In my series discussing capitalism and socialism, a commenter said that both frameworks have problems with externalized costs. According to the internet, “Externalized costs are costs generated by producers but carried by society as a whole.” For example, pollution.
I want to discuss externalized costs through the lens of a specific concrete example: cap and trade policies in California. I choose this example because I have a friend willing to explain it to me because I live in California and know all about it.
Generally speaking, cap and trade is a policy to reduce carbon emissions (or greenhouse gasses). The government auctions off “allowances” that give companies permission to produce a certain amount of carbon emissions. There are a fixed number of allowances available (that’s the “cap” part), and further carbon emissions are restricted. The companies are free to buy and sell the allowances at prices of their own choosing (that’s the “trade” part). The number of allowances decrease over time in order to meet the government’s pollution reduction goals.
The idea behind the policy is that climate change from greenhouse gasses is an externalized cost. If companies seek to maximize profits, then often their best strategy is to completely ignore externalized costs–to the detriment of the environment. With a cap and trade policy, we make it so the cost of climate change is no longer external, it’s just part of the cost calculations.
The government could just order a halt to all carbon emissions, but that would be no good because it would cripple the economy. Ideally, we would still allow carbon emissions, but only for the most vital economic activities. Under a cap and trade policy, the idea is that the most vital economic activities are the ones that produce the most profit, and are therefore willing to pay the highest prices to buy allowances.
It is instructive to compare to an alternative policy, “cap and tax”. Cap and tax was an option investigated by the California Air Resources Board (cite, cite), but to my understanding was rejected because it’s not very good. Under cap and tax, each entity is restricted to producing only a certain amount of carbon emissions per year, and this amount decreases each year at a fixed rate (that’s the “cap”). They are also obliged to pay the state a fixed price for carbon emissions (that’s the “tax”), although reportedly the main driver for carbon reduction is the cap rather than the tax. Companies are no longer allowed to buy and sell allowances with each other.
Why is cap and tax bad? In theory, one industry might be very flexible in terms of their carbon emissions, and another industry might be very inflexible. Under cap and trade, the flexible industry would sell its allowances to the inflexible one, and carbon emissions would be reduced without throttling either industry. Under cap and tax, the flexible industry wouldn’t put in the R&D to reduce emissions, and the inflexible industry is SOL.
Now, let’s talk about problems with cap and trade.
- Since this is only a California policy, an obvious dodge is for companies to move polluting activity to nearby states. This can also create political pressure if California workers lose their jobs. But then, perhaps the solution isn’t to end cap and trade, it’s to enact more cap and trade policies nationwide.
- As far as worldwide climate change goes, it doesn’t matter where greenhouse gasses get produced. However, pollution also has local effects, so you might say that pollution near a dense urban area has greater external costs than elsewhere. Pollution particularly affects low-income communities, who have less power to move away. California addresses this by directing revenue towards disadvantaged communities that are negatively impacted by pollution (cite).
- Cap and trade works because carbon emissions are relatively easy to measure and regulate. You might imagine that this model does not work for all kinds of externalized costs. For instance, there are many other kinds of pollution. I also have another example in mind that I want to discuss next time.
This is an open discussion, so please feel free to question my assumptions, or express any other concerns. A few questions:
- Is cap and trade a good policy?
- What obstacles and issues does the policy face? Are there better alternatives or fixes?
- Is cap and trade a good model for how to deal with external costs, or is it more of a specialized solution?
Cap and trade is as good as it gets, and it’s actually very good, especially if we have a good idea of the amount of pollution we can tolerate and the benefits of abatement.
An important consideration is who initially owns the permits. It doesn’t affect the internalization of external pollution costs (see the Coase Theorem), but the initial allocation has distributional consequences. I don’t know how the initial distribution works in California.
Since this is only a California policy…
I agree with your opinion.
You might imagine that this model does not work for all kinds of externalized costs.
You would imagine correctly. Ease of measurement and determination of the source are critical, as are knowing the benefits of abatement and an optimal level of abatement.
The most vital economic activities are the ones that are essential for human wellbeing. Things like healthcare, education, food. The most profitable economic activities are, well, other things.
It depends on how it is enacted. For example, how exactly the emission credits are distributed, how much do they cost to purchase, etc. Then there’s also the fact that without international agreements that would make all countries to implement similar requirements, businesses can just relocate their factories overseas where there are no caps.
Ultimately, I doubt the efficiency of cap and trade when it comes to actually reducing greenhouse gas emissions. For industries that use lots of fossil fuels, the cost of converting to more renewable resources can be very high. The emission credits, and even penalties and fines for exceeding a cap limit are all cheaper than going through a conversion to a new source of energy. This means there is no real incentive for those industries to change their practices.
In general, I tend to be skeptical of any proposals, which claim that free market will solve some problem. I want to see some solid proofs before I’ll believe that in this particular case it might actually work. Whenever businesses push politicians to implement some new plan that expects the free market to solve some problem, I expect the worst by default and demand good evidence before I’m willing to give the new plan a try. Not that anybody asks me, though.
For me it seems that carefully designed system of taxes and regulations is more likely to succeed in reducing greenhouse gas emissions. By regulations I mean things like, for example, “You are forbidden to burn any coal starting with year 20XX. Period.” That’s more effective than saying, “If you want to keep on burning coal, just purchase some emission credits.”
@Larry #1,
California holds a quarterly auction (single round sealed bid). I’m not sure what the state does with the revenue, but as mentioned in the OP at least some of it is directed towards disadvantaged communities affected by pollution.
@Andreas Avester #2,
Yes, I agree with this critique. The most important economic activities are not necessarily the ones that are willing to pay the highest prices for allowances. For what it’s worth, I think healthcare and education are not regulated by cap and trade at all. According to Wikipedia (linked above), the regulations apply to utilities, large industrial plants, and fuel distributors.
I agree. I’m afraid that California’s cap and trade does not do much by itself. But California does tend to be a policy leader among the states, so I hope it will inspire the rest of the nation. And then, uh, maybe the US could impose regulations on any companies that trade with the US or something, not sure. Apparently California has already linked its cap and trade policy with Quebec’s, that’s pretty neat.
In practice the penalties for exceeding a cap limit are much more expensive than the market price of allowances (as it should be).
The situation you’re describing, where an industry is very inflexible in terms of its carbon emissions, that’s similar to what I described in the cap and tax example. Yes, such an industry would just buy more allowances, instead of converting to renewable resources. However, each allowance purchased is one less allowance for someone else, so this still results in a reduction of carbon emissions. If all industries are inflexible, then this would result in a sharp increase in allowance prices, until some of the industries decide that they’re flexible after all.
Cap and trade also has the advantage that it allows something to be done without confronting the rich and powerful, who are disproportionately making the problem worse. Make their private jet more expensive and they’ll just pay it. Make the economy seats for tourists more expensive and they might reduce their travel a bit. It works out nicely for the billionaire, purely by coincidence, as things generally tend to.
I have a hypothesis that none of these approaches are worth a bucket of warm spit, because if they were, they would not be permitted or they’d be cheated on. A problem that results from unrestrained stupid greed doesn’t seem to me like it will be solved by anything that ignores taking on that root cause.
Marcus,
The rich will always be better off no matter which method you chose for lowering emissions unless you get rid of capitalism. And I don’t see that going away any time soon.
Cap and trade also has benefits for the less fortunate in that people can keep their jobs in industries where it is more difficult (or more costly) to lower emission quickly by allowing them to buy credits from industries where it is easier or even beneficial to go quickly. (Yes I know, keeping a crappy job is not great but that’s also part of the capitalism issue…)
And yes Quebec is part of the same carbon market as California. Ontario was also part of it before they elected Trump-lite (Doug Ford) who quickly got rid of any carbon pricing policy.
My friend added the following comments/criticisms:
I don’t understand. That’s not a benefit. That is indicative of a negative of the plan. This is indicative that we could lower emissions faster if we went with a tax. It is unfortunate that this hypothetical poor worker has a job in a CO2 emissions industry, but in order to make progress, his job needs to go.
It’s still my opinion that James Hansen’s fee-and-dividend approach is better than any cap-and-trade system. When you compare the complexity of the system of cap-and-trade compared to a system emissions-tax approach, the whole system of initial allocation, and bidding, and trading, still seems like a scam to me which was intentionally designed in order to allows some rich bankers to get even richer. Bankers cannot skim off the top of a emissions-tax system unlike how they can with many of these cap-and-trade systems.
Unfortunately, I believe that there is insufficient political will to place a sufficiently high tax rate on CO2 emissions and also have the same tax on imports of products whose manufacture produced CO2 emissions.
@EnlightenmentLiberal,
By “fee-and-dividend”, I think you mean a system where there’s just a flat (but increasing over time) fee on carbon emissions? I think that’s “alternative 2” in the ARB report–see page 18. They seem to think cap-and-trade is better although I don’t understand why.
By and large, it sounds about equivalent to cap and trade, plus or minus details. I mean, it depends on how high the cap is, and how high the fee is, but for any given fee there is some cap that has about an equivalent effect. It seems plausible to me that the fee and dividend is cheaper to implement, although it is hard for me to say. It also seems like there could be disadvantages, like it might be harder to hit a particular emissions target, or it might be easier for carbon-producing industries to influence the political process.
I favor flat bans. We’re not going to survive if we keep fucking around with this, trying to unscramble capitalism and imperialism one strand at a time. It’s all got to go – may as well be tomorrow.
To Marcus
I like flat bans. However, that has to be at the same time as real replacements are rolled out. I know what can replace fossil fuels. Whereas, certain other groups really don’t know what can, and they’re looking to future unspecified technological breakthroughs and changes to figure it out. They’re relying on the magic invisible hand of the market to figure it out. I’ve rather fix this through a command-economy approach, with (partial) solutions that we know would work (e.g. nuclear), and massive R&D into commercialization for the other technologies that would fill in the gaps (i.e. synthetic gasoline). Do that, and also phase out coal and nat gas plants at the same time.
To Siggy
James Hansen advocates for an increasing CO2 emission tax on all domestic emissions, at the source of the emissions and/or the mines, in order to make it easy to oversee, plus, CO2 emissions tax on all imported goods from countries that do not have the same CO2 emission tax. Then, increase the tax year over year. And instead of using that money to fund government, which would be regressive taxation – instead, distribute all collected money once per year to every citizen and resident equally regardless of personal emissions.
@EnlightenmentLiberal #11,
I would dispute that the policy that you’ve described is any more progressive than cap and trade (in the sense of progressive vs regressive tax, not in the political sense). And perhaps we’re looking at it a bit differently–I think of the taxation policy and spending policy as essentially independent policies. So you could ask whether the taxation is progressive or regressive, and also independently ask whether the spending policy is progressive or regressive, and then ask about the total policy. As far as the taxation component goes, cap-and-trade and fee-and-dividend seem equivalent. As far as the spending component goes, cap-and-trade as a concept doesn’t specify a spending policy so it’s impossible to compare. I don’t know how the revenue is spent in California, but at least part of it is distributed to disadvantaged communities, which is by definition more progressive than distributing it to citizens equally.
But really, either policy sounds good to me. Thanks for introducing the idea.
My understanding still is that a simple tax approach is easier and cheaper to oversee, and contains less less possibility for cheating, and leas possibility for bankers and organized crime to profit from the new market. Why have a market of allowances when a simple tax accomplishes the same goal? See
https://www.zerohedge.com/article/cap-and-trade-gigantic-scam
@Siggy#12,
There are a couple of advantages that fee-and-dividend has over cap-and-trade. First of all, as EL says, fee-and-dividend is simpler and so there would be less gaming of the system either in the creation of allowances or in their secondary market. Of course, attempts could still be made to hide carbon emissions, but that would be a problem for any system.
The second advantage is having the dividend publicly tied directly to the system. Those who pollute less would be profiting and invested in the system, making it hard to eliminate and perhaps raising the political will to instantiate it, and this would be true whether dividend payouts were progressive or not.
If we simply do not much care about producing goods and services for private consumption, then a flat ban is probably the most efficient method. And it may well be the case that CO2 (and other greenhouse gas) emission has gone too far to worry about private consumption: we can all die in luxury or survive in hopefully temporary poverty. While I’m sure some clever economist could study military resource allocation, our ordinary economic models are not, I think, well equipped to study war or its “moral equivalent”.
But if we are to use ordinary economic models to address CO2 and GHG emissions, then cap and trade has some advantages over a tax or flat fee. Briefly put, if we decide on a total level of abatement, then it requires the least cost overall if the marginal cost of abatement (how much to reduce pollution by one unit) is be about the same for all businesses and industries that pollute. If we know that “magic” marginal cost, then a tax or fee system is fine. If we do not know it, then a cap and trade system allows industries to use market mechanisms to determine the magic marginal cost.
I am not generally persuaded by “simpler is better,” although I do agree that “extremely complicated” is generally bad. Cap and trade does not seem extremely complicated.
@Marcus Ranum #9
Graydon agrees with you:
“[W]e need to zero out fossil carbon inputs and thus fossil carbon extraction by 2025. (Well; 2000. Earlier would have been better.) But 2025 is worth it for limiting-the-damage purposes. The appropriate policy now is carbon rationing along that decreasing schedule to zero, backed up with whatever level of force is required to enforce compliance.”
To Larry Hamelin
I’m just a broken-wheel right now with what I’m about to say. I’m just pissed because the people who should be fixing this problem are actually the biggest impediment to fixing. The Greens / mainstreams environmentalists are the biggest obstacle to fixing the problem because of their adamant resistance to nuclear power and because nuclear power is the only plausible approach to fixing this problem. When Greens get into power, they shut nuclear power plants and build coal plants, as seen by Germany and California. I’m not alone in thinking this – some of the most famous environmentalists are on my side, such as James Hansen, who says that believing in renewables is like believing in the Easter Bunny or the Tooth Fairy, and Kerry Emanuel, who has said that history may record Greens being the biggest problem to fixing the climate.
We can also talk about impact on immediate human health and immediate impact on species, and nuclear is the best there too, beating out coal, natural gas, oil, and even beating out solar and wind and other renewables. For example, WHO says about 7 million people die premature deaths every year due to complications from airborne particulate pollution which we could almost entirely eliminate with widespread nuclear power.