The Rise and Fall of Cap-and-Trade

Markets can fail.  But market mechanisms are often the best way for governments to address such failures.  This has been demonstrated in areas from air pollution to traffic congestion to spectrum allocation to cigarette consumption.    Markets for emission allowances – in which those firms that can cheaply cut pollution trade with those that cannot – achieve desired environmental goals at relatively low economic costs.   As of a decade ago, that long-standing economic proposition had become widely recognized and put into action. Yet the political tide on both sides of the Atlantic has been against “cap and trade” over the last five years.

In the United States, the highly successful trading system for allowances in emissions of SO2 (sulfur dioxide) has all but died since 2012.  In the European Union as well, the Emissions Trading System was in effect overtaken by other kinds of regulation in 2013.

Cap-and-trade was originally considered a Republican idea.  Market-friendly regulation was pushed by those who thought of themselves as pro-market, rather than by those who thought of themselves as pro-regulation.  Most environmental organizations were opposed to the novel approach;  many of them thought it immoral for corporations to be able to pay for the right to pollute. The pioneering use of the cap-and-trade approach to phase out lead from gasoline in the 1980s was a policy of Ronald Reagan’s Administration.  Its successful use to reduce SO2 emissions from power plants in the 1990s was a policy of George H.W. Bush’s administration.  The proposal to use cap-and-trade to reduce SO2 and other emissions further was a policy of George W. Bush’s administration ten years ago under, first, the Clear Skies Act proposed in 2002 and then the Clean Air Interstate Rule of 2005. (See Schmalensee and Stavins, 2013, pp.103-113.) 

The problem is not that cap and trade is a theoretical proposal from ivory-tower economists that cannot survive application in the real world.   To the contrary, its performance in action surpassed expectations.  The mechanism in the 1980s allowed lead to be phased out more rapidly than predicted and at an estimate savings of $250 million per year compared to the old-fashioned approach that did not permit trade.  (Stavins, 2003.)   SO2 emissions were curbed at a much lower cost than even the proponents of cap-and-trade had predicted before 1995, let alone what the cost would have been under the old command-and-control approach.   As expected, the electric power sector chose to close down those plants where it was cheapest to achieve pollution cuts. The flexibility of the cap-and-trade system also allowed the industry to take advantage of unexpected developments such as new scrubber technology and newly accessible low-sulfur coal, to a much greater extent than would have been possible without the market mechanism. (Among those explaining why costs came in so low are Ellerman, et al, 2000.)

The Republican candidate for president in 2008, Senator John McCain, had sponsored US legislative proposals to use cap-and-trade to address emissions of carbon dioxide and other greenhouse gases responsible for global warming.  (He had co-sponsored the Climate Stewardship Act with Senator Joe Lieberman in 2003.  It was defeated in the Senate by 55 votes to 43.   They tried again as recently as 2007, but got no further.  McCain continued to advocate a cap-and-trade approach to climate change during the 2008 presidential campaign; Washington Post, May 13, 2008, p. A14; and Financial Times, May 13, 2008, p.4.) 

Republican politicians have now forgotten that this approach was ever their policy.  To defeat the last major climate bill in 2009, they worked themselves into a frenzy of anti-regulation rhetoric.  (The American Clean-Energy and Security Act, sponsored by Congressmen Ed Markey and Henry Waxman, was passed by the House of Representatives that year, but not the Senate.) The Republican rhetoric successfully stigmatized cap-and-trade.  Schmalensee and Stavins (p.113) sum it up: “It is ironic that conservatives chose to demonize their own market-based creation.”

This stance left in its place alternative approaches that are less market-friendly (Stavins, 2011) — especially after court cases pointed out that the 1970 Clean Air Act and its 1990 Amendmentswere still the law of the land (originally signed into law by Republican Presidents Richard Nixon and George H.W. Bush, respectively, with heavy bi-partisan congressional majorities both times).

The non-market alternatives, such as “command and control” regulation requiring that particular energy sources or particular technologies be used, are less efficient.    Nonetheless they are again the dominant regime.   The number of SO2 allowances specified by the cap-and-trade regime has not been adjusted since 2000. As a result, emissions have since 2006 been steadily declining below the ceiling. The cap is no longer binding.  People aren’t willing to pay for something if they already have more of it than they need.  So the price of emission allowances has fallen steeply, essentially hitting zero since 2012, which indicates that it no longer affects behavior in the electric power sector.  (Schmalensee and Stavins, p.106-07; 114.)

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In Europe, the peak of cap-and-trade came 10 years ago.   The European Union adopted the Emissions Trading System (ETS) in 2003, as a cost-effective way to achieve the commitments it had made under the Kyoto Protocol on Global Climate Change.  It rapidly became the world’s biggest market in the trading of carbon allowances.  But ETS has in recent years been pushed aside by older “command-and-control” approaches, in which the government dictates who should use which technologies, in what amounts, to reduce which emissions.   

European directives say that 20% of energy must come from renewables by 2020.  Renewable energy has been promoted by mandates and subsidies.  These policies along with excessive allocations have collapsed the price of emissions permits in the ETS, because demand for the permits now falls short of any binding constraint.    The price of carbon fell below 3 euros a ton in April 2013, rendering the market almost irrelevant.   It remains very low (5 euros a ton).  This in turn contributes to the burning of coal – the worst energy source, from the viewpoint of global warming or local pollution – which would not have happened if the central policy to address these problems were still a mechanism to put a price on carbon. 

On top of that, the EU methods of encouraging renewables have proven ruinously expensive.  This has been giving pause to European officials as they decide how to extend the 2020 framework to goals for 2030.  The European Council will discuss this at a meeting scheduled for March 2014.    The EU should abandon its numerical targets for renewables and go back to relying on the ETS, with whatever limits on permit quantities are  necessary to keep the price up.  This route can achieve greater progress at reducing Greenhouse Gas emissions at lower cost to the European economies.
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There is nothing inevitable or irreversible about the recent trend away from cap-and-trade.   Indeed in some parts of the world, such as China, governments seem to be moving in the direction of emissions trading as an efficient way to address global climate change.  

Even in the US, where it began, there is still grounds for hope.  The Environmental Protection Agency is currently developing federal guidelines for state programs to reduce CO2 emissions from power plants under the Clean Air Act [Section 111(d)].   As a good model for putting a price on carbon, the EPA should consider the cap and trade schemes that have been developed by the northeastern RGGI, California, and some Canadian provinces. The Regional Greenhouse Gas Initiative (RGGI) began trading permits among large power plants in 2008 and continues to operate among nine northeastern statesCalifornia recently started an important new emissions trading system.  But the Golden State is another example where policies to set standards for particular fuels or particular modes of power generation are in danger of undermining the emissions trading plan ["Assembly Bill 32"].

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[This is the first of a two-part post, which is the extended version of an op-ed published at Project Syndicate.  Comments may be posted there -- or at Economist's View where there is a lively debate. The full version is also to appear at VoxEU.]