Cap and Trade: Economic Efficiency and Reduced Emissions

This is a guest post by Charles F. Wurster, Ph.D. He is Professor Emeritus of Environmental Sciences at the State University of New York at Stony Brook, and is a founding trustee of Environmental Defense Fund.

Global warming and climate change will severely affect life on Earth during this century. It is primarily caused by burning oil and coal, along with deforestation.  Numerous effects are already occurring around the globe. Yet the American Clean Energy and Security Act (ACES), intended to reduce climate change, passed the U.S. House of Representatives by a tiny 219-212 majority.  Why wasn’t it unanimous?

Some thought the bill too strong.  Others considered it too weak.  Some believed it would cost too much.  Others don’t take climate change seriously.   Only half of Americans think human activities are the cause.

Opponents of the bill have intentionally disseminated disinformation and confusion about climate change. Many companies also oppose the bill because they suspect it would reduce their profits.  There’s a vast amount of wealth and political power amassed in the status quo.  Why should they change?

Despite the many compromises needed to gain the votes for passage, Congress must pass ACES if we are to diminish climate change, the greatest issue of our time.  The basic structure of the bill is a cap-and-trade system, which is misunderstood by many Americans, including congressmen.   That hampers passage.

Cap and trade was pioneered in the 1980s by Dr. Dan Dudek, an economist with Environmental Defense Fund, to combat acid rain.  EDF convinced the first President Bush to include it in the Clean Air Act of 1990, and by 2000 emissions of sulfur dioxide, the cause of acid rain, were cut in half at a small fraction of the original cost estimates by the industry.  Compliance was 99% because its mandate was unavoidable.  Cap and trade became the most effective anti-pollution device in recent memory.

Now cap and trade is being applied to carbon dioxide (CO2) emissions, the main pollutant causing climate change.  Cap and trade was adopted internationally under the Kyoto Protocol, which was rejected by the second Bush Administration but ratified by 184 other countries.

To be clear about how cap and trade works, consider a simple example:

• A company we will call “Easy Inc” is able to reduce CO2 emissions easily and cheaply, but has not done so for lack of an incentive.
• Another company called “Difficult Inc” would find it difficult and costly to reduce its emissions.

Under cap and trade, next year they will only receive 90% of their present emissions allowances (the “cap”), so they must reduce emissions 10% next year. Here is what they do:

• Easy, Inc., has no problem reducing emissions by 10%, but Easy can sell on the carbon exchange (the “trade”) any extra allowances if it abates more than its required 10%.  So Easy abates 20%.
• Difficult, Inc.,  does not abate at all.  Instead, Difficult buys Easy’s extra 10% of allowances.

Under the C&T system, Easy has reduced emissions for both Easy and Difficult, and the average CO2 abatement of 10% has met the system requirement.  Easy has profited by selling its extra allowances to Difficult, and Difficult has abated through Easy at a lower cost than if it had done so itself.

Difficult also has an incentive to seek ways to reduce future emissions so that it doesn’t have to buy more allowances.  Everyone knows that available allowances, the cap, will continue to decline by law in the future.  The government does not tell polluters how to meet the requirements, thereby stimulating innovation, emissions are carefully monitored, there is no incentive to cheat, and compliance rates will be high.

The ultimate goal is an international treaty with a carefully structured and regulated cap and trade system that includes all nations, along with a marketplace for buying and selling CO2 allowances.  Abatement will therefore proceed by the cheapest and best technologies — economists call it economic efficiency — and investments are thereby channeled into clean, efficient, low-carbon energy systems throughout the world.  It will no longer pay to pollute; instead it will pay to abate pollution.

Cap and trade will set off a stampede toward energy efficiency because efficiency improvements are the cheapest, often most profitable, and quickest route to emissions abatement.  Countries with extensive rain forests, such as Brazil or Indonesia, can sell allowances to keep their forests intact, putting a value on standing forests with their vast carbon storage, instead of gaining short-term profits by cutting them down.  Preserved biodiversity is an additional huge benefit.

The ball is in our court and the time is now!  The rest of the world, already functioning under the limited Kyoto Protocol, waits to see whether the USA will act.  The climate bill containing the basic cap and trade structure, however much compromised to pass Congress, must become law for the world to build on that structure to limit climate change.