An Explanation of Emissions Trading

In my last post, I suggested that it might be possible to create a ‘no cost’ (or ‘low cost’ anyway) solution to CO2 Growth. In this post I will start to explain the principles behind my own conservative proposal for how to curb CO2 growth without hurting the economy.

My idea on this dates back to, of all things, a conversation I once had with my extreme libertarian friend. This is that friend I mentioned before that believed that the freeway system hurt the economy because it put the trains out of business and didn’t let a natural market solution grow. Being an extreme libertarian, he naturally believed that the market was all good. If you just let the market alone it would, in his view, always find an optimal solution through the famous invisible hand of the market.

To prove his point to me, he started to explain to me how emission trading worked. Now mind you, this is a real thing that really has been tried out successfully by local governments for various types of pollution. He used the example of air pollution. This is how he described it.

Bruce, the market solves all problems. It can even solve air pollution. The only good thing to ever come out of the EPA was emissions trading. It’s brilliant because it’s a market solution to pollution. What they did was they sold emission rights to companies. This created a market for pollution rights. They could then sell to each other or to anyone. The Sierra Club got together and pooled their money and actually bought up pollution rights from companies. Because the pollutions rights now had a market value companies wanted to sell them if they could, so it was good for everyone. See, Bruce, the market really can solve all ills.

This really was very close to what he actually told me. I was, I admit, intrigued.

After thinking about this for a few days I went back to him. And here was my ‘counter’ argument.

Jeff, there is one thing you’ve missed. Until the government legislated an emissions market, the markets did not naturally put a correct price on pollution. So this ‘market solution’ is, at it’s core, still a government regulation and markets do not solve all ills on their own. So some government regulation is necessary to produce a good market after all.

Still, Jeff’s point stuck with me. I do not doubt that once you did use government regulation as a way to force pollution to be ‘visible’ to the market, that the market would then promptly start to fix the pollution problem far more elegantly and efficiently than any direct government regulation could ever hope to.

Not long later, I took a class as part of my MBA program and actually studied how emissions trading really worked. It turns out it’s a bit more complicated than my libertarian friend had made it sound.

Externalities

Markets are notorious for failing to respond to certain types of ‘externalities.’ Pollution is a type of externality.

The traditional analysis of externalities assumes that market failures arise because people ignore the external effects of their actions. (Economics: A Contemporary Introduction, p. 676.)

Often externalities are solved by the market without government intervention. According to The Caose Theorem:

As long as bargaining costs are small, an efficient solution to the problem of externalities will be achieved [merely] by assigning property rights. (p. 677)

The example used in the text I’m quoting from is of a lab that tests delicate equipment that happens to be located next to a heavy machinery manufacturer. The vibrations from the machinery manufacturer throw off the delicate lab equipment next door. That vibrations produced by the machinery manufacturer are the externality that the market needs to find a solution for. In this case, let’s say it would cost $2 million for the manufacturer to reduce their vibrations and $1 million for the lab to move location. 

Without a doubt, the efficient market solution is for the lab to move. As it turns out, all the government needs to do to cause the market to find it’s efficient solution is assign ‘property rights.’ It doesn’t even matter how they assign them. If the government decides that the testing lab has the ‘right to operate free of vibrations’, then the machinery shop will offer $1 million for the testing lab to move rather than pay $2 million for the necessary vibration proofing. If, on the other hand, the government decides that the machinery shop has the ‘right to operate there,’ then the lab will pay $1 million to move rather than $2 million to get their neighbor to vibration proof themselves. The outcome only effects who has to pay, not whether or not the efficient solution is found. (p. 677)

However, a natural logical corollary of The Caose Theorem is that if negotiation costs are high, then the market will fail to find the efficient solution.

Inefficient outcomes do occur, however, when the transaction costs of arriving at a solution are high. For example… a power plant emitting sulfur dioxide would have trouble negotiating with the millions of people scattered across the downwind states. (p. 677)

This is why pollution is an externality that usually the market can’t solve on it’s own. Unfortunately markets are ‘blind’ to such externalities. So additional government intervention is needed to make the market ‘aware’ of the problem so that the correct cost of the externality gets built into the market price.

This is a known failing of the free market system. The Invisible Hand cannot efficiently solve an externality problem if transaction costs are high. Thus we have a case for regulation to assist markets with finding an efficient solution. But this is also why I favor Emissions Trading, because it uses the markets to find its own solution with minimal government interference.

Emissions Trading / Selling Pollution Rights

For example, suppose that a firm dumps it’s pollutants into a river as an “inexpensive outlet for pollutants that otherwise would have to be disposed of at greater cost.” (p. 678). Economic theory predicts that the daily discharge rate will continue to occur until the private marginal value of discharging wastes falls to zero. Since it’s free, that’s a lot of pollutants. The market, being blind to the externality, fails to price it into the cost of firms sales like it should have.

Now imagine that the government mandates that the river must have no more pollutants than is still safe to allow swimming and fishing. Also assume that monitoring pollutants is possible. How can we reach our goal?

Consider first the problems of either slapping the firm with fines or taxing them for pollutants. Both of these require that government be smart enough to figure out exactly what the cost of the fines or taxes should be to reach an efficient market solution. Make the fines/taxes too low and the river will be too dirty to swim in because the firm has incentive to go over the required amount and just pay the extra fines/taxes. Make the amount too high and the river is cleaner that it needs to be and the market isn’t being efficient.

Worse yet, what do you do when a new firm wants to start up and also pollute the river? Now you have to adjust the fines and taxes all over again.

Instead, we could use an Emissions Trading approach by giving pollutions rights, at the desired level, to the first firm at no cost. This will force them to immediately cut their pollutants, but they probably won’t care because they were just given something valuable for free. This is one of the best things about a Emissions Trading system. Existing companies often favor them because they are “receiving something of value, [so they] are less inclined to fight the… program.” (p. 680)

Even better, now when the new firm wishes to open up, they have to buy pollution rights from the market and the market itself sets the price for the right to pollute. (p. 679)

Conclusions

This is why I favor an Emissions Trading approach to CO2. I believe this constitutes a true market solution to the CO2 growth problem. It does not represent any sort of carbon tax because the money goes to the market and the market gets to set the appropriate costs for emission rights. And even the tree huggers can pool their resources and buy up CO2 emission rights if they really wish to save the world from imminent doom.

Oh, by the way, another name for emissions trading is “Cap-and-Trade.” However, I admit I do not know whether or not my proposal is the same sort of cap-and-trade that the liberals favor, so this may be two things that happen to use the same name. 

16 thoughts on “An Explanation of Emissions Trading

  1. Pingback: Tweets that mention » An Explanation of Emissions Trading The Millennial Star -- Topsy.com

  2. Bruce, I’m going to be busy the next few days, but I oppose can and trade for many reasons. Your libertarian friend doesn’t sound very libertarian (or at least he does not understand that the primary purpose of libertarianism is to push govt so that it only concentrates on providing “public goods.”)

    In any case, here are a few things to read in the meantime, some of them from actual libertarians.

    http://www.cato-at-liberty.org/cap-n-trade-the-ultimate-pork-fest/

    http://www.cato.org/pub_display.php?pub_id=10069

    http://blog.heritage.org/2009/06/22/cbo-grossly-underestimates-costs-of-cap-and-trade/

    http://www.heritage.org/research/testimony/the-economic-impact-of-cap-and-trade

  3. For me, the most important issue is the initial allocation of emission permits. If they’re given away to current polluters, that’s a pretty big windfall for them. I’d favor a carbon tax instead, which is equivalent to the government selling permits to polluters in a cap-and-trade system. The carbon tax seems to be easier to administer and harder for polluters to co-opt. A carbon tax is as much a market-based solution as cap and trade, since both are putting a price on pollution, allowing polluters to respond in an efficient way. If (and only if) the value of what’s being produced is greater than the cost of the associated pollution to society, it will be produced, which is the outcome we want.
    Geoff, isn’t elimination of externalities a public good of sorts, in the sense that it allocates property rights in a sphere where those property rights weren’t enforceable, so that no Coasian bargain could previously exist? In that sense, I don’t see it as being any different from the legal system, which I presume you support the existence of.
    Whether there actually are negative externalities from greenhouse gases is a different issue, but if we believe that negative externalities from pollution exist, society would be better off using a market-based solution like cap and trade or a carbon tax than doing nothing or using a regulation-based approach.

  4. It does not represent any sort of carbon tax because the money goes to the market and the market gets to set the appropriate costs for emission rights.

    No, actually it is worse. Under any sort of cap, the initial emission rights are extremely valuable. For political reasons (and to avoid cratering the economy) the government tends to allocate them to existing emitters, which is a massive gift.

    The people who then pay for that gift are those that purchase additional energy in a growing economy, who must (on balance) bear the entire burden of subsidizing “clean” energy, while the existing “polluting” energy companies make out like bandits.

    The existing “unclean” energy companies reap a windfall because their costs remain the same while the market price of energy “necessarily skyrockets”.

    So yes, even if not a single dime flows through government hands, it represents a massive tax on the cost of energy purchases, some of which subsidizes “clean” energy projects, and all the rest straight to the pocketbooks of existing nonconforming providers.

    Even if carbon dioxide actually represented some sort of pollution (which is ridiculous), a straight pollution tax would be radically more fair, and more market oriented than any sort of cap and trade system. There are two reasons why cap and trade is so popular: (1) Existing energy companies stand to gain most all of the benefits courtesy of free emissions permits from the government, and

    (2) It is a much more draconian regime than any kind of carbon tax. Under a carbon tax, people would pay any amount up to the cost of the next most economical form of energy, but energy prices only rise as much as the tax, and so carbon dioxide emissions do not necessarily go down.

    Whereas under cap and trade, the price of energy “necessarily skyrockets” as the entire burden of shifting (on balance) all new energy sources to carbon free / carbon sequestered ones falls on the public, a burden demonstrably higher than a 100% tax on carbon based energy with the sort of caps under discussion.

  5. I agree with Mark D’s comment #3, and would hasten to add the following: the most successful anti-pollution efforts are those that are localized, rather than generalized.

    I would characterize Southern California’s anti-pollution efforts as pretty successful. If you ever visited LA during the 1960s and 1970s (as I did), you saw a vision of air pollution hell. The difference today is remarkable. Yes, there are still bad days but not nearly as many as in the past.

    So, what we have learned is that localized anti-pollution efforts work. They involve the consent of the governed (most people in LA favor them) so therefore do not interfere with personal liberty as much as a globalized solution. But what if those same laws were extended to, say, Boise, Idaho? They would not have applied and would have hurt the Boise economy in a draconian fashion.

    The exact same principle applies to any carbon trading scheme. The only way it has any effect whatsoever is if it is global in nature. A scheme without Russia, China and India will have nearly zero effect on the global climate. Russian and Chinese scientists are highly skeptical of global warming nostrums, so they would be highly unlikely to participate.

    But if I am understanding you correctly, Bruce, you are proposing a hypothetical system that might be used to prepare for some hypothetical world solution in case global warming really does become a problem. Your attempts to use the marketplace are admirable. But in the end I think any cap and trade policy has more drawbacks than advantages.

    Personally, I would favor a reserve geoengineering solution (such as an infusion of SO2 in the atmosphere) more than cap and trade in case of a true global warming emergency. This would also have the advantage of being a lot less costly than a cap and trade system.

  6. “Your libertarian friend doesn’t sound very libertarian”

    He was the most overwhelmingly libertarian person I have never met in my life bar none.

    I think the problem is that we tend to read things and not think them through all the way. He had (I’m guessing) read an article that used emissions trading as proof that market solutions are superior to non-market ones and “repeated” that information to me without realizing it supported my point of view as much as his. Thus he was trapped.

    If he had happened to have first read an anti-emissions trading article perhaps the outcome would have been very different.

    But in a case like this, emissions trading actually lives between a government regulation program and a market solution. It’s both simultaneously. So in a sense, he was right but we were both right. Market solutions are the best. But sometimes to get a market solution you have to use regulations/laws.

  7. Geoff,

    While there is no rational problem with you agreeing with Mark D in principle, you cannot possibly agree with him in my specific case.

    You have already said you want to make a gentleman’s bet that there will be a natural cut over to non-carbon fuels. This position of yours is mutually exclusive to you agreeing with Mark D on my proposal. If we are going to experience a natural cut over any how, then my proposal has absolutely none of the downsides Mark D is predicting.

    So you need to make up your mind — which is it? Is Mark correct about the problems in my proposal or are you right that there is going to be a natural cut over?

  8. If there is going to be a natural cut over, then the government doesn’t need to do anything, right?

  9. Mark D:

    That is correct. If — as Geoff asserts — there is going to be a natural cut over, then there is no need for government to do anything. But the logical corollary to this is that Geoff should therefore have no objection to the government regulating that there will be additional costs for CO2 (say through a carbon tax or cap-and-trade) after the point he claims will never be reached.

    Mark, this can’t be flipped around like you are trying to do. I am not claiming to know at what point CO2 becomes a problem. I have a pretty good idea – really good actually – that at some point it will become a problem. But I think our science is not up to snuff on telling us when. Therefore we have a real risk that needs to be mitigated based on our lack of knowledge and the high potential damage.

    Geoff (and others, perhaps even yourself) is advocating for the point of view that there is no risk because there is going to be a natural cut over anyhow long before the danger point is reached. To declare this a non-risk you would have to be virtually certain – actually completely certain – that this is the case. I am not feeling that certain.

    Let’s put this mathematically. There is a curve of growing CO2. There is a point where it becomes dangerous (though it may actually beneficial or neutral before that point.) We’ll call that point Y. I am claiming to not know what Y is and I’m advocating for actions that are based around not knowing what Y is. Asking me if I agree that if there is going to be a natural cut over first I must therefore be against government regulation is silly because I do not claim to believe that there will be a natural cut over first. This is Geoff’s belief, not mine. Rather I am just pointing out the logical ramifications of Geoff’s own stated beliefs – namely that he is certain that we’re going to see a level off before Y (whatever it is) is reached.

    Now obviously you don’t actually know what Y is. I get that. In fact, that’s my whole reason for rejecting your position in the first place. But you are acting as if you do know. So all I’m asking – and I think this is very reasonable – is to stick your neck out a bit. Tell me a conservatively reasonable Y. Pick anything you want and let it be criticized publicly. If you want to say 10,000 parts per million is the danger point, be prepared to back that up. If you want to be a bit more conservative (and therefore have less to justify) then say 500 parts per million. Take your pick and stick your neck out. Believe in something rather than merely disbelieving in something. That number will then be our Y.

    Now that we have a Y that you can live with, let’s make a strategy that starts a cap-and-trade or carbon tax when we’re within, say, 80% of it then gradually builds until we get to 100%. How can you possibly object now? You believe it’s never going to happen and the costs are zero or negligible until that point is reached.

    This really is a very conservative and very reasonable thing for me to be asking of you guys. And it makes no sense at all for you to force me to tell you what Y is. You tell me what I can get you to politically accept.

    If you can’t accept anything as being Y, then let’s be honest that all you’re doing is rejecting any proposal. But if you are sincerely giving this issue real thought, then you’ll see that you do owe me a reasonable Y that I can start working with rather than just rejecting anything anyone brings up.

    No, of course, it may be that you’ll intend to pick Y high enough that it will never be reached. But what it if does? Then obviously this will mean that you were wrong in the first place and this should be a pretty good justification for switching over and taking a stronger stance against CO2 growth.

  10. Bruce, I am traveling internationally this week and may not be able to give this the attention it deserves. You have put a lot of time into this and deserve an answer — but it may not happen in the next few days.

    I’ll let you know how the TSA scan-and-get-radition or be-groped-in-the-groin scheme goes.

  11. There are other options to the situation of the heavy machinery manufacturer and the lab, as well. They could work together and each spend $500K to move the lab, or each spend $1M to upgrade the manufacturer’s site to reduce vibration.

  12. Bruce, yes, there would be no problem with this approach (in theory) after the “point of no return” is reached. However, I believe you will find that global warming alarmists want a carbon emissions trading scheme like you are proposing now. This is what I oppose (ie, acting now on something I don’t think will ever be needed).

    Would such a carbon emissions scheme solve the problem once that point is reached? Probably not.

    This is why I would prefer a geo-engineering solution.

    My position is:

    1)Any carbon emissions trading scheme or carbon tax involves unnecessary govt action now.
    2)If the situation changes and world temperatures go up, say, 5 degrees C in five years, something would need to be done.
    3)We should study emergency actions (such as SO2 geo-engineering or something similar) in case of 2).

    Bruce, I’m sure you will find some contradiction there someplace, but this is my position.

    Anyway, I’m off to the airport and will have limited internet access the rest of the week. Have fun in the meantime.

  13. Rameumptom,

    Yes, there are logically other options available. But I think you’ve missed the point. This example was not about ‘fairness’ nor ‘sharing.’ It’s an attempt to teach a certain economic principle via an example.

  14. Geoff,

    I am proposing two separate solutions to two separate but intermingled problems.

    For AGW, I am proposing geo-engineering at a contingency plan.

    For CO2 Growth, I’m proposing a risk mitigation strategy that addresses the concern of economic problems via a slow implementation.

    You seem to be agreeing with me on the first of those strategies, so let’s build on our common ground.

    First, I admit I just don’t know enough to know what an appropriate limit would be before we start geo-engineering. So 5 degrees in 5 years means little or nothing to me. I remember reading (as part of my research) that when the globe was 2 degrees on average cooler than today North America was under a mile of ice. I have no idea if this is true or not, but if it is true, then obviously a 5 degree rise in global temperature would probably be absolutely enormous and dangerous.

    For the sake of discussion, let’s pretend that we have agreed upon a number of degrees: X degrees. I actually think if we were making policy together we could probably come to an agreement without too much problem, so I think this is actually a fair assumption for the sake of argument.

    I’m a bit more concerned about the idea that you are putting a time limit on it. For the sake of argument, let’s say we agree X degrees rise is dangerous, so why would it make a difference if we rose X degrees in 2 years vs. 5 years vs. 10 years vs. 20 years? Obviously the shorter the time frame the more out of control we are, but if X is considered dangerous, then it’s dangerous over any of those time frames. Since we are not dealing with geological timeframes, probably any number of years we dream up will be roughly equal. So would you be willing to drop the time frame and instead put in a plan that we start implementing a geo-engineering scheme upon X degrees average temperature being reached?

    Finally, I gather that we are in agreement that spending money now to research geo-engineering techniques is a valid use of money, correct? What do you think of my idea to simply start using the existing research funds and putting them into geo-engineering techniques instead?

    Actually, it seems like the existing AGW research is valid on at least two fronts: 1) We need a way to actually measure the rise in temperatures. This requires continued funding and research, 2) We need to research a geo-engineering contingency plan in case X is reached.

  15. Oh, and I wish to still make the case that a CO2 growth curbing startegy is a conservative thing to do if done the way I’ve outlined (i.e. over a long periods of time as to not effect the economy). But I’ll save that for a future post.

  16. Tangent on how highways killed the railroads:

    You may not have given your friend’s entire story, so I don’t know if he is aware of this.

    One of the major factors in the highway-vs-railroad dynamic was that as the railroads were federally-regulated, they were forbidden to get into the local pickup/delivery business. And if I remember correctly, were even forbidden to directly partner with local delivery businesses.

    What that meant was that the railroads could only ship things from station to station, but could not pick up things by truck from the local customer’s dock. (Though, if the customer had tracks going to their loading dock, they could.) Nor could the railroad transport the goods via their own trucks on streets/roads from the destination station to the destination business.

    Nor could the railroad sub-contract out the local pickup/delivery to trucking/delivery companies. (Which were also not only regulated, but also unionized, so there may have been a refusal of trucking companies to deliver from/to rail stations).

    This created a huge hassle for companies that wanted to ship by rail, but were not big enough to run tracks to their business, or big enough to own their own trucks (and hire drivers) to get the goods from the business to the local rail station. Plus, they’d still have to individually arrange for final delivery from destination station to destination business, because the railroad company was forbidden to be involved in local deliveries.

    The small shipper (or their expeditor) would be forced to individually deal with 3 transportation companies for each shipment.

    The hassle/time/paperwork factor of dealing with three companies for each shipment easily exceeded the long distance fuel savings of using rail shipping. Therefore small to medium sized businesses used trucking companies where one company picked it up at the origin, and carried it all the way through to the final destination.

    So as it was explained to me back in the 70′s, it was government regulations forbidding railroads from entering the local delivery business (or even partnering with them) that doomed the railroads.

    Now that the cost of fuel and the labor cost of 1 driver per container shifts the economics greatly in favor of rail transport for longer distances, we’ve lost the vast majority of our tracks.

    And not just the physical iron rails. Almost all right-of-ways for those lost tracks were transfered back to land-owners back in the 1990′s and are practically irrecoverable.

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