July 12, 2009
The Cap and Trade Carbon-Emissions Bill
The Cap and Trade Carbon-Emissions Bill--Posner
The energy bill just passed by the House of Representatives and awaiting action in the Senate is extremely long and complex, and cap and trade is only one part of it; but like Becker I will confine my remarks to that part, and thus treat the cap and trade component as if it were a separate bill. I will also assume that it will be enacted, and in much its present form.
Becker's analysis of the political realities surrounding the bill are persuasive; and he probably is also right that revenues generated by a tax (in lieu of a quota) approach to carbon emissions would be dissipated on other government programs, such as health-care reform, rather than used to pay off some of the nation's mounting public debt. Moreover, imposing heavy new taxes in the midst of a depression would retard economic recovery.
In principle, a stiff tax on carbon emissions (and other greenhouse gases, but for the moment I'll confine myself to carbon) is, it seems to me, superior to the quota (cap and trade) approach. (I develop this argument in my book Catastrophe: Risk and Response [2004].) Not because it would necessarily reduce carbon emissions more than a quota approach would do, but because it would stimulate research into ways of solving the global-warming problem technologically. The higher costs of energy to energy producers would create strong incentives to develop technologies that would solve the problem, including technologies for removing carbon dioxide and other greenhouse gases from the atmosphere, which may well be a more promising approach than trying to induce the substitution of "clean" energy sources for fossil fuels. (To create incentives for developing technologies for taking carbon dioxide out of the atmosphere, a carbon-emissions tax would have to be complemented by a negative tax--a bounty--for carbon dioxide removed from the atmosphere.)
The incentive effect of the cap and trade bill is weaker. Each energy producer will receive a quota, and many of the producers will be within their quota or able to meet it at low cost. Those producers that cannot comply with their quota may be able to purchase the rights of other producers (that is the "trade" component of cap and trade) at modest cost; for the aggregate reduction in carbon emissions required by the bill--a 17 percent reduction over the 2005 level, phased in between 2012 and 2020--is modest. Moreover, they may be able to buy additional allowances from the federal government (which is holding some allowances in inventory, as it were) at a modest price (depending on what the government decides to charge), or--what looks like a potentially huge loophole--"offsets" to the emissions that they cause. This means undertaking or financing projects to reduce emissions from other sources, such as afforestation projects designed to increase the absorption of carbon dioxide (trees consume more carbon dioxide than they produce). The evaluation of such projects will be extremely difficult.
Assuming the "cap" component of the bill will reduce the output of energy generated by burning fossil fuels, energy prices will rise and consumption therefore fall. The reduction in output may increase the profits of the energy companies, just as when competitors form a cartel to increase prices and profits by reducing output.
True, a quota that reduced the output of an energy producer by the same amount as a tax would create an opportunity cost equal to the tax: that is, the same innovation that would reduce the tax to zero by eliminating the producer's carbon generation would increase the producer's output to its former level. But is a difference in the likely efficacy of the two methods, quite apart from the fact that the tax (to the extent not reduced to zero as a result of an innovation) but not the quota would generate government revenues. As a matter of practice though not of theory, firms often do not react to opportunity cost as quickly as they do to an out-of-pocket cost. The out-of-pocket cost shows up right away on the balance sheet (some of it at any rate--some part will be passed forward in the form of a higher price) and is likely to affect the price of the corporation's stock more quickly than a failure to take advantage of an opportunity to eliminate the cost by innovating.
The effect of the cap and trade bill on the amount of carbon dioxide and other greenhouse gases in the atmosphere is thus likely to be slight, and the administrative costs of the program will be great. Emissions will continue to increase, probably at no lower rate than at present; for the modest effect of the bill will be offset by the growing emissions by China, India, and other rapidly developing countries. Conceivably the bill will provide some impetus to effective international cooperation to limit global warning, but one cannot be very optimistic. Hence the importance of a technological fix, which does not require international cooperation to be effective. If technology were developed for removing carbon dioxide from the atmosphere, Third World countries could emit carbon dioxide to their hearts' content.
We may indeed already have the technological fix, though mysteriously it receives little attention. Sulphur dioxide, the cause of acid rain and the poster child for cap and trade--because the cap and trade program for sulphur dioxide has been a big success--is the opposite of a greenhouse gas: it cools the atmosphere by reducing the amount of sunlight that reaches the earth's surface. Injecting relatively small quantities of sulphur dioxide into the atmosphere would offset the effect of atmospheric carbon dioxide in heating the earth's surface. The opposition of environmentalists to using a pollutant to combat global warming and therefore seeming to approve of pollution, and concern with the bad effects of increasing the amount of sulphur dioxide in the atmosphere (effects that might not be limited to a modest increase in the amount of acid rain), have thus far kept this option from serious consideration in political circles.
Becker raises the interesting question of the implications of option theory (though he does not use the term) for dealing with the global-warming problem. Since there is considerable uncertainty concerning the gravity of the problem, there is an argument for moving slowly (as in the cap and trade bill) while gathering additional information in an effort to dispel the uncertainty. But option theory can be run in reverse and be appealed to as a ground for taking early preventive measures. Suppose that at time t there is some nonquantifiable but nontrivial probability of a disaster of immense proportions at time t + 2. Suppose further that at time t + 1 we will learn the probability of the disaster at t + 2, but that by then the cost of effective preventive measures will be immensely higher. Although the tradeoffs are uncertain, it may make sense to incur the much lower cost of preventive measures at time t.
This is the tendency of current thinking about a future financial crisis such as the one last September that has brought about the depression we find ourselves in. No one can estimate the probability of a future such crisis, but it is widely agreed that preventive measures should be taken against the possibility of one. The analogy to the global-warming problem lies in the fact that both economic depression and climate change are disequilibrium events involving adverse feedbacks. In the case of an economic depression, the adverse feedback is a deflationary spiral, in which falling demand results in falling employment and prices, producing hoarding, which in turn reduces demand further and therefore output and therefore employment, and so on down. In the case of global warming the possibility of dangerous adverse feedbacks is illustrated by the melting of the arctic tundra in Alaska and Siberia. Much methane, a potential greenhouse gas though one found in only small amounts in the atmosphere, is trapped in arctic tundra. As surface temperatures rise, tundra melts, releasing methane into the atmosphere, which in turn causes surface temperatures to rise more, releasing more methane, and so on.
The possibility of serious adverse feedbacks makes both economic depressions and climate change extremely dangerous events, warranting emphasis on preventive measures taken well in advance. That is an argument for more aggressive measures than contemplated by the cap and trade bill. But the power of special interests and our soaring national debt make the argument academic.
But may we at least have a decade before the danger of acute global warming becomes acute? Probably, though no one can say for sure. Still, a wait and see approach for a decade is certainly a defensible option.
Legislation on Clean Energy-Becker
In late June the House of Representatives approved The American Clean Energy and Security Act. If the Senate approves a similar version, this would constitute the most important American legislation on overall control of carbon-emitting gases. The main provision of the bill is a cap and trade system, to begin in 2012, which would provide allowances for emissions of carbon dioxide and other greenhouse gases. The goal of the bill is to reduce the carbon emitted by American industries to 17 % below 2005 levels by the year 2020, and to reach more than 83% below 2005 levels by 2050.
Some environmentalists have criticized the 2020 energy-reduction goal as too little and too late. However, I believe that the optimal greenhouse gas policy is to go slow initially until greater evidence on the severity of global warming becomes more apparent. The main threat to the world from global warming is an as yet unknown probability of quite severe warming that would cause considerable harm-the world could adjust at relatively little cost to a moderate degree of global warming. The additional evidence accrued during the next decade will provide more information about the likelihood of the severe warming that would merit more drastic steps. If such steps become warranted, then the rate of carbon reduction and carbon storage should be speeded up beyond that envisioned in the House bill. On the other hand, if milder versions look likely, the 2050 goal of a more than 80% reduction in carbon emissions could be relaxed.
Another reason for going slowly at first is to determine how much will be done on global warming not by EuropThese and other developing countries, along with the US, will be the major contributors to greenhouse gas emissions during the next decade. If the BRICs cannot be bribed or threatened into taking steps to reduce their carbon emissions, the US might rethink how much it wants to do. Rethinking American policy would be especially urgent if the more the US did, the greater the migration of industries from America to developing countries.
While accumulating information during the coming decade on the severity of the global warming problem, the US should greatly invest in trying to achieve breakthrough technologies in advanced carbon control and storage. The aim would be to acquire technological knowledge that could be quickly implemented without enormous cost if the evidence warranted imposing major carbon controls and storage in a short period of time. The House bill allocates about $1 billion annually to the Carbon Storage Research Corp for further research. This is probably not enough, given the possible need to act quickly and decisively to combat global warming.
Under the House bill during the first decade or so, almost all carbon allowances will be given away, mainly to companies, rather than sold to the highest bidders. Over time the fraction sold would continue to increase until the vast majority of allowances would be sold. Many economists have criticized this giving away of allowances during the next couple of decades as a missed opportunity to raise revenue for the federal government through the sale of allowances. In light of the pending massive federal deficits during the next several years, auctions might seem the best approach.
However, the political reality is that significant cap and trade legislation might not gain enough political support if the government sold energy emission allowances rather than giving the majority to the industries most affected. For energy-intensive industries are well organized politically, and they would strongly oppose a carbon tax-which is what an auction of emission allowances amounts to- since such a tax would reduce profits in these industries. On the other hand, energy-intensive industries might support, or only weakly oppose, a cap and trade system where most allowances were given to them since that system could increase their profits, or only reduce them by a little.
Economists typically assume that when a new tax, like a carbon tax, is introduced, government spending is held fixed, so that other taxes can be reduced. That assumption is often useful for analysis, but may not be realistic politically. The revenue from a new tax may be mainly used to increase government spending rather than to reduce other taxes. The case for selling emissions through auctions rather than giving them away is a lot weaker if the government wasted much of the additional revenue, or if the additional spending itself distorts behavior by households and firms. Empirically, the most common response to "new" tax sources, like a carbon tax, is a combination of reduced other taxes and greater government spending (see Becker, Gary S., and Casey B. Mulligan, "Deadweight Costs and the Size of Government." Journal of Law and Economics, October 2003). This typical response makes the case for selling cap and trade allowances considerably weaker than if government spending were held fixed after new tax revenues were collected.