Cap-and-Trade Is the Way to Deal With Climate Change

Cap-and-Trade Is the Way to Deal With Climate Change appeared as a letter to the editor in The Washington Post of May 26. By Dirk Forrister, leader of the White House Climate Change Task Force under President Bill Clinton, it was in response to a May 18 Post editorial, "Cold Reality."

Mr. Forrister makes some telling points in championing a cap-and-trade approach to limiting carbon emissions — as opposed to an out-and-out carbon tax, a policy option which this blogger preferred in Waxman-Markey Climate Legislation but thought better of in Caps, Trades and Offsets: Can Climate Plan Work?.

First, some background: the American Clean Energy and Security Act, a.k.a. the Waxman-Markey bill, is being considered by the full House of Representatives after recently being vetted by Rep. Waxman's own House Energy and Commerce Committee. Waxman-Markey would, as I said in Caps, Trades and Offsets, effectively "tax" carbon-gas sources such as power companies and oil refineries. They would have to obtain allowances, also called credits or permits, to cover the amounts of "greenhouse gases" — carbon dioxide and methane, mainly — they are directly or indirectly responsible for putting into the atmosphere, thereby adding to global warming and climate change.

85 percent of the government-created allowances would be given away for free under Waxman-Markey, while the remaining 15 percent would be sold at auction to the highest bidders. The monies thus raised by Uncle Sam could be thought of as a "tax" on carbon emissions.

The total number of units of greenhouse gases America could emit would be reflected in the sum total of the allowances issued; this is the "cap" part of "cap-and-trade." The "trade" part would arise from the ability of the allowances, once issued, to be bought and sold in a marketplace, such that a polluter who cleans up its act promptly and winds up with extra allowances could sell the excess allowances — possibly via Wall Street financiers — to another polluter which cannot (yet) afford to reduce its carbon emissions.

Proponents of cap-and-trade such as Liz Martin Perera of the Union of Concerned Scientists say it will "harness the power of the market, to find the cheapest reductions first. If it's going to be cheaper for me to reduce [emissions] than you, then I'm just going to go ahead and reduce and sell you my permit."

As I said in my earlier post, Waxman-Markey seems to be a way to create a tax burden on carbon pollution, carve it up into tiny pieces, and sell the pieces in a marketplace, thereby engendering implementation efficiencies.

That means it offers something to both conservatives and liberals. Conservatives extol the efficiency-engendering benefits of marketplaces. Liberals love to use taxes to engineer changes in how things work in America.

But many liberals (apparently including the Post editorial writer) want a straight-up carbon tax. Mr. Forrister is also a liberal, but he prefers cap-and-trade.

He says a carbon tax fails three tests: environmental effectiveness, political possibility, and simplicity:

1. Environmental effectiveness: "Some companies would undoubtedly pay the tax rather than lower emissions, and the cost of the tax could be passed on to consumers." Since there is no hard-and-fast cap on emissions, if companies could pass along the tax to their customers, emissions levels might come down too slowly, if at all.
2. Political possibility: "With the country looking to emerge from its economic struggles, it is unlikely that any legislation involving a new tax will be passed."
3. Simplicity: "The U.S. tax code stretches for thousands of pages and includes endless exemptions and loopholes. A carbon tax would be no different." (I personally doubt that. Waxman-Markey makes provision for "offsets" as well as allowances. These would allow polluters to demonstrate ways in which they have forgone or otherwise made up for hypothetical carbon emissions, and to use these claimed "offsets" to reduce their need for allowances. Offsets equate in my mind to exemptions and loopholes, so I think Waxman-Markey would end up being at least as complex as a carbon tax to administer.)
   

Be that as it may, I continue to believe (following my recent conversion) that cap-and-trade à la Waxman-Markey is the way to go.

Caps, Trades and Offsets: Can Climate Plan Work?

Caps, Trades and Offsets: Can Climate Plan Work? in today's Washington Post is a fair-minded introduction to what is soon to become a hot topic: the Waxman-Markey bill recently introduced in the House of Representatives that would establish a "cap-and-trade" system for ratcheting down the rate at which the nation increases its carbon emissions. The bill was endorsed by Rep. Waxman's House Energy and Commerce Committee on Thursday night, May 21. Now it comes before the full House.

I talked about the bill in Waxman-Markey Climate Legislation, in which I indicated that I favor a straight-up carbon tax over cap-and-trade (C&T). However, the political winds currently favor C&T.

The overall goal is to radically slow down the pace at which the U.S. and, ultimately, the world keep spewing more and more carbon compounds into the atmosphere: mainly carbon dioxide (CO2) and methane (CH3). CO2 in particular is produced by (among other processes) burning fossil fuels, including coal, natural gas, and petroleum products such as gasoline. Much of our electricity comes from burning coal.

The Post article is useful in explaining the C&T mechanism as it is envisioned by lawmakers:

The bill would require polluters [e.g., power companies, oil refineries whose products will produce carbon emissions further on down the road] to obtain "allowances" — permits allowing them to emit a given amount of a greenhouse gas such as carbon dioxide or methane. ... This bill would put a price on them.

Notice that allowances are permits are interchangeable terms. They both mean the same as credits, used later in the article. (But they are not the same as offsets, also mentioned in the article.)

Allowances or permits or credits (I'll call them permits) are things that polluters such as power companies and heavy industrial concerns will need to amass if they want to go on emitting carbon. The bill

requires polluters to amass credits equal to their emissions and then allows them — and others, including Wall Street trading firms — to sell them on an open market if they cut their emissions, giving them a surplus of credits.

Permits will originate with the U.S. government. I expect the Environmental Protection Agency will be the designated source, but I'm not sure about this. Pending clarification, I'll just say that somehow the EPA would decide what the total amount of carbon emissions can be in a given year (the "cap") and would distribute permits covering that amount to all polluters as a body.

Again, I am not clear as to precisely how the permits would be divvied up under the overall cap. The article does say that, despite earlier assumptions, not all permits would be auctioned to the highest bidders. Instead, "85 percent would be given away."

Presumably, the overall cap would be set low enough that not all carbon emissions that would ordinarily happen would actually be allowed. The carbon shoe would necessarily begin to pinch. My assumption is that the 15 percent of permits that are not given out gratis would provide a pressure-relief valve, such that polluters who feel they cannot effect quick reductions in their carbon emissions could buy portions of that 15 percent up at a going rate established at auction.

Meanwhile, polluters who are in a position to reduce their emissions in the short term would wind up with a surplus of permits that they could then sell on the open market to other polluters who would otherwise be in a bind, having failed to secure enough permits in the auction phase to cover their excess (i.e., not permitted under the cap) emissions. These open-market operations are the "trade" in cap-and-trade.

That open market is thus a second pressure-relief valve. A third is "offsets." The article describes them this way:

Instead of buying an allowance to cover their pollution, a factory could buy an offset to negate it. An offset would be a certificate showing that, for example, emissions have been avoided, or taken up by newly planted trees, or captured and pumped underground.

"Avoiding" emissions is something that presumably could be done by a power company that (for example) opts for building a wind farm or solar-cell array instead of an anticipated coal-burning plant. It would cause offsets to be issued to the company that could be applied against the carbon emissions that its older coal-fired smokestacks continue to belch into the air.

Another way to get offsets would be to plant enough trees to eat back up their offending carbon emissions, or to use new (as yet unproven) to "sequester" those emissions and store them permanently below ground level.

Companies that replace older, dirtier coal-burning power plants with newer plants that are not as polluting would presumably not get offsets, but would wind up with extra permits to sell on the open market. Exactly where the boundary is between offsets and allowances/permits/credits is not clear.

Be that as it may, the effect of the open-market approach, says the article, is, in the words of "Liz Martin Perera of the liberal-leaning Union of Concerned Scientists": "... to harness the power of the market, to find the cheapest reductions first. If it's going to be cheaper for me to reduce [emissions] than you, then I'm just going to go ahead and reduce and sell you my permit."

I find that pro-C&T argument a convincing one. A market in a commodity "as tradable as a Pontiac or a pork belly" generally can be expected to maximize efficiencies as it minimizes costs.

Put simply: If I'm a power company and I think buying permits on the open market is cheaper this year than trying to get my under-construction nuclear plant online ahead of schedule, at elevated cost, I'll buy permits. I won't waste money speeding the new plant into service. Later on, when the new plant arrives online without busting my budget, I'll retire some of my coal-fired generators. I'll wind up going green without too much unnecessary expense.

I may even be able to pass on some or all of the cost of the permits to my customers. This means I might be able to bill them at a higher rate per kilowatt-hour than I would use in the absence of cap-and-trade.

About this pass-on-costs option the article says:

Because so much about this system is untested or unknown, experts disagree about how much cost will be passed on from utilities and oil refineries to average families. The EPA thinks it will fall between $98 and $140 per year, causing barely a stutter in the U.S. economy as a whole.

The Union of Concerned Scientists thinks the system will actually make money for families, since more efficient technologies will save on energy costs. But the conservative Heritage Foundation thinks it will cost big: $4,300 per family in a few decades.

Whether the costs of allowances/permits/credits (other than the initially "free" 85 percent issued by the EPA) are passed on on not, they amount to a hidden tax on carbon emissions. The polluters would pay it, then pass on whatever they can to their customers.

Will it all work? That's the big question. Critics are saying a similar plan tried recently in Europe has been a failure, in part due to the ability of polluters to "game" the awarding of offsets. (See also Is a Popular Carbon-Offset Method Just a Lot of Hot Air? in the June 2009 Scientific American).

Additionally, a Greenpeace spokesperson is quoted in the Post article as saying, "If you give all the pollution credits away, it doesn't actually serve the market principle of making carbon have a cost." (My assumption: it does actually impose a cost the the extent that selling a percentage of the credits occurs. The question is: is 15 percent of the credits enough?)

Conservatives, on the other hand, disparage the plan as "a 'light-switch tax,' because energy costs would go up."

This criticism would seem to be incompatible with Greenpeace's. If Greenpeace is right, energy costs would not go up. If the conservatives are right, costs would go up, and the extra costs would in fact amount to a hidden tax. I think the conservatives are right, to which my response is, "Your problem being ... ?"

C&T à la Waxman-Markey seems to be a way to carve up a tax burden on carbon pollution and sell pieces of it in a marketplace, when you come right down to it!

Waxman-Markey Climate Legislation

House Panel Begins Debate on Climate Bill appeared on the Washington Post website (and in the print edition?) on April 23, 2009, giving a heads-up on a major piece of legislation being drafted by the House Energy and Commerce Committee. The Waxman-Markey bill would comprehensively address climate change with its "calls to reduce the nation's greenhouse gas emissions to 20 percent below 2005 levels by 2020 and by 83 percent as of 2050."

One of the prime initiatives in the bill is a cap-and-trade system for auctioning off "carbon allowances" to electric utilities and others that burn fossil fuels. I have begun seeing op-ed pieces and the like lambasting the bill, which is still in its draft stages, for putative inadequacies relating to cap-and-trade and carbon allowances.

Frankly, the discussions have left me scratching my head. What exactly is cap-and-trade (C&T), what are the various ways in which it might be implemented, and why are some who otherwise support proactively addressing climate change against the bill right from the get-go?

Thomas Friedman, who strongly supports federal involvement in slowing down climate change, recently wrote "Show Us the Ball" in the New York Times opposing C&T and supporting an out-and-out carbon tax. C&T has been called by its critics, including Mr. Friedman, a hidden carbon tax — i.e., one that "hides the ball" of carbon taxation. One of the things I'd like to find out is why C&T has been called a "hidden" tax on carbon.


This Wikipedia article on "emissions trading", another name for C&T, says C&T is basically this:

A central authority (usually a government or international body) sets a limit or cap on the amount of a pollutant [e.g., carbon dioxide] that can be emitted. Companies or other groups are issued emission permits and are required to hold an equivalent number of allowances (or credits) which represent the right to emit a specific amount. The total amount of allowances and credits cannot exceed the cap, limiting total emissions to that level. Companies that need to increase their emission allowance must buy credits from those who pollute less. The transfer of allowances is referred to as a trade. In effect, the buyer is paying a charge for polluting, while the seller is being rewarded for having reduced emissions by more than was needed. Thus, in theory, those that can easily reduce emissions most cheaply will do so, achieving the pollution reduction at the lowest possible cost to society.

I find that confusing already. Is the limit or cap on emissions set for the country as a whole, or for each industry, or for each polluter?

Where do the allowances or credits come from originally?

Are they simply issued by the government to polluters, or do polluters (or other parties) have to buy them, perhaps at auction?

If polluters have to buy them, why would a polluter buy more credits than it needs, such that it might later trade (sell?) excess credits to another polluter?

Would a speculative market in allowances/credits spring up, and if so would that be good or bad?


If allowances/credits are created by the U.S. government and sold at auction on a yearly basis, utility companies and others would presumably bid competitively on these allowances once a year. They would be sold, allowance by allowance, to the highest bidder and might be effective as of, say, January 1.

Say Utility A and Utility B both expect hot summers in their regions. Summer is when most electric companies emit the most carbon pollution, to power all those air conditioners. When the mercury rises, utilities have to bring online generating capacity that is normally idle. This is typically capacity that is old, dirty, and inefficient.

If Utility A's region turns out to have a cool summer and Utility B's region experiences temperatures even higher that anticipated, A can wind up using fewer allowances than it ponied up for on Jan. 1, while B will need to buy additional allowances. A can sell its excess allowances to a desperate B at a profit.

Notice that A has an opportunity to pass its windfall profits back to its customers in the form of reduced electricity rates. But is there any guarantee that it would?

B, meanwhile, might be in the position of needing to charge its customers more per kilowatt-hour than anticipated, to fund buying allowances from A. Would the regulations under which utility companies operate permit this?

Clearly, if a utility could just pass its "surprise" operating costs on to its customers each year, it would have little incentive to modernize by switching to non-polluting sources of energy. The whole point of C&T seems to be to nudge polluters to modernize, so that as total yearly caps come down over time, polluters will already have seen the writing on the wall and planned their "carbon exit strategies."

Ideally, it would seem there should be less, not more, desperate buying of carbon allowances by utilities each year to cover unanticipated fossil-fuel usage, as time marches on.


If the government sells — auctions off — allowances each year to the highest bidders, what the bidders pay in could be considered a "tax," or at least a user fee: use a certain percentage of the country's overall target for carbon pollution in a given year, and you need to pay Uncle Sam a fee. (Then you can subdivide and sell to others portions of the target usage you have bought, if you like.)

Many are asking, then, why not make it an out-and-out tax?

Per Thomas Friedman, a true carbon tax would "show everyone the ball," rather than hiding it from view:

Advocates of cap-and-trade argue that it is preferable to a simple carbon tax because it fixes a national cap on carbon emissions and it “hides the ball” — it doesn’t use the word “tax” — even though it amounts to one. So it can get through Congress. That was true as long as no one thought cap-and-trade could ever pass [under George W. Bush], but now that it might under Mr. Obama, opponents are not playing hide the ball anymore.

Mr. Friedman worries about this aspect of the situation:

In the past two weeks, you could hear a chorus of Republicans, coal-state Democrats, right-wing think tanks and enviro-skeptics all singing the same tune: “Cap-and-trade is a tax. Obama is going to raise your taxes and sacrifice U.S. jobs to combat this global-warming charade, which many scientists think is nonsense. Worse, cap-and-trade will be managed by Wall Street. If you liked credit-default swaps, you’re going to love carbon-offset swaps.”

Some of the refrains from this song have a very catchy appeal. They could easily kill [the Waxman-Markey] effort.

An out-and-out tax, says Mr. Friedman, has been proposed in an alternative bill authored by Representative John B. Larson, chairman of the House Democratic Caucus. The Larson bill

... would impose “a per-unit tax on the carbon-dioxide content of fossil fuels, beginning at a rate of $15 per metric ton of CO2 and increasing by $10 each year.” The bill sets a goal, rather than a cap, on emissions at 80 percent below 2005 levels by 2050, and if the goal for the first five years is not met, the tax automatically increases by an additional $5 per metric ton. The bill implements a fee on carbon-intensive imports, as well, to press China to follow suit. Larson would use most of the income to reduce people’s payroll taxes: We tax your carbon sins and un-tax your payroll wins.

To my simple mind, that sounds like a much better approach than cap-and-trade! Mr. Friedman agrees:

People get that — and simplicity matters. Americans will be willing to pay a tax for their children to be less threatened, breathe cleaner air and live in a more sustainable world with a stronger America. They are much less likely to support a firm in London trading offsets from an electric bill in Boston with a derivatives firm in New York in order to help fund an aluminum smelter in Beijing, which is what cap-and-trade is all about. People won’t support what they can’t explain.