Lessons Regarding Cap-and-Trade

As the U.S. presidential election approaches, and an new president is elected, expect to begin hearing more about cap-and-trade for reducing carbon emissions. Both presidential candidates support some form of cap-and-trade, and the Congress at this point seems inclined to proceed. Fortunately for the U.S., Europe implemented cap-and-trade for carbon in 2005, and their experiment offers a number of lessons that hopefully U.S. lawmakers and regulators will learn from.

As reported in an International Herald Tribune article, emissions from factories and plants that trade pollution permits actually rose 0.4% between 2005 and 2006, and 0.7% between 2006 and 2007. It appears that the initial problem developed when the market was created, as some EU governments allocated too many trading permits to polluters. The flood of permits caused their value to be cut in half, and raised questions about the validity of the permit market. The overall allocation not only allowed polluters to keep polluting, but also allowed companies to sell excess permits into the market, profiting from their sale while reducing their value along the way. Prices have since rose after reforms were put in place.

Another problem with the system is the catch-22 of not enough, yet too much government intervention. Without government intervention it is unlikely that industry would impose such a system on themselves, yet with too much intervention, the market is not allowed to operate as it probably should. Of course, government intervention also gives lawmakers opportunities to do one of the things they do best - look out for businesses and industries within their own states and districts. Not that this is inherently a bad thing, but in this case it does not facilitate the problem at hand - reducing carbon emissions.

Careful consideration also needs to be made as to the type of system put in place. While the cap-and-trade systems created in the 1970s and modified in the 1990s to reduce acid rain did have some success, and is now being seen as a framework to build on for carbon trading, the environment at the time - pardon the pun - was different. The acid rain problem was somewhat localized, at least the part we were interested in. Carbon emissions are more of a global problem, and being consider as such. While a cap-and-trade system could possibly help to reduce U.S. emissions if successfully implemented, a U.S. system may do little to curb overall global emission levels, even with the large levels of emissions generated by the U.S. If developing and fast growing countries are not on-board or forced to participate in a similar market system, especially larger countries such as India and China, then the global benefits will be small. Furthermore, making business operations more expensive for small companies and developing countries makes it more likely that companies will either go out of business, pass costs on to consumers, relocate, or look for ways around the regulations. Developing countries will find it more difficult to lift their citizens out of poverty. If not probably designed, and we simply dive in for the sake of political expediency, then the only thing regulators and lawmakers will have achieved is to reduce U.S. competitiveness, and make it more difficult for countries to increase the quality of life and standard of living of its citizens - the very thing such regulation is trying to achieve. If done right, there is potential, but various outcomes must be considered first.

Market solutions may in fact be the answer to reducing carbon emissions, but increased regulation and government interaction often make it less likely that markets can operate efficiently. Ironically, high crude oil and gasoline prices, a result of market forces already in place (be it supply-and-demand and/or speculation driven), may do more than even cap-and-trade could for reducing carbon emissions. As carbon-based energy sources continue to rise in price, the marketplace will look for cheaper, and often cleaner, alternatives. We are already seeing this with the increased interest and investment in solar and wind energy (and even the government mandated ethanol - which has its own carbon footprint). While each does have various forms of government incentives for investment, the market is still being allowed for the most part to operate as its should. Maybe in the end we don't need another market to solve our problem. Maybe what is needed is a little patience, a little incentive, a little trust in the markets, a little faith in American business and ingenuity, and a lot of political courage.