is more environmentally insensitive than any other investment tool: it’s just sloppy policy-making to defeat the purpose for which you are instituting a policy! Cap and trade would have to invent its own more baroque micro-economics and corporate finance tools that will always be more inefficient and fault-prone than using a simple price signal and NPV.

So if true belief in markets and economic rationality of individual market actors is fundamental, then a carbon tax or fee that is correlated directly with the amount of carbon or global warming potential (dealing with more powerful greenhouse gases than carbon dioxide) emitted is the clearest, most predictable price signal. Cap and trade’s baroque double decker market structure is like a climate policy that has been thought up by an overeager 5-year-old who gleefully stacks markets on top of markets because it seems more “market-like”. Having one “meta-market” emit the carbon price to the real market for carbon emissions reduction solutions is a bad idea. An excess of markets in this case does not encourage rational economic behavior on the part of individual market actors.

“It’s All that We Have”: Making Do is not Good Enough

A number of commentators, bloggers, and politicians critical of the state of climate policy nevertheless hang on to cap and trade. Some agree with some of my criticisms while others might find my foregoing criticisms gratuitous or simply giving aid and comfort to climate deniers. Or, even if they are frightened of the monumental hand-off of responsibility that is contained within the cap and trade system, they might feel that so much political capital has been spent on cap and trade that it must be defended as the embodiment of climate policy itself.

Below, I will suggest that in fact we have a wealth of choice in the area of climate policy, almost all of which will be more effective and efficient than cap and trade. For one, governments around the world including the Obama Administration are taking action in other areas that do not deal with carbon pricing or trading of permits or credits/offsets. You could say that governments that openly advocate a cap and trade system might be seen as also hedging their bets. Secondly, it will be fairly easy to replace cap and trade with an ensemble of different measures or a carbon tax with any number of features. If history is any guide, other countries have implemented a carbon tax within months rather than the years long efforts to install cap and trade systems.

It pains me that so many people many of them good-hearted and well-intentioned have expended political capital and reputations on such a faulty instrument. In their own defense, depending on their social scientific or business backgrounds, they could not necessarily have known differently. However, that is no reason to stay with an instrument that has a high probability of gumming up the wheels on climate action rather than speeding it up.

Before describing alternatives to cap and trade, I want to first outline what I think the tasks are that the policy needs to address. Without a common vocabulary for these tasks, stripped of bias towards a particular policy instrument, you, the reader, won’t be able to evaluate whether these are substantially better than what we have already. In most cases I am not reinventing the wheel, but simply observing and compiling what I see is out there already.

The Fundamental Challenge of Climate Policy

The fundamental challenge facing governments, climate activists, green-oriented businesses, and concerned citizens is a neat intersection between a massive policy challenge and a massive political challenge of the early 21st Century. Policy and politics are not always so closely intermingled but in this case they run for historical reasons very closely together.

Instituting cap and trade rather than more effective policies is a bad idea spawned of an era in which government was supposed to become more “market-like” in all matters. We have discovered in so many areas of life that this philosophy of government is flawed, despite continuing political disagreements around this issue in governments around the world. Our current generation of politicians got elected by taking one stance or another (but mostly one stance) on the either/or proposition of whether government or markets were “better”. Markets unregulated, as it turns out, encourage short term thinking and satisfaction of immediate appetites. Fortunately or unfortunately, to face the future threat of climate change, a revision of government’s distinctive place vis-à-vis regulation of markets and our own appetites is required.

Climate policy has the unenviable task of

  1. saying “stop” to our impulses to overuse fossil fuels and overexploit the world’s forests and soils,
  2. directing, under constant political attack, substantial streams of public and private investment to building a new energy and energy-use system and
  3. changing our patterns of land use to fix more carbon in plants and soil.

This places government, and government is the only instrument up to the task, at loggerheads with citizens’ and businesses’ impulses to use more and more energy (and non-renewable natural resources), as cheaply as possible with a disregard for the negative consequences. While ideally such policies would enact a form of “aikido” on our wishes, using the momentum of our wants for more and better stuff to instead be used to transform society for good, there still needs to be a firm boundary and governmental “center of gravity” that is clear to all (otherwise it cannot perform aikido on anything). In the end, what is required is the return of government’s legitimate role and moral authority to set this type of reasonable limit and redirect energies that would otherwise go elsewhere.

Radar_gun

Police are not generally appreciated for catching speeders; to get caught speeding almost always feels like an injustice to an individual driver. Still, the net effect of fairly enforced speeding laws makes driving a safer experience for all drivers. Government needs to be accorded the same legitimacy with regard to curbing GHG emissions in order for there to be an effective climate policy of any description. (Photo: Sgt. Lek Mateo)

The analogy of speeding on the highway can bring this closer to our personal experience. Without traffic cops, many of us, including myself, would drive too fast, increasing the possibility of fatal accidents; furthermore automakers have tended to put whatever mechanical efficiency gains that come from among other devices, turbochargers, into making cars more powerful and “fun to drive” than into gains in mileage. Yes, there are those of us with a conscience or without the interest in driving fast but we cannot count on these forces alone to curb fast driving, especially given the powerful automobiles to which we now have access. The police who catch speeders are not very popular but, if they avoid corruption and are not subject to absurd ideological attack, they maintain moral authority and can do their job.

Fossil fuel use (or wanton deforestation) is similar to the propensity to speed in that it offers us and our economy an easy way to satisfy our wants without regard for the long-term consequences. Fossil fuels are notably energy dense and we in most developed or in oil-rich countries do not pay nearly enough for them given their social and environmental costs. In an uncharacteristic moment of clarity within his Presidency, George W. Bush put his finger on it when he said that “America is addicted to oil”. As in addiction, only firm limits and sometimes harsh measures are able to stop the addict from re-using the drug he or she desires. The authority of government to intervene (double entendre!) in the domestic economy has been over the past 30 year undermined by an ongoing political barrage that suggests that government has less legitimacy and moral authority than the market. Cap and trade is an effort to wrap government in the faux moral authority of the market, as promoted by the market fundamentalist creed of the last 3 decades. The market unregulated, as it turns out, is amoral, not caring that much about long term consequences. Markets are not “bad” or essentially immoral, they just are tools that lately have been called on to do tasks to which they are ill-suited. As even Alan Greenspan now attests, they have been fundamentally misunderstood most notably by him and by many others.

Especially in the US but also abroad, governments, in order to do their work, must re-establish moral legitimacy in many areas of domestic policy which have been thrown into question by our decades-long experiment in market fundamentalism. The substance of the politics surrounding cap and trade is largely about the moral authority of government to restructure our energy system and secondarily about the legitimacy of natural science. The content of this moral legitimacy is that government can when functioning well, represent the general or common interest in making and enforcing rules, collecting taxes, and spending that revenue for the purpose of maintaining and improving the future viability of the nation. Even more so in the area of climate change, which will mean over a period of a decade or two, dramatic changes in at least three sectors of our economy, governments’ moral legitimacy needs to be well established to effect whatever policy is chosen.

Cap and trade’s “prospectus” (a.k.a. political sales pitch) suggests that government can after declaring a “cap” essentially recede into the background, while the “hand” of the permit trading market does its work. Its superficial political attraction is that it reinforces the pre-existing “rap” that government is “bad’ or ineffective and the market is “good” and effective. However, to work in any shape or form, climate regulation and policy, including cap and trade systems such as they are, is going to need government action in spades. So, cap and trade sets up its advocates for a long-term political defeat: even if a weakened form of it passes, people will ultimately start to wonder why there is so much government involved in cap and trade (and so ineffectually at that). Maybe its advocates believe that “people know” that cap and trade is really just another government regulatory program and won’t feel betrayed; given the state of civic understanding of government’s role, I believe they are sorely misinformed.

Ultimately the leaders of government(s) are going to need to take responsibility for protecting their people and the environment from substantial degradation via curbing our own emissions of greenhouse gases. The language and parallel institutions of cap and trade interfere directly with the process of by which government leaders would take responsibility, suggesting that automatic processes will “take care of themselves” via the invisible hand of the carbon permit market. I have demonstrated that such an invisible hand will play tricks with the policy itself compromising its effectiveness. Both the policy in its pure form and even more so efforts to curb its tendencies will create a baroque structure that does not work directly and efficiently on the basic tasks that are required to reduce carbon emissions rapidly within a decade.

The Basic Elements of Climate and Energy Policy

To open up the field of alternatives to cap and trade, as well as understand cap and trade better in context, we need to understand what the generic tasks of any climate and energy policy would be. A comprehensive climate and energy policy has most of these elements independent of policy instrument choice:

  1. Disincentives for (or rules against) the use of fossil fuels, leading either immediately to switching to virtually carbon neutral fuels/energy sources or vastly more efficient use of fossil fuels prior to switching to carbon neutral energy.
  2. Incentives for private investors to build carbon neutral electric generation and carbon-neutral energy storage as replacements for fossil electric generation.
  3. Incentives for vastly more efficient energy use of all types in transportation, buildings and industrial processes (or conversely disincentives to “waste energy”).
  4. Provision of or facilitating the financing of site- and regionally-specific public goods that lead to carbon neutral energy use (electric transmission, electrification of railways, build out of railways, electric vehicle recharging networks).
  5. Revenue sources for financing public goods and incentive programs that enable a society to cut emissions.
  6. Incentives for maintaining and increasing carbon sequestration in land use in agriculture, silviculture and in forest preserves.
  7. Disincentives for (or rules against) the release of sequestered carbon in land, vegetation, and sea.
  8. Reduce black carbon emissions via introducing emissions controls or alternatives to biomass combustion or other black carbon sources.
  9. Develop, identify and institute standards for lower- and zero-emissions technologies and processes.
  10. Generate regional and national plans based on better and best practices to curb emissions
  11. Fund basic climate and energy research

There is no single policy that does all of these tasks well nor will some policy package address all of them. We see that cap and trade is an attempt to address a number of them with a single instrument, most particularly numbers 1, 3, 5, and 6. As we have indicated cap and trade’s inherent laxness and unclear carbon price signal interfere with 1 and 3 (energy efficiency, fuel switching, and restriction of fossil fuel use). It does offer to join these efforts with 6, which has spurred interest in the developing world. Again there have been difficulties in establishing whether funded carbon sinks/offsets needed the funding and also run into problems with 7, the release of carbon once sequestered. Would development projects need to pay the money back if the forest they are leaving to grow is cut down by them or someone else?

The temptation of policy makers, in their first take on a climate policy to lump a number of concerns together is understandable, especially if climate policy, in relative terms, has been a low priority. However cap and trade has been extremely cumbersome to set up and ineffective or marginally effective in each of these areas with a high probability of continued problems given its long list of inherent flaws. Moving to or at least seriously considering any one of a number of alternatives is advisable given cap and trade’s ability to block other policies and clog governmental channels. Furthermore translating our thinking about climate into its terms limits our ability to imagine other scenarios that will work much better. In every one of these categories there is a more effective instrument than cap and trade, meaning that we of necessity must move to a multiple instrument platform because of cap and trade’s lack of effectiveness as well its (and any instrument’s) lack of comprehensiveness.

I will offer here (in the next part) two main directions, one mainstream and the other “heterodox”, that both will achieve more quickly and easily emissions reductions than cap and trade.

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Comments

1. Cap and Trade Derails the Ethical “Locomotive” of Substantive Climate Action – Part 1 « Green Thoughts - November 18, 2009

[…] current and emerging set of technological solutions.  I have attempted to do the latter recently here.  Without understanding what climate policy must do independent of any particular policy […]

2. Sorry, Kyoto Signatories, Emissions Traders, Carbon Taxers, Homo Oeconomicus Won’t Save the Climate – Part 2 | New Economic PerspectivesNew Economic Perspectives - April 7, 2014

[…] of the policy, that suddenly, if polluters neither purchased permits, offsets nor cut emissions, regulators would shut down a particular plant or an industry segment, contradicts the entire modus operandi of emissions trading, at least as it has been sold to the […]


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