Tag Archives: cap and trade

How Economics Can Save the Environment

During his presidency, Ronal Reagan helped introduce a “cap-and-trade” system to curb America’s use of lead-based gasoline.  Experts today believe that Reagan’s cap-and-trade system lead to a much more rapid elimination of lead-based gasoline use in the United States while saving the economy $250 million each year relative to a “command-and-control” system (under which the government explicitly dictates which technologies and energy sources can be used).  George Bush senior led a similar environmental revolution through the use of a cap-and-trade system, effectively reducing SO2 emissions in the 1990s.  Given its historical success, it seems logical for governments to continue using a cap-and-trade system to address today’s environmental issues.

Unfortunately, however, cap-and-trade systems are losing favor.  In the United States, even Republicans have “demonized their own creation,” leading to a reduction in cap-and-trade usage.  As a result, over the last 5 years, the United States has mostly switched to command-and-control systems, leading to less efficient, less swift, and more costly reductions in pollution rates.

Europe has also abandoned its cap-and-trade system.  In April 2013, Europe disbanded its cap-and-trade regulations on carbon emissions entirely.  According to European officials, the economic pullback has resulted in below-equilibrium production levels.  Consequently, firms are naturally emitting fewer pollutants than allowed by cap-and-trade issued quotas, leading to a reduction in quota prices.  With prices so low, quota trading has become inconsequential and essentially irrelevant.  As such, instead of focusing on renewable energy sources (Europe has a goal to obtain 20% of its energy from renewable sources by 2020), many European firms have reverted to the large-scale use of coal.

Interestingly, as prices have gone down, Europe has failed to reign in the supply of quotas made available to firms.  Failing to do so undermines the entire purpose of a cap-and-trade system, as keeping the supply of emission quotas constant fails to reduce emissions over time (and as technology improves, it naturally leads to a reduction in quota prices).  Ultimately, it seems that Europe’s failure to commit to a strong cap-and-trade system is what caused the system’s failure; by not reducing the supply of emissions quotas, Europe could not effectively control the price of emissions.

Fortunately, California is showing that there is still hope for cap-and-trade regulation.  After introducing a cap-and-trade system in 2013, California has decided to expand the program in 2014.  Like Reagan, California has seen success through cap-and-trade regulation, as evidenced by the state’s reduction in carbon emissions.  Auctioning off emission quotas has also helped California raise over $1 billion dollars in revenue, which has helped fund subsidies for renewable energy.  Indeed, California has seen so much success in its cap-and-trade system that as of January 1, 2014, California has partnered with Quebec to create the first international cap-and-trade system.

It is surprising to me that conservatives, typical proponents of the free-market system and the original supporters of cap-and-trade regulation, have abandoned such a historically successful system.  As Reagan and Bush senior made very clear, economics and the free-market system can be environmentalists’ best friends.  That said, I am comforted by California’s use of a cap-and-trade system, and I am hopeful that conservatives will get on board, partnering with one of America’s most liberal state (and Quebec) to bring economics and environmental policy back together.

 

general approaches to carbon emission

Carbon dioxide, one of the main components of the greenhouse gas, is notorious for causing global warming which is very likely to cause enormous environmental damage and economic costs in the near future. In order to prevent disastrous global warming from worsening, global society has tried to reduce carbon emission. Sadly, the Wall Street Journal reported that carbon emission related to energy production in the U.S. increased last year after 2 years of decrease of carbon emission. This increase of carbon emission mainly resulted from the increase of coal consumption. As the price of natural gas increased, firms became more dependent on coal last year. What a rational behavior of firms!

In economics, carbon emission is a typical example of negative externalities that consumption or production of certain goods or services has a negative effect on other consumers or producers’ well-being. These negative externalities are regarded as one of the market failure. In this example of carbon emission, firms do not include social and environmental cost of emitting carbon dioxide in their cost function. So, market equilibrium quantity of carbon emission is determined much higher level than socially desirable level. However, if social cost of carbon emission is taken into account for determining price and quantity of carbon emission, firms are induced to emit less carbon dioxide to socially desirable level. Technically speaking, as firm’s marginal cost of production increases by adding up social cost of carbon emission, the new market equilibrium moves to less quantity and higher price than original market equilibrium.

In Microeconomics by Robert Pindyck and Daniel Rubinfeld, there are three approaches to correct the problems of the negative externalities; setting a legal limit for emitting carbon dioxide; levying a fee on each unit of firm’s carbon emissions; adopting marketable emission permits. Generally, levying a fee is regarded as more efficient way than setting a legal limit because each firm makes its own decision based on its costs of carbon emissions. By taking each firm’s different cost factors into account, the industry as a whole can reduce the cost of reducing carbon emission compared to uniform setting of legal limit for each firm. In order to effectively levy a fee, we need to know each firm’s cost structure for reducing carbon emission. But it is not easy for policy makers to know cost information of each firm. So, many argue that marketable emission permits, which is also known as the cap and trade system, is more effective. In the cap and trade system, each company is allocated a certain amount of permits to emit carbon emission, and its permits can be traded in the carbon permit markets. By doing so, total amount of carbon emission can be limited to a certain level while firms that have lower cost structure for reducing carbon emission sell some of their permits to firms that have higher cost structure for reducing carbon emission.

The main challenge for effective functioning of carbon emission market is to determine the appropriate level of carbon allowance. The Economists reported that Europe’s emission trading system almost collapsed last year due to the overcapacity of carbon emission with carbon price plunging. This overcapacity of carbon emission was mainly caused by the the economic recessions and decrease of natural gas price resulting in decrease of coal and oil consumption. Also, as we can see from the Japan’s case, worsening economic conditions or political interests can make reduction of carbon emission difficult. The Wall Street Journal reported that last year Japan reduced its carbon emission target to promote economic activity.

Unfortunately, the U.S. failed to pass the cap and trade legislation in 2010. In spite of its legislation failure, according to Bloomberg, carbon emission in the U.S. had been decreasing mainly due to strengthening regulation under current legislation and decrease of price of natural gas. But we should not be satisfied with this result, and keep trying to decrease carbon emission to protect our environments and society. For more stable policy implementation, legal foundation for decreasing carbon emission should be strengthened.