Cap-and-Trade
There is impending legislation in House for a Cap-and-Trade bill, which likely won't pass the Senate and almost surely won't make it past the President, however it has initiated a discussion of how best to deal climate change and global warming. Almost everybody sees this legislation as being a 'dry run' for when a new President takes office next year. But before we discuss Cap-and-Trade let's look at the unfortunate politics of it, starting with the economic principle of product substitution.
The economic principle of product substitution is simple: suppose a study is published that states that eating red meat is bad for you. People will start to eat less red meat, substituting chicken and pasta for steak and hamburger. This is good for the pasta producers and chicken farmers, but bad for the beef industry. Fewer beef sales means less revenue and fewer profits for cattle farmers and meat packers. The beef industry will likely fight back, defending their business by commissioning their own studies and publicizing the positive aspects of red meat (more protein, for example) and discrediting the original report. The end result is confusion and doubt on behalf of the consumer. We see this same tactic used with the tobacco industry and now with fossil fuel providers (aka Big Oil and others). Scientists have come out with evidence linking carbon dioxide emissions from burning fossil fuels to global warming - with a logical result that people are trying to replace fossil fuels with alternative renewable energy sources (wind, solar, nuclear, etc.). The product substitution is a threat to Big Oil since it means less fossil fuels sold and therefore lower profits. Not taking this lying down, Big Oil has commissioned their own studies and are on a public relations campaign to create uncertainty and doubt about climate warming.
The Republicans have traditionally seen themselves as the champions of business, while the Democrats have seen themselves champions of the environment. So even before the climate warming issue arose, the political battle lines were already drawn. Those on the Right being climate skeptics (led by such colorful characters as Senator Inhofe, who was the Republican majority leader on the Committee for Environmental and Public Works), while the Left has embraced climate change and the need to reduce green house emissions. Cap-and-Trade is one such solution to assist in limiting our global carbon footprint, and thus the current bill in Congress. The Right has been losing the battle of climate skepticism, their argument withering in the face of overwhelming scientific evidence, global opinion, and some masterful public relations marketing including Al Gore's movie An Inconvenient Truth. Part of the lack of success of Climate Skeptics is their scattered message. Some have taken the scientific approach, stringing together sets of data points to call into question global warming. For example, they often cite the one species of polar bear whose population is growing and that the middle of the Antarctic is actually getting colder - omitting that 16 of the 17 species of polar bears have declining populations as their habitat is destroyed and that even though the heart of the Antarctic may have had record cold in the last few years, the rest of the Antarctic and the rest of the world is getting warming1. Other approaches have been to write global warming off as God's will or, often citing ice ages, that global warming is simply a natural phenomenon. Still others, not wanting to make personal sacrifices, accept that global warming is occurring but think the best approach is to wait until it affects them personally, and by then science will have developed technology to fix the problem ("head in the sand" approach is what we term this philosophy). The result has been that the discussion has moved on from if Global Warming exists to how best to deal with it. Once the approach is decided, the next big argument will be a discussion of how much society is willing to pay to help stabilize our planet.
Those opposed to Cap-and-Trade (generally Republicans) are suggesting a demand side solution: a tax on carbon emitting fossil fuels, which in contrast to the Democrats supply side solution of Cap-and-Trade. To best understand the difference between the supply side and demand side arguments, let's look a something most everyone is familiar: the Corporate Average Fuel Economy (CAFE) program for setting mile standards. With the CAFE program, the goal was to improve the overall fuel efficiency of American cars. This could be done either through a supply side solution (via the car manufactures) or a demand side solution (via the public car buyers). If the government had chosen the demand side, they would have implemented a gas tax. Higher costs for travel would result in people buying higher mileage cars, and therefore, ultimately, the car companies would produce more higher mileage cars. However, the government chose a supply side solution. They created a law that required each car manufacture, across its entire fleet of cars produced to meet a blended fuel efficiency standard and then left it up to the car companies to figure out how best to meet these standards. The standards weren't done all at one time, rather they were raised over a series of years - allowing the car companies time to figure out how best to meet the goals.
Ultimately, car companies realized there were two real solutions:
- Change the mix of cars / trucks. A car manufacture could produce more gas guzzling SUVs, but then they would have to produce more high efficiency cars to offset. However, this solution doesn't necessarily change the public's demand - people would still want their SUVs and trucks - so the law of economics say that few gas guzzlers in the showroom mean car companies could charge a premium; a glut of fuel efficient cars means they would have be sold cheaply. So someone looking for a SUV might not want to pay $40,000, especially when they can buy a fuel efficient car for $20,000 - thereby balancing supply with demand.
- The second way to solve the problem would be for car companies to ask the question "How can we raise fuel efficiency without changing the mix of models of cars?" This would create an 'arms race' for new technology to help fix the problem. Sure, it costs money and those costs would be paid by consumers in form of high car prices, but all the money that society pays for new technology for better fuel efficiency goes directly to commercial car manufactures who are free to spend it on those technologies that they feel will produce the best returns for the least costs (free markets).
What is exciting about the supply side solution is that the results are measurable - its known ahead of time how much mileage will be raised - and that it fosters innovation. Any additional costs borne by consumers via a supply side solution are directly fed back into the form of R&D trying to create more fuel efficient vehicles. In a demand side solution, the additional money raised through taxes goes to the government and doesn't necessarily go into research of technology that helps fix the problem, and even if the government specifically redirects it into R&D efforts - it's a government run program - which means would likely be inefficient. Thus, as you can see, The Party of Common Sense is supportive of supply side solutions.
So how does this apply to Cap-and-Trade and how would a pure Cap-and-Trade solution work? Take the example of an industry that produces and average of 10 pounds of carbon dioxide for a single unit of output (for those climate skeptics, substitute sulfur dioxide which causes acid rain for carbon dioxide in this example). Let's say the most efficient factories with the best environmental cleaning equipment can product 6 pounds of carbon per unit of economic output. If the government set a limit of 6 pounds, it would require every older factory to be torn down and rebuilt using the latest and best equipment - certainly not an economically feasible solution. So let's say the government compromises and want to bring down the carbon output to 8 pounds per unit of output. Year one, the government issues 10 pounds of carbon credits (each carbon credit would be the right to produce one pound of carbon dioxide) for every unit of economic output that a factory produces. Those factories that are inefficient will need to buy credits from those that are more efficient. But there are enough credits to go around and the price is reasonable. (Note in this pure cap-and-trade example the government isn't selling credits - just issuing them to each factory based on the number of economic units produces - the price comes from third party, private transactions between factor owners.) The next year, the government issues 9.5 credits for each unit of economic output. According to the principles of free-markets, the scarcity of carbon credits will drive up the cost of a carbon credit. Each factory manager will need to evaluate for themselves - is it better to buy the credits on the free market, or make an investment to update their efficiency? Say a factory manager can install a scrubber on their smoke stacks for $10 million, but that would save them $5m in estimated costs for buying carbon credits, and would lower their carbon output to, say 8.5 pounds per unit produced. Since the government is issuing 9.5 credits per and the upgraded factory is only producing 8.5 units, the factory manager has extra carbon credits to sell. Let's say for $5m. Meaning it now makes economic sense to upgrade the factory (this calculations are actually more complicated because of the out-year returns and savings on the upgrade equipment, but we'll ignore that for the sake of argument). In subsequent years the government will offer only 9 pounds of carbon credits, then 8.5 and finally 8 pounds of carbon credits - reaching the goal of 8 pounds of carbon per economic unit produced. If it is very expensive to lower carbon output, a majority of factory owners will likely take their chances by buying carbon credits on the open market - meaning carbon credit prices will rise - whereas if there are cheap and easy ways for factories to reduce their carbon output, we'll see carbon credits fall in price.
Instead of having the government proscribe solutions, for example, that our hypothetical industry must use solar instead of coal to create energy consumed by the factories - what we see is that free markets find the most efficient way for each factory to meet the goals. Solar power may make sense for the factory in Arizona, but not in Ithaca, NY. Those factories that are hopelessly inefficient will be scuttled and rebuilt using much more efficient equipment and processes. Like water flowing downhill, the industry will find the path of least resistance - the most cost effective methods that create the most carbon savings.
Unlike the current Cap-and-Trade bill, you'll note that throughout this example industry, the government doesn't charge for these credits, or sell more to create profit - it simply issues them and monitors the factory outputs to ensure compliance. Non-compliance may mean fines or being shut down - but this is the same as the FDA, EPA, or any other oversight department. If a demand side solution of a straight government tax on carbon producing fossil fuels were implemented it would give the government more money - which would then presumably then be spent for government run programs to upgrade industries and reduce carbon - and we all know how well government run programs work. Unfortunately, Congress seems to have the overriding desire to get in the middle of things - so rather than propose a pure cap-and-trade bill, they have included having the government raise money by selling credits. However, The Party of Common Sense doesn't believe this is the proper role of government. Let's look at the proper role of government.
Conventional wisdom states that the Right is for free-market, liaise faire economies, whereas those on the Left are for government intervention. At the beginning of the industrial revolution, we saw unfetter free market capitalism, and doing what is economically expedient isn't necessarily in the best economic or well-being interests of society. For example, let's say I owned a factory which produces a toxic waste byproduct. What economically expedient is to dump the waste into the ground or into a stream. However, the societal costs of town people getting sick, or the collapse of the fishing industry is greater than economic cost of ecologically proper disposal of the waste. Even if I wanted to properly dispose of the waste, it would incur greater costs, which would allow my cross town rival to undercut my pricing and drive me out of business. So during the industrial revolution we saw rise to problems with pollution, products that didn't work, rigged stock markets, unsafe products, abusive and unsafe work conditions, etc... On the other side, too much government intervention creates way too many market inefficiencies, as we saw the collapse of communism.
Society's answer was to create rules to industries could compete within, refereed by the government, but then allow competitors in that industry to compete in a free market economy setting. For example, under unfettered free markets, it would be perfectly legal to sell tainted food (in fact, the term "pork barrel" came about through politically connected businessmen selling rotten pork to the Union Army during the civil war) and the free-market types would argue that after people got sick or died, people would stop buying that brand of meat and the processor would go under. Under conventional wisdom, the far left would say the only way to ensure a safe food supply would be to put the food supply under government control. What has happened is that the government has put safe food rules in place, enforced by the FDA and others. So long as the food is safe, anyone can produce, price, and sell food accordingly.
At The Party for Common Sense, this makes, well, common sense. Most people don't want to return to the day when they had to worry if the food they were feeding their family could cause them to get sick or die, and most people recognize that monopolies, especially government controlled ones, tend to become corrupt and inefficient. The system of setting the rules and allowing competitors to compete within those rules seems to be the best compromise to insure safety while allowing free market competition. (Actually, this system is showing cracks with mine collapses, unsafe food, uninspected planes, lead paint in toys, etc., etc... Over the last eight years the Bush administration has hollowed out these enforcement agencies by emphasizing loyalty over competence - everyone remembers FEMA's "heck-of-a-job" Brownie - and by appointing industry insiders to leadership positions in these oversight departments. It has gotten so bad that thirteen states are now suing the EPA just to get it to do its job. But we'll save this discussion for another day.) So we believe the proper role of the government is setup a Cap-and-Trade system and to get out of the way - only providing refereeing services to ensure compliance.
The Cap-and-Trade has worked in the past. In the US, in the 1990's the EPA tried to mandate reductions in sulfur dioxide emissions, but met with much industry resistance citing the cost of improvements. So the EPA created a sulfur dioxide credit trading. It was initially successful but quickly the market for the credits collapsed. In the EU, the market for carbon emissions (CO2) credits was established in 2005 and it collapsed in 2006. The reason for the collapse of these markets isn't because credit markets don't work, it's that they worked too well. It seems to be cheaper to reduce emissions than the industry claimed, and therefore it was much cheaper to fix the pollution problem than to buy emission credits. It seems free markets incentives are more effective than legislated fiats.
So we can see how a supply side solution is better than a demand side solution, and that Cap-and-Trade is a successful, proven solution the problem, why would the Right want a demand side solution? George Will, in his Washington Post article on June 1st, 2008 (here) suggests replacing a cap and trade system with "a straightforward tax on fossil fuels based on each fuel's carbon content". The claim is repeated the next day by Robert J. Samuelson the next day in his aptly named article "Just Call It Cap-and-Tax" (here). My radar starts beeping anytime you see conservatives proposing new taxes, and what would likely be, additional government run programs to use that tax money to research new technologies. The problem is that the price of gas in January, 2000 was $1.59 and as of the writing of this in June, 2008 was $4.16. During that period monthly consumption of oil has gone up by 18 million barrels of oil per month, which seems to show that a tripling of prices may have slowed, but has not leveled out demand. It's only now that are starting to see the demand side kick-in, with people exploring other options to gas guzzling trucks and SUVs. So to make any meaningful impact under a demand side solution would require a substantial tax. Since people are practically rioting in the streets at $4/gallon gas, what would happen if the government proposed a $1 or $2 gas tax? Everyone realizes that a gas tax isn't palatable for Americans, and likely political suicide for Congress. The Conservatives appear to be clinging to their 'climate skeptic' belief that there isn't a problem, and see the best way they to prevent a solution is to propose an impractical one - one that would be dead on arrival in Congress.
With the currently proposed legislation, the cap would get tighter over time, until by 2050, emissions would be reduced to 63% below 2005 levels. According to the current bill, about a quarter of the credits would be auctioned and the rest given away, with the sold credits going towards government run programs. At the Party for Common Sense, we believe in a pure Cap-and-Trade solution - not necessarily the mucked up hybrid bill proposed in Congress. The government should set the limits, referee the battle, and let pure supply side free market economies battle it out. We’ll see if both sides can come around and do the right thing.
Sources
1 As further evidence of the severity of the polar bear's decline, on May 14, 2008 the U.S. Department of the Interior reluctantly reclassified the polar bear as a Threatened Species under the Endangered Species Act, citing concerns about sea ice loss.
