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?