The case for cap-and-trade

Friday, July 1, 2011

THE CAP: A limit on the total carbon emissions for the country. Shares are allocated to companies in the form of emissions permits.

THE TRADE: The sale of unused permits by a company that can inexpensively reduce its emissions to a company that has higher emission reduction costs or that wants to increase its emissions.

Although “cap-and-trade” legislation in Washington is dormant for the time being, the issue of climate change has not gone away. Carbon emissions continue to accumulate in the atmosphere, and the U.S. Environmental Protection Agency continues to move along a road of costly regulation.

In the upside-down world of politics, most free market proponents seem to have celebrated the temporary defeat of cap-and-trade as a victory over heavy-handed government regulation. If so, they have it backwards. Cap-and- trade is the free market based approach to complex multilateral problems like climate change. Free market environmentalists should applaud this approach over more costly government regulation, while working to make an eventual climate bill adhere tightly to free market ideals.

It is clear that free market environmentalists—as environmentalists—love the environment. Of course, caring about the environment does not oblige us to jump at every hysterical claim that the sky is falling. Conservatives and libertarians alike do well to be skeptical of “experts” who claim that the crisis du jour requires radical social change. But while free market environmentalists have a posture of healthy skepticism, they do not have a theory of atmospheric physics. To say “I believe in limited government, therefore I do not believe in anthropogenic climate change” is a non-sequitur. To the contrary, free market environmentalism must look problems like global climate change in the eye, and offer free market solutions.

Market-Based Environmentalism

Reducing excessive pollution is a legitimate purpose of government, but the guiding principle should be to do so in the least obtrusive, least heavy-handed way possible. The first generation of federal environmental policies, passed in the 1970s, ignored this principle. These command-and-control policies have injected the government unnecessarily into countless manufacturing and commercial decisions, increasing administrative and economic costs while dulling incentives for environmental entrepreneurs.

In contrast to these intrusive regulatory policies, free market economists, like the late Milton Friedman, have long advocated market-based approaches to the environment. Naturally, the starting point of this approach is a deep appreciation for the efficiency of markets. Markets provide incentives for people to work hard and to innovate. More deeply, the invisible hand of the marketplace coordinates the actions of countless individuals by using prices as the signals which convey their local and specialized knowledge—knowledge that no central planner could ever have.

Either way, these market-based approaches have three advantages over more intrusive command-and-control regulations. First, they create flexibility in who cuts their pollution. Industrial facilities that find it easy to reduce their emissions can save money by making extra cuts and selling their pollution rights, while those that face steep abatement costs can pollute more. Second, market-based approaches create flexibility in how the cuts are made. Plant managers, who know their own business better than anybody in Washington, are given full freedom to make the cuts however they choose. Finally, market-based approaches create incentives for entrepreneurs to devise new ways to reduce pollution more efficiently.

Market-based approaches create incentives for entrepreneurs to devise new ways to reduce pollution more efficiently.

There is plenty of room for free market environmentalists to debate the relative merits of emissions taxes and cap-and-trade. The two approaches are similar in their flexibility in determining how abatement is achieved, but they differ in how they treat the remaining pollution. A carbon tax could mean more than $100 billion in new tax revenue annually. Proponents of this approach argue that this revenue represents an opportunity to reduce the budget deficit or to lower other taxes, such as the income tax or the capital gains tax.

But it’s also possible that those new funds simply would tempt government to find new ways to send money down a rat hole. Provisions in previous climate bills to earmark a portion of revenues to “green jobs” training and energy programs illustrate this tendency. Cap-and-trade is an alternative approach without this temptation. Like any market, cap-and-trade creates incentives through prices, but rhetoric equating it with a tax is either misinformed or misleading. In contrast to taxes, where the price on pollution is a transfer to government, with cap-and-trade, the price is set in a market, so the pollution price represents exchanges within the private sector. If cap-and-trade is a tax, then all market purchases are taxes.

Property Rights for the Environment

There is another reason to like the cap-and-trade approach: It unleashes the full power of property rights. One of the pioneers of the property rights approach to the environment was economist and Nobel laureate Ronald Coase. Coase’s insight was that one reason markets in pollution do not evolve organically is that the rights to the environment are poorly defined. Nobody will buy a right from you if they are not convinced you have it to sell.

Environmentalists would have the opportunity to purchase pollution rights and retire them.

Coase argued that if rights are well defined and if transactions costs are low, markets will efficiently allocate resources— including the environment. He not only envisioned trade among polluters, but also between polluters and conservationists. If conservationists hold the right to the environment, they could sell it to polluters. If polluters hold the right to pollute, conservationists could buy it from them, and refrain from exercising it. Whoever has the higher value for the resource will end up with the rights.

Cap-and-trade is based on this property rights approach, as Coase himself has noted. By setting up a trading system, it lowers the costs of transactions, which can occur at a commodities exchange. Under the cap, allowable emissions are allocated to industry as tradable property. Emissions reductions represent property claimed by the government for the public interest.

As Coase argued, the environment is a scarce resource, with its use as a sink for disposing of carbon and other wastes competing with its use in maintaining ecosystem services. The problem with the status quo is that it ignores this scarcity and treats the atmosphere like a free good. The “cap” in cap-and- trade establishes limits on its overuse by defining the extent of rights to dispose of wastes. The “trade” in cap-and-trade allows those rights to be priced like any other natural resource or scarce input, with the price going up and down as participants discover their needs and react to new conditions.

Additionally, compared to other approaches, cap-and-trade represents a more gradual realignment of property rights. Taxing pollution can be viewed as equivalent to the government first appropriating all rights to the environment and then selling them back at a fixed price. With cap-and-trade, a large portion—perhaps even most—of the rights would remain with industries that have the precedent of using them historically.

A cap-and-trade bill that free market environmentalists can support should rely on the market to make decisions about how and where to reduce pollution.

In fact, consider a non-binding cap. Suppose, for example, that CO2 emissions in the United States are reliably about six billion tons per year. Then suppose that the government establishes a cap-and- trade system with a cap of six billion tons. This may appear to be about as futile as a labor law requiring a holiday on every sixth Sunday of the month. But to the contrary it would have done two important things: establish the rights to the environment and facilitate trading. From that point on, environmentalists would have the opportunity to purchase pollution rights and retire them. This is precisely what the Nature Conservancy and countless local land trusts do now with rights to land ownership. Defining property rights in this way is a fitting role for even the most limited government.

Improving cap-and-trade

None of this is to say that free market environmentalists should support the actual cap-and-trade bills in Washington. But if those bills are to be rejected, it should be for straying too far from cap-and-trade principles, rather than for following them.

A cap-and-trade bill that free market environmentalists can support should do three things. First, it should truly rely on the market to make decisions about how and where to reduce pollution. The Waxman–Markey bill that passed the House of Representatives in 2009 fails this test. That bill would further inject the federal government into building codes, lighting standards, and automobile technologies. Most troubling, it would include burdensome requirements that 20 percent of electricity come from renewable energy by 2020. This standard will be impossible to meet in some states and undermines the whole point of cap-and-trade. If the objective is to limit carbon, the federal government need not decide how to do it. That is exactly what markets do well and what governments do abominably.

Second, a cap-and-trade bill should provide maximal flexibility with respect to the timing of reductions, with industry allowed to bank their permits for future use. Often overlooked, banking allows firms to time pollution reduction investments efficiently, with additional benefits for the environment.

Finally, a climate bill should adhere to the principle of gradual change. The cap should mandate only small cuts for the next 10–20 years and then begin to ramp up. Passing a bill now but mandating cuts later is better for the economy than delaying a bill, because it gives businesses an opportunity to plan for the future when making longterm investments. It also creates the incentives right away for entrepreneurs to begin developing new green technologies. In the long run, such innovation is always the most important factor for creating wealth out of the environment and improving environmental quality.

Whatever their feelings about applying it to carbon, conservatives and free market liberals alike can cheer the cap-and- trade approach to pollution as a victory for their ideals.


What would a free market cap-and-trade bill look like?

A free market environmentalist cap-and-trade bill would:

Rely on the market to decide how and where to reduce pollution

—No government-mandated building codes, lighting standards, or automobile codes. Finding the best way to comply with a cap is what markets do well and what governments do abominably.

Provide flexibility with respect to the timing of reductions

—Industry should be allowed to bank permits for future use. This allows firms to time pollution-reduction efficiently.

Adhere to the principle of gradual change

—Mandate small cuts for the next few decades, then ramp up, allowing businesses to plan for the future when making long-term investments.



Spencer Banzhaf is a Professor of Economics at Georgia State’s Andrew Young School of Policy Studies, a Senior Research Fellow at PERC, and a Research Associate at the National Bureau of Economic Research (NBER). Spencer’s primary field of study is environmental policy analysis, focusing on the urban environment and issues related to air quality...
Read More > More Articles by Spencer Banzhaf >