Wednesday, July 25, 2007

Emissions Trading

Today, your pseudo candidate for the House of Representatives is going to continue to look at energy policy. One of the policies that would be put before me, if I were elected, would be ‘emissions trading’.

What Came Before

So far, if elected as your pseudo Representative, I have said that I will not support renewable energy subsidies. Nor will I support renewable portfolio standards. I am not going to support a policy of providing customers with price relief - keeping the price of fossil fuel consumption artifically low - since this will only encourage consumption and increase the negative effects of consumption.

I will, on the other hand, support a pigovian tax on fossil fuels that brings the price of fossil fuels consumption up to its true social cost. I would make sure that this tax covered the additional costs imposed on the people of the world by the energy company’s actions in deceiving and manipulating the public on the harms that result from the use of their products.

However, I will not support any policy that protects the customers from the costs of those increases. After all, it is the behavior of those customers (consumption levels) that we most need to influence. We want the consumer to quit consuming at the point that the net social benefit of his consumption is less than the net social costs, and that does not happen if we shield the customer forom he net social costs.

Finally, as a legislator, I hold that a legislator’s duty is not to vote only for ideal options, but to vote for the best politically possible option. I would violate these rules and vote for renewable energy subsidies and renewable portfolio standards if these are the best politically viable options. However, these are only the best political options only to the degree that energy companies have a legal license to kill and maim others for profit.

[Let’s see. Have I alienated ALL potential voters yet?]

Emissions Trading

Emissions trading, in one simple form, involves putting a cap on emissions. For the sake of illustration, let us simply say that Congress has set an emissions cap of 1,000,000 of, say, 1,000,000 units. It then sells permits for emissions. If Company C emits 10,000 units per year, then it would have to purchase permits to emit 10,000 units. It would find itself in competition with others who would want to emit the same substance, which would bid up the price. If this company wants to save money, or to get itself out from under these restrictions, then it could do so by installing technology that would reduce its emissions, to the degree that it is cost effective to do so.

Emissions trading has a lot to recommend it. For one thing, politicians do not decide where to cut emissions. The market makes this decision. The system employs man of the market’s advantages of blending information and incentives. The system captures the relative value to the public of the different reasons to emit the substance, driving the least valued uses out of business, while allowing the most valued uses the ability to collect the money that would allow them to purchase licenses. The very instant that a new technology is invented, the price of emissions permits will drop, making emissions available to industries that otherwise could not have afforded them. All of this gets done without an ounce of legislative interference, once emissions trading is established.

The objective for a cap and trade policy would be to establish a trading system where the purchaser’s price of emissions permits reflects the social costs of emissions. This includes the price of the emissions trading system itself. Furthermore, the revenue should go to those who will be made to suffer the effects of those emissions. Otherwise, our system is still producing negative externalities and free riders – where the free riders, in this case, would include those who are actually obtaining the funds that should go to the victims of the activity.

Externalities, Subsidies, and Taxes

I want to tie this in with a comment that ADHR made to my earlier post on subsidizing renewable energy.

One might want to claim reduced emissions are the lack of a negative externality, but given that emissions (and associated penalties) are continuing to rise, reducing emissions clearly generates a benefit relative to other possible outcomes. I don't see any in principle reason, though, for denying that someone can free-ride on a reduced negative externality just as easily as on a positive externality.

I have argued so far that it is best to deal with positive externalities by subsidizing the activities that produce them, and negative externalities with a pigovian tax – a tax that drives the price of an activity up to the point where it covers social cost, and where the revenue can then be used to mitigate or compensate for the harms done.

ADHR is correct to note that a reduction in externalities is certainly a good (or, at least, a ‘better than’). However, when it comes to giving companies an incentive to reduce emissions, it is a ‘better than’ best brought about through a pigovian tax. Subsidizing a competing industry still leaves the price of those activities below the social costs, and thus still encourages people to engage in those activities even where the activities do more harm than good.

However, the argument that a rise in negative externalities justifies subsidizing industries that produce fewer negative externalities is something like saying that since rape-murder is on the rise we should subsidize mere rapes. After all, if we can induce people into mere rapes, we prevent murder, which is a good thing.

Subsidized renewable energy may produce fewer negative externalities, but it still produces externalities. It may cause impose less injustice, but it still imposes injustice. This is inevitably the result of lowering the price that a consumer pays for a product below its social cost. Others still suffer those social costs. The only time when a subsidy is legitimate is when one wants to raise the benefits to a provider up to the level where the provider can realize a reward for the benefit he provides for society. A benefit to society is not ‘doing less harm and injustice than the next person’.

Cap and Trade

Now, assume that you run a company that puts 10,000 units of emissions into the atmosphere. Licenses cost $100 per unit. However, Company D, at a cost of only $10 per unit, can engage in an activity that sucks 10,000 units of emissions out of the atmosphere. Why should the company be forced to pay $1 million for emissions licenses? Why not allow it, instead, to pay $100,000 to Company D to suck 10,000 units out of the atmosphere, and save $100,000?

Note that this will not work if the adverse effects of the emissions are local. For example, if an emission produces health effects for those those who live downwind, then it does no ogood to have people on the other side of the world suck an equal amount of the emissions out of the atmosphere – those who live downwind from the plant will still suffer. However, the system does work if the problem is more widely distributed. Greenhouse gas emissions affect the planet, and the effects of 10,000 units of emissions on one part of the gloe can be mitigated by 10,000 units drawn into a sink on the other side of the globe.

Ultimately, the difference reflects the different activities between the price of an activity and its true social costs or benefits.

The way this works is that the sink industry is allowed to ‘manufacture’ emissions permits. The sink company engages in an activity that sucks 10,000 units of emissions out of the atmosphere. The company has then ‘manufactured’ permits for 10,000 units of emissions that it can then sell on the market. Companies then bid for these emissions permits. The higher the bidding goes, the more profitable the sink industry becomes, the more money that goes into growing the sink industry.


A emissions cap and trading system still has a disadvantage in that the legislature needs to decide what the proper cap should be. Ideally, the cap should be where the marginal social cost of an additional unit of emissions exceeds the marginal social benefit. Those legislators will be expected to try to figure this out while being lobbied by special interest groups where many have no moral qualms against legislation allowing them to bring about the death and suffering of others when it profits them to do so.

However, the question is not whether this is an ideal solution. The question is whether this is among the best of all available real-world solutions. Emissions cap and trading is clearly not ideal, but it is better than many of the alternatives.


Psychols said...


I have been enjoying this series of posts, particularly the manner in which you have progressed from moral objectives (reducing externalities) to solutions (such as emissions trading). I am curious as to how far you can take us towards a truly international solution.

If I understand you correctly, the pigovian tax on emissions will increase the price of the energy and products we consume. How can those pigovian tax funds realistically be directed to everyone who was and will be impoverished by the emissions generated in the production and use of the energy and products? The US government (or in my case the Canadian government) will collect a sum of money. Between our two nations, we have about 5% of the world’s population but we are impoverishing 100% of the world’s population with our emissions. Ninety five percent of the funds should be distributed outside of North America. (Of course, some of the funds collected in other nations will be directed to us so the actual dollars sent abroad will be reduced).

If GHG reducing technology existed then that would eliminate some of the need to transfer funds from high consumption richer economies to lower consumption poorer economies.

Do I have it right?

Anonymous said...

One of the biggest problems with cap & trade systems is that they are not truly open markets. If I am an environmental group and I wish to purchase the rights to 1,000 units of pollution so that I can retire them permanently, I am not allowed to do so. So yes, Cap & Trades are a good idea, but they don't go far enough. The market needs to be open to everyone, not just industry.

Alonzo Fyfe said...


Many cap and trade systems do allow individuals or groups to buy permits - and then simply not use them. In other words, they are open to everybody.

This is an optional provision, and a provision that I would support in any cap and trade system. Attempts to keep people out of the market is an attempt to outlaw the expression of certain preferences in the free market.