CHAPTER 1 CAP AND TRADE, MARKET REGULATION, AND ECONOMIC FACTORS INVOLVED IN CLIMATE CHANGE
| Jurisdiction | United States |
(Jan 2015)
CAP AND TRADE, MARKET REGULATION, AND ECONOMIC FACTORS INVOLVED IN CLIMATE CHANGE
Senior Vice President
Co-Chair, Environmental Practice
NERA Economic Consulting 1
Washington, D.C.
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DR. ANNE E. SMITH is an economist and decision analyst. She is senior vice president of NERA Economic Consulting, a global economics consulting firm, co-heading its environment practice. With a focus on air and climate change regulation, she conducts benefit-cost, risk, and economic impact studies, advises companies on business strategies to manage regulatory/market uncertainties, and serves as an expert witness in regulatory proceedings and major litigation. An area of particular expertise for Dr. Smith has been assessing the market and business implications of alternative designs to regulate emissions, such as cap-and-trade and emissions taxes. For over 20 years, she has researched and written on this and many other aspects of climate change policy for energy and finance companies, research institutions, industry associations, non-profit organizations, and governments globally. She has testified before numerous committees of the U.S. Congress, and has also served on advisory committees, such as for the National Research Council. She presently serves on the Board of Directors of the Society for Benefit-Cost Analysis. Prior to joining NERA in 2011, Dr. Smith held leadership positions in other major consulting firms, and worked in the Economic Analysis Division of the U.S. Environmental Protection Agency. She has a PhD degree in Economics from Stanford University, with a PhD minor in the Engineering Department.
I. INTRODUCTION
Societal efforts to manage the negative impacts of pollution on people and the environment can take many forms, from outright bans of certain polluting activities to highly flexible and even voluntary commitments negotiated among affected parties. For significant environmental issues that are experienced widely throughout a large jurisdiction, a regulatory approach is2 usually considered necessary to ensure that control objectives are effectively and consistently achieved. However, as modern societies have developed increasingly strong objectives to achieve their economic growth with minimal environmental degradation, the need for effective regulation has morphed into a need for regulation that is also cost-effective. Since the 1970s, regulatory approaches that create price signals to motivate polluters to internalize the societal costs of their pollution into their production or behavioral decisions have become common. The concept of such "market-based" approaches gained popularity as initial experiments with them proved successful at achieving environmental objectives with much reduced cost.
This paper provides a non-technical overview of the fundamental elements of market-based pollution regulation, and describes the similarities and differences between the two core alternative forms of market-based regulation: cap-and-trade and emissions taxes. This section is general to any form of pollution control. The paper then focuses on the specific case of greenhouse gas (GHG) regulation using market-based measures. The mechanisms by which GHG pricing filters through the economy are traced, with the purpose of providing the reader with a heightened understanding of how market-based regulation for GHGs works, and also why it is an especially challenging issue for policy makers to resolve. The paper then describes the evolution of the policy discussion in the US around cap-and-trade. It starts with an overview on the history of cap-and-trade for emissions other than GHGs, and how this failed to continue into an application to GHGs in the US. Current variants of quasi market-based approaches that have emerged for controlling GHGs are characterized, explaining how they work, and their limitations relative to pure market-based approaches. This section includes an
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overview of regulation of GHGs under the Clean Air Act. The paper concludes with a few thoughts on what companies in the minerals and mining sector should prepare themselves for as the drive towards US GHG policy continues to develop.
II. WHAT MARKET-BASED REGULATORY METHODS DO...AND WHAT THEY DON'T DO
A price signal as the common feature
Many people think that a "market-based" measure requires the presence of an observable market in which pollution rights or "permits" are bought and sold, however, this is not the most important fundamental feature of market-based regulation. The defining characteristic of a flexible approach to regulation is that the polluter must pay for what he/she emits - that is, a price per unit of pollution is created by or through the regulation. In the case of cap-and-trade, the regulator does not set the price, but rather sets up a requirement that each polluter obtain one "permit" per unit emitted, and then creates a pool of such permits. As long as that pool of created permits is less than the unregulated level of emissions, scarcity will be created, which will cause permits to become a new and essential costly input to emitting production processes. When the regulator allocates the permits but allows them to be traded thereafter, or auctions them off to the highest bidders, that scarcity value emerges as a market price for the permits.3 It is the price per unit emitted that causes emitters to decide how much to reduce their emissions, not the existence of a market per se. That is, the regulator could achieve the same outcome in emissions without any emissions market if it were to impose a tax on the same set of emitters with the same price rate per unit emitted.
Thus, regulations that harness economic incentives to achieve more cost-effective outcomes are all fundamentally price-based. Whether to create the price signal with a tax or via a competition for a scarce supply of permits, the way that cost-effective controls are motivated by a regulation is the same. From the emitters' point of view, the decision of whether to reduce one's emissions or instead pay for those emissions is financially identical. From the regulator's point of view, if emitters make the same emissions reduction decisions, the environmental outcome is identical. There are important differences between the alternative price-based approaches, however, that give them different relative merits for different types of pollution situations. These differences will be discussed further in Section III.
Why a price-based regulation produces a cost-effective outcome
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A central insight of classical economic theory is that price signals that emerge from the equilibrium in which supply equals demand "invisibly" guide human behavior and productive decisions towards outcomes that maximize societal welfare (or "utility"). Systems that operate by price signals are informationally efficient -- no individual or government authority needs to know the cost structures and preferences of the society to achieve an optimal outcome. Given that these costs and preferences are highly diverse and difficult to directly observe, the advantages of being able to rely on price signals rather than a central planner are apparent theoretically, but have also proven themselves also empirically through nations' many historical experiences with less market-oriented economies.
Regulations are warranted to improve societal welfare when a "market failure" exists. One classic market failure is the case of pollution. If an emitter were to be the only entity to experience his emissions' impacts, then he would be motivated by his personal experience to choose the optimal level of emissions, because all of the damage from those emissions (their negative value) would be internally accounted for ("internalized") in his own utility-maximizing (or profit-maximizing) decision making. But the more typical case with pollution is that it also affects other entities in a community, none of whom can control those emissions through their own actions. Thus, the majority of the welfare damages from an emitting activity are not internalized in the emitter's decision making, and a societally excessive amount of pollution is the common result of the existence of this "externality." The market failure occurs because there is no natural mechanism for an emitter to have to pay for, and thus be motivated to incorporate the full negative value of his activities into his own choice. To rectify this situation, the rest of the individuals in society need to have a voice in the productive or behavioral decisions of the emitter, which is one of the roles of government, in the form of a regulator.
The traditional regulatory response to an externality was to impose directive mandates on productive or behavioral choices in a manner often referred to as "command and control." The merits of correcting a missing price signal by creating an ersatz price signal through regulation are now more widely understood and accepted. Additionally, the informational efficiency of a price-based approach has increased in value in the fact of the greater complexity of today's environmental goals, and society's level of ambition for them. In a modern society with a complicated and diverse array of technological processes that emit, and a large number of different entities contributing to the overall pollution, a regulator would need to have extensive information (much of which is private in nature), and omniscience about how interrelated commodity and product prices will respond changes set in motion by a regulatory requirement, if the regulator is to have any success using a command and control approach. Clearly, the emitters themselves know their own options and their respective direct and indirect costs far better than a regulator can ever achieve. By...
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