Policy for Market Failure Market-based strategies: Cap and trade

1. Policy for Market Failure Market-based strategies: Cap and trade Known by many names: marketable/tradable/transferable permit/right/allowance/quota “marketable permit”, “tradable permit system” • Pollution: “tradable emissions allowances”, “transferable discharge permit” • Development: “transferable development right” • Fishing: “individual transferable quota”

2. Instrument taxonomy

3. Example: SO2 tradable emissions allowance market The problem: • 1980s: scientists discovered that lakes, streams, and forests - even buildings and statues - were being damaged by acid rain. • Effects: robs soil of nutrients, can make lakes uninhabitable for aquatic life, damages man made objects. • Congress authorized a ten-year, $570-million study to determine the cause, and a major culprit was found: sulfur dioxide (SO2), • air pollutant generated by power plants and other  industrial facilities. Effect of acid rain on a forest, Jizera Mountains, Czech Republic, http://en.wikipedia.org/wiki/Acid_rain From US EPA website: http://www.epa.gov/acidrain/images/origins.gif Sources: http://www.etei.org/case_study_1.htm, http://www.rff.org/documents/RFF-DP-00-38.pdf

4. SO2 Allowance Market The policy response • 1990: Congress revises the Clean Air Act • A yearly cap on SO2 emissions was established (also NOx) • Scope: Began with the largest emitters (1995) then expanded to cover all fossil-fuel electric power producers (2000) • Ratcheting: Yearly cap decreased with an ultimate target of 50% of 1980 levels by 2010 (17.5 million tons of SO2 were emitted in 1980). • Also instituted an emission allowance trading program • The industry is allocated a fixed number of total allowances • Firms are required to hold one allowance for each ton of sulfur dioxide they emit. • Firms are allowed to transfer allowances among facilities or to other firms or to bank them for use in future years • The Environmental Defense Fund helped to write the revision Sources: http://www.etei.org/case_study_1.htm, http://www.rff.org/documents/RFF-DP-00-38.pdf

5. SO2 Allowance Market SO2 Allowances Transferred Under the Acid Rain Program Allowance Prices (1994-2010) http://www.epa.gov/airmarkets/progress/ Schmalensee & Stavins 2012

6. Cost effectiveness comparison over alternative instruments If we had perfect foresight over what was going to happen to prices for permits and important inputs like low-sulfur coal. (Source K&O, p. 187)

7. SO2 Allowance Market • B = 10*C: Overall the benefits of the program are around 10 times greater than the costs • The prediction was: B = C (Portney 1990) • Compliance cost: one-half or less of what was anticipated in 1990 (Burtraw, 2000) • Some savings from trading • Primary source of savings: flexibility in choosing abatement strategy in the firm (Hahn, 2000) • Fuel switching (e.g. low-sulfur coal made cheaper through railroad deregulation), • Innovation -- Not typically patentable discoveries, but rather subtle process changes and changes in markets and organizational behavior • Most of the estimated benefits have come through reduced risk of premature mortality by reducing exposure to sulfates (Burtraw, 2000)

8. SO2 market surprises • put in place to curb acid rain, but main source of benefits from it was unexpected • main source of cost-effectiveness was an unanticipated consequence of earlier railroad deregulation • cap-and-trade now demonized by conservative politicians (yet, initially championed and implemented by Republicans) • court decisions and regulatory responses have led to the collapse of the SO2 market (what the government gives, the government can take away) (Schmalensee & Stavins 2012)

9. Transferable discharge permit system (TDP) • The most frequently employed market-based environmental instruments in the United States (Stavins, 1998)

10. State and regional programs(Hahn, 2000)

11. How TDP works • Key regulator decisions • scope: which polluters should be regulated • what the cap (quantity of permits) will be (setting the level/target). • how to initially allocate the permits • Regulator allocates permits and sets up a market for permits to be exchanged between polluters • polluters decide • how much to abate, • how many permits to buy/sell, • [sometimes] how many to bank for use or sale next year

12. How TDP works – “simple” example • 2 emitters (A, B) • What is the level of total unregulated emissions? • Suppose: • policy goal: 50% overall cut • allocation rule: proportional to pre-existing emissions. • A: 0.5*120 = 60 permits • B: 0.5*90 = 45 permits • Are there gains to be had from trade? • The last unit abated by B cost ~ $4K • B would be WTP <= ~$4K to avoid abating that last unit • The next unit abated by A would cost ~$1.2K • A would be WTA >= ~$1.2K to abate another unitfreeing up a permit for B to use • Under the initial allocation, is the equimarginal principle satisfied? • Who would have an incentive to buy permits? Sell permits? (Think marginally!) • Note: A is the lower cost abater, B is the higher cost abater

13. How TDP works – “simple” example From the initial allocation, A (LCA) reduces emissions by one unit to free up a permit to sell to B (HCA). E.M.P. satisfied? If no, repeat…. still gains from trade

14. How TDP works – “simple” example • 2 emitters (A, B) • What is the level of total unregulated emissions? • Suppose: • policy goal: 50% overall cut • allocation rule: proportional to pre-existing emissions. • A: 0.5*120 = 60 permits • B: 0.5*90 = 45 permits • At the predicted equilibrium of the permit market between these two: • Is the equimarginal principle satisfied? Why should we care? • After trading, has the total quantity of emissions changed?

15. Carbon offsets • Carbon offsets: a tradable credit for reducing carbon emissions by some amount (e.g. ton) generated outside a regulated system, recognized within a regulated system (e.g. a cap-and-trade regime) as a substitute for holding and using an emissions permit. "Regulatory" offset. • "Retail offset": An offset marketed to individual consumers. Possibly but not necessarily recognized by any institutional authority.

16. Retail offset:

17. Attributes for carbon offset effectiveness Offset issues: is the offset… • Real: has the unit of emissions actually been avoided and not just claimed? • Additional: was the unit avoided due to the offset policy or would it have been avoided regardless of the offset mechanism? (Was this criteria satisfied in the “Cheat Neutral” ‘example’?) • Permanent: is the unit avoided permanently or only temporarily (e.g. will a planted tree just be burned in 10 years)? • Verifiable: can we ensure that each attribute above is actually attained so that stakeholders in the over-arching climate policy can ensure that the policy is not being undermined?

18. “Cheat Neutral”

19. “Cheat Neutral” • 0:18 - 2:40 • Q: "Have you ever cheated on your girlfriend?" A: "…No, certainly not. Cause that would be wrong." • “…The total levels of heartbreak have not gone up.“ • 3:25 - 5:12 • "...cheating and jealousy are just a natural part of most modern relationships, and what we needed was a market-based solution to dealing with that." • Q: "Does that make sense?" A: “…No." • "What we're making sure is that the total amount of cheating doesn't go up. So if you want to cheat it's no longer something you have to feel bad about…" • Offset price: $5. • "All we're doing is taking this well-established concept of carbon offsetting and moving it into the arena of cheating and relationships."

20. Short paper • Costello et al (2012): “A market approach to saving the whales”. • Are individual tradable quotas a way forward from the current impasse in controlling international take of whales? • Sandel (1997): “It’s Immoral to Buy the Right to Pollute” • What do we lose when we commodify the environment?

21. Criteria for policy evaluation:Efficiency vs. Moral precepts "A tax on child pornography, for example, might be more efficient than certain criminal penalties in limiting the prevalence and severity of such activity; however, taxation would be considered a morally unacceptable policy in this instance because laws are important instruments for forming and communicating ethical values” (Sterner, 2003, p. 198).

22. Optional additional slides

23. Setting the level – the cap • Similar thought process to setting a performance standard or Pigovian tax (if efficiency is the goal). • The total cap is often ratcheted/reduced over time by the regulator (e.g. S02) • Reasons: • technological improvements lower the efficient level • softens initial impact on industry (gradual adjustment to stringent ultimate target believed less costly).

24. Initial allocation of permits • As long as the initial allocation is fairly well dispersed (to avoid a permit trading monopoly), the resulting trading market should not be greatly affected. (Cost-effectiveness likely not affected.) • The particular rule or formula will have distributional impacts • Example allocations • Give them away • Equal number of permits per firm • BUT firms differ in size • According to firms’ share of pre-existing emissions • BUT rewards bad actors • According to firms’ share of goods market • Sell them • Auction • Involves a transfer to government • Hybrid (give away fraction then sell remainder)

25. Political economy of cap and trade • C&T has emerged in the U.S. as most likely the lead instrument to control GHG emissions. WHY? • Political economic story over next slides summarized by J.Broder (2009. “From a Theory to a Consensus on Emissions” (5/16/09) New York Times). http://www.nytimes.com/2009/05/17/us/politics/17cap.html?_r=4&scp=1&sq=cap%20and%20trade&st=cse

26. Political economy of C&T • Previous take on C&T from many of those support C&T today: • “an industry-inspired Republican scheme to avoid the real costs of cutting air pollution.” • The preferred approach they said (previously) was: • “strict government regulation, state-of-the-art technology and a federal tax on every ton of harmful emissions”

27. Political economy of C&T • Congressional history: • 1993: President Clinton “proposed a tax on all forms of energy, a plan that went down to defeat and helped take the Democratic majority in Congress down with it a year later.” • Horse trading: • C&T is highly amenable to the “buying and selling of political support” through the permit allocation process (to industries and particular congressional districts).

28. Political economy of C&T • Previous success: the SO2 model • During the Bush (Sr.) administration a C&T plan for SO2 reductions was outlined in the White House and sent to Congress. • This C&T plan became a critical component of the amendments to the Clean Air Act in 1990, “considered by many to be the most successful domestic environmental legislation ever enacted.” • Even after vigorous debate in congress the target held: “roughly 50 percent reduction in emissions over the next decade”

29. Is a C&T system essentially equivalent to a tax? • W. David Montgomery (1971 doctoral thesis on emissions trading) • “It [a C&T approach to GHG control] is a steel fist of regulation covered by a velvet glove of emission trading….” • “Why not just impose a carbon tax?”

30. “Companies Earn Big Profits From Free Carbon Credits”* • “During his election campaign, President Barack Obama pledged to institute a system in the United States where all permits would be auctioned. That could avoid the mind bogglingly large windfall profits made by utilities in Europe.” • “The head of the nation’s largest burner of coal for power generation last week signaled his group’s determination to fight for a significant chunk of free allowances under any United States system, according to Reuters.” • Michael Morris (chief executive of American Electric Power): “If you auction all of the credits, then it’s just a carbon tax,”… “So let’s forget the game. Let’s call it a carbon tax, and let’s see if the populace wants to have a carbon tax.” • *Source: New York Times (03/09/09): http://greeninc.blogs.nytimes.com/2009/03/09/companies-earn-big-profits-from-free-carbon-credits/

31. Setting up the market for permit trade • General rule: simple and clear rules (keeps “transactions costs” low) • Single overall market for permits where buyers and sellers can interact openly and where information on prices is publicly available to all participants. • Added transactions costs will likely hurt the efficiency of the market • If trades require regulator approval, the additional bureaucracy and uncertainty will generate transactions costs. • Who is allowed to trade? • Just polluters? Third parties (e.g. private citizens, NRDC) who’d like to buy/retire permits?

32. Setting up the market for permit trade • Normal forces of competition would bring about a single price • Permits would tend to flow LAC  HAC polluters • LAC: Low abatement cost polluters would be those with better pre-existing technologies AND/OR those who have invested in better abatement technologies. • Our equilibrium prediction is that MACA = MACB = p* What is the predicted MAC of each firm after trade? Demand: HAC polluters, expanding firms, or new firms Supply: LAC polluters or firms leaving the business

33. TDP and Incentives for R&D Model for an individual firm: Under performance standard at e1 • What is the incentive to innovate (to MAC2)? Under a TDP system, with market permit price p • Suppose initial allocation of permits is A=0 (firm must buy all permits it needs on the open permit market) • What is level of abatement? Permits required? (Under MAC1? MAC2 ?) • What is the total cost of compliance (TCC) for the firm including total abatement cost (TAC) and total permit cost (TPC)? TCC = TAC + TPC • What is the incentive to innovate? • How does the incentive to innovate under TDP compare to that under emissions charges (at least in theory)? ---------------------------------------------------------------- • Alternatively, suppose that A = e1. Does the abatement level change? Does the TCC go up or down? Does the incentive to innovate change? Note: when many firms are involved, we will assume that each firm treats the permit price as fixed, i.e. their own buying and selling of permits is too minor to affect the market permit price. This is different then the simple 2 firm example previously discussed.