Sunday, June 28, 2009

Confusion and Misinformation on Cap-and-Trade

Republicans in Congress have been reciting a set of talking points regarding the recent cap-and-trade legislation that are misleading. In this entry I'm going to explain a bit about how cap-and-trade works, and why "it will drive up energy prices" is a dumb complaint to make.

First a bit about pollution. The problem with pollution is that the person making it doesn't pay the full costs of it, so he or she does too much of it. That is, the owners of the power plant emitting carbon dioxide will not bear much of the costs of global warming, so they emit whatever amount they find convenient, unless forced to do otherwise. This is called a negative externality--the costs are external to the person creating them. Economists generally prefer two tools to control pollution (whether CO2 is a pollutant or not isn't really important; if we want to reduce it, all the economics in this post applies): pollution taxes or tradeable emission permits, the latter of which is also known as "cap-and-trade". If done correctly, these programs will internalize the externality--that is, they will cause the people producing and consuming the polluting goods and services to recognize the costs they are imposing on others.

I've talked a bit about pollution (or "pigouvian") taxes and cap-and-trade before. Both tools are known as market-based regulatory devices because they attempt to alter incentives and let the market do the rest. For example, a pollution tax raises the cost of emitting pollution. If a firm is charged, say, $5 by the government for each ton of pollution emitted, then if a firm can clean up that pollution at a cost of less than $5, it will do so and avoid the tax. It is in the firm's interest to find the cheapest way to clean up, because it will save money by doing so. If it costs more than $5 to eliminate that ton of pollution, then the firm will go ahead and pollute.

How does cap-and-trade work? In the economist's preferred setup, the government would auction off permits, selling for whatever price emerged from the auction. Each permit allows a firm to emit one ton of pollution. Suppose a firm buys a permit for $5, then finds out that it can actually reduce that ton of pollution for a cost of only $3. Now the firm can sell that unnecessary permit to another firm, which can avoid eliminating its pollution.

At this point some environmentalists get confused, suggesting that this means firms can simply buy their way out of polluting. For a particular firm this is true, but it is not true in the aggregate. A particular firm could buy a bunch of permits, which would allow it to pollute as much as it wants. This means that some other firm must be selling permits, however, which means that it must be reducing its pollution. The total number of permits is limited. That is, the government might issue permits for, say, 5 billion metric tons of CO2. Any increase in emissions by one firm must be matched by an equal decrease from another firm. This regulatory method is currently used for Sulfur Dioxide (which causes acid rain as well as health problems) and has been wildly successful, reducing pollution significantly and at a much lower cost than expected.

Both the programs I have described raise revenue. In the first case it is tax revenue, and in the second it is auction revenue. In both these cases firms will have to reduce their pollution, which is costly to them. Higher costs will mean higher prices for pollution-intensive goods and services, such as electrical power from coal plants. The Republicans have been repeating this point over and over, saying that for this reason (higher energy costs for consumers), the cap-and-trade program is a terrible idea.

They have it precisely backwards. Higher energy costs is the primary point of the program. It is supposed to raise energy costs. The reason why this is a feature, and not a bug, is that it communicates to consumers the harm that is done by their purchase of energy that creates CO2. That is, by raising the cost of energy, consumers are induced to buy less of it. If CO2 is harmful--and the strong consensus is global warming is real, and will probably be harmful--then we want consumers to consume less energy. It is as though the Democrats passed a bill to reduce pollution, and the Republicans objected that it would reduce pollution.

Another objection is that reducing pollution may be too costly for some firms, which may shut down. Again, this is a feature, not a bug. Firms which produce goods of such low value that they cannot justify the harm produced by their pollution should shut down.

Finally, another advantage of pollution taxes and cap-and-trade is that they encourage development of cleaner alternatives. Cleaner sources of energy pay less tax or buy fewer permits. This gives them an advantage, and causes dirty energy producers to switch to cleaner technologies. It also causes firms to research new technologies which might be even cleaner still. Best of all, it gives firms a strong incentive to find the best new clean technologies. By contrast, the government has in the past tried to subsidize research into clean technologies, with mixed results. Why have these results been poor? Because the government has little incentive to find the best, lowest-cost ways to reduce pollution, because it has little at stake. By contrast, firms that find fantastic new technologies stand to profit substantially.

One way to make higher energy costs less painful for consumers is to give the revenue collected to them. A simple way to do this would be to use the revenue collected to simply eliminate a tax, such as the payroll tax. This could result in efficiency gains (known as the double dividend), although for complex general equilibrium reasons (having to do with the form of taxation eliminated and the response by consumers to the tax cut), it might not happen. Still, for distributional or for efficiency reasons, it may be desirable to give the money back to consumers.

Here's where a legitimate complaint about the current bill might be made. The proposed cap-and-trade program does not auction off the permits. It simply hands them out for free. It still reduces pollution, and firms can still buy and sell them, and energy prices will still go up, but there is no revenue collected by the government. This is equivalent to taxing the firms for polluting, and then giving them all the tax revenue back. Most economists would prefer that the money be used to eliminate distortionary taxes, or at least to reduce the level of government borrowing. Republicans are not making this complaint. They could also complain that there are inefficiently few permits being issued, but they're not doing that either. They are instead complaining that the regulation might do exactly what it is designed to do. That is confusing and misleading, but I suppose that's politics.

Update: From Greg Mankiw's blog, here are two articles describing legitimate problems with the current cap-and-trade bill. One of the problems discussed is the free distribution of permits (as opposed to an auction) that I mentioned before.

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