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A Primer On Cap And Trade (Or Is It Cap’n Trade?)…

October 10th, 2009 · 13 Comments
Econ 101 · Environmental Econ · Policy · Videos

We’ve been hearing a lot on the news recently about this idea of cap and trade. Democrats want it, Republicans hate it, yada yada yada. We hear an endless number of views on the various strategies to reduce pollution, but does anyone bother to actually explain how the different strategies work? Of course not, since then we could form our own opinions rather than having to take them from various bobble-headed news pundits. 🙂 Personally, I only take information from fake news pundits, so I will start you off with this clip from The Daily Show:

The Daily Show With Jon Stewart Mon – Thurs 11p / 10c
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Daily Show
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Political Humor Ron Paul Interview

Hee. “The plan allows pollluters who have money to keep doing what they’re doing, like in the old days when indulgences allowed sinners in the Catholic church to pay for the right to sin again.” Jon Stewart is right in a way, though technically I would say “The plan allows polluters to keep doing what they are doing as long as they are willing to pay someone else to clean up on their behalf.” Put this way, why not? It’s basically like subcontracting. Nevertheless, I can’t stop thinking about my friend who said he would order two hamburgers rather than one whenever he goes out to eat with a vegetarian just to ensure that the vegetarian’s efforts are pointless. (I’m an economist who thinks that cows are tasty, so I would also argue that instead it’s perfectly reasonable to pay someone else to not eat meat rather than to not eat meat myself. We’re an odd bunch sometimes.)

But back to the matter at hand…so what is this whole cap and trade thing? Here are the main points:

  • Companies would need permits in order to pollute. (This of course assumes that pollution can be measured, which from what I know is logistically feasible.) They would need one permit for every unit (ton of carbon or whatever) of pollution they produce.
  • The pollution cap (i.e. total amount of pollution allowed) would be set at a level lower than the current level of pollution.
  • Firms would be given some initial number of pollution permits. (It’s unclear what the strategy for allocating permits would be. Don’t even get me started on the politics of this.) The total number of permits given out would equal the cap on pollution.
  • Firms would then be allowed to buy and sell the permits to each other. (This is the trade part of cap and trade.) In this setup, firms can then either pollute less or buy permits to cover their pollution, or implement some combination of those two options. It’s unclear whether this trade would happen on a one-off negotiation basis or would be centralized in some sort of market system.

I’ve taken the liberty of making a few videos that go through the economics of cap and trade and the related options for pollution reduction. I examine 3 options:

  • Option 1: Permits are given out but trade is not allowed
  • Option 2: Tradable permits are given to firms
  • Option 3: Pollution permits are auctioned off

I put some commentary at the end for after you’ve finished with the videos.

Don’t you feel smarter now? Here are the main takeaways:

  • If the government is going to set a pollution cap and issue permits, allowing trade of the permits reduces the overall cost to the system of reducing pollution. This is because market forces direct the cleanup effort to the firms for whom it’s cheapest to clean up.
  • Yes, cap and trade is a form of tax in that it imposes costs on the firms that pollute. But reducing the amount of pollution isn’t free, so somebody’s got to pay for it. We seem to have decided that it’s beneficial to society to reduce pollution (which means that there is a societal cost associated with pollution), so it makes sense to have the solution to the pollution problem at least partly paid for by the firms and consumers involved with the products that are causing the pollution.
  • Cap and trade is already somewhat of a compromise between a straight carbon tax and nothing, since companies are still being given a free pass regarding some of their pollution in the form of the initial free permits. The outcome would be more like a straight tax if the government auctioned off all of the permits.

Hopefully this has been fairly straightfoward, since the mecahnics themselves are easy*. The hard part is deciding what’s efficient and/or fair in terms of a pollution cap, distribution of permits, etc. I always tell my students that economics is easy but policy is hard for these sorts of reasons, but at least understanding the economics can help to make an intelligent policy argument.

* This assumes that the market for permits is efficient and straightforward, which I suppose isn’t necessarily true. If I were a “better” economist, I would come up with a model of strategic interaction that could predict when a firm would refuse to sell permits to a competitor out of spite (read, competitive/anticompetitive behavior) and whatnot. (Gotta love the use of air quotes.)

A couple of weeks ago, Paul Krugman gave an overview of why cap and trade can be beneficial to society. He calls it a “textbook” explanation, but even I find it a tad confusing. Maybe I’ll skip ahead and do some videos on externalities next.

Tags: Econ 101 · Environmental Econ · Policy · Videos

13 responses so far ↓

  • 1 Scott Ritchie // Oct 11, 2009 at 12:29 am

    I don’t think I’ll ever understand the politics of it. When I was in college it was the (more conservative) economists advocating cap-and-trade and the (more liberal) environmentalists advocating straight mandates/bans. Now it’s the (more liberal) Democrats advocating cap-and-trade and the (more conservative) Republicans advocating nothing.

  • 2 econgirl // Oct 11, 2009 at 12:46 pm

    Well, those positions, relatively speaking at least, are consistent. Cap and trade is essentially a compromise along the spectrum, which goes something like (from most to least severe):

    — Straight ban
    — Mandate (not sure how this is actually different other than the wording makes me think of it more as a suggestion than a ban)
    — Per unit tax
    — Permit auction
    — Cap and trade
    — Asking nicely for companies to be cleaner
    — Nothing

    So what’s happened is everyone has moved along the spectrum towards the “doing nothing” end of things, but the left and right are still in the same place relative to one another.

    I got an interesting comment on my Facebook wall: “It’s insane to consider it a benefit to society when considering the initial allowance of credits will be so high in the first place not to make any discernible difference.” This makes me think that the Republicans may have a brilliant negotation strategy in that they got a compromise in upping what the supposed pollution cap would be and then are using(?) that compromise to argue that nothing should be done because it wouldn’t have enough of an effect anyway.

  • 3 BradyDale // Oct 11, 2009 at 3:32 pm

    I’m totally pro-Cap-n-Trade, towing the line of my eco colleagues. My big concern is point #2… the total amount allowed. Two forces that will move it up are the pressure from the industry that wants to pollute more and the industry that will rise up around it. Because they will lobby for higher amounts because that will yield more business for them.

  • 4 Scott Ritchie // Oct 11, 2009 at 3:38 pm

    Your spectrum doesn’t make much sense — as you point out, the severity of the program depends entirely on how big the cap is. A very low limit cap and trade bill is much more “severe” than a 2 cent tax or a mandatory 1% reduction for everyone.

    So maybe if the spectrum isn’t about severity it’s about the sheer amount of law concerned. But that doesn’t make sense either – a cap and trade bill (while more efficient economically) necessarily is more complicated than a simple tax or ban.

  • 5 Dennis Delay // Oct 11, 2009 at 5:43 pm

    Again, I think RGGI is a model, as long as you are going to do it, for cap and trade. Waxman Markey is only adapting part of it, and extending it to all, not just electric utilities. Still, I find it fascinating that the price of carbon is dropping. Apparently recessions are good for the environment.

  • 6 bla // Oct 11, 2009 at 8:14 pm

    Note that the third system does increase taxes. And that is not in the sense that someone has to pay for pollution reduction.
    Firm A will pay $400 in a new tax, etc.

  • 7 chaz s // Oct 23, 2009 at 10:01 pm


  • 8 econgirl // Oct 23, 2009 at 11:59 pm

    You’re lucky I was drunk the first time I read that. 🙂

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