A Modest Proposal: After Cap and Trade

Addressing the environmental problems created by the world’s dependence on fossil fuels, and the ensuing global climate change, will help ensure security and economic stability for future generations. Unfortunately, current proposals to address climate change through economy-wide cap and trade are unworkable both politically and economically. An alternative approach, more modest in scope, that can be enacted quickly and improved upon over time, is urgently needed.

Economy-wide cap and trade proposals start from the worthy goal of limiting the total amount of greenhouse gas emissions that may be legally released into the atmosphere. The limit creates a market price for emissions, reflecting the stringency of the cap. However, the simplicity of “cap and trade in theory” is quickly lost as the challenges of implementing “cap and trade in practice” become apparent. There are three interrelated problems with economy-wide cap and trade proposals:

  1. First, pricing greenhouse gas emissions will increase the costs of goods and services. But the cost impacts will not be manifested in equal proportions across different regions of the country or industries. The prospect of purposefully raising energy costs in some areas more than others creates a substantial political challenge to economy-wide cap and trade right from the start.
  2. Second, to alleviate the disproportionate regional and industry-specific cost impacts of cap and trade, transition strategies must be developed which will add to the complexity of the original policy. Economy-wide cap and trade proposals variously include provisions for freely allocating certain emissions permits to some industries, auctioning other sets of permits, allowing some types of emissions reductions to offset other sources of emissions, and setting artificial price ceilings and floors on the cost of emissions. These transition strategies will undermine the public’s trust in the regime as the inevitable horse-trading ensues around who gets free permits and who doesn’t, what kinds of offsets “count”, etc. In short, to mitigate all of the unintended consequences and collateral damage of putting a single price on greenhouse gas emissions, cap and trade proposals have come to mirror the U.S. tax code in complexity, looking more like a delicately balanced Rube Goldberg machine than the elegant solution to climate change that was promised.
  3. Third and finally, price-based, market mechanisms are not always the most cost-effective emissions reduction approach. This fact has often been overlooked in the push to develop cap and trade. Fundamental economic theory tells us that in industries with efficient, well-developed markets, putting a price on emissions will create a powerful market signal, generating emissions savings. However, the flip-side of this economic reality is that in industries that are not characterized by efficient, well-developed markets, a price signal on emissions will not be the most effective or least-cost way to reduce emissions. In the building-sector for example, and to some degree in the transportation sector, businesses and individuals already have an economic incentive to choose the more energy efficient option, yet they often do not. Finding innovative ways to overcome the non-economic barriers to energy efficiency will represent a significant source of low-cost emissions savings.

After more than a decade of watching some of the best minds in industry, environmental groups and Washington try to negotiate past these challenges to economy-wide cap and trade, the U.S. appears no closer to passing comprehensive climate legislation than when the Kyoto Protocol was adopted in 1997. An alternative, more certain and low cost approach is needed so that our economy can begin to turn the corner on reducing harmful pollutants from fossil fuels, including greenhouse gas emissions, as soon as possible.