Why Cap-and-Trade is Economically Sound

Cap-and-Trade has gotten a lot of attention lately as it’s at the forefront in the fight against climate change. It’s unfortunate that this sound policy has been hijacked and used for political gains by liberal politicians. As a result of this, the inspiration for, and the consequences of, cap-and-trade have been greatly distorted.

In reading on the blogosphere and newspapers, it is clear that hardly anybody actually knows what cap-and-trade is all about. The conservatives bash it because it’s been put forward by the democrats, therefore it must be a damaging tax, or at the very least, some clever smoke-and-mirrors trick designed to secretly advance an extreme leftist agenda. Neither of these claims is true. The liberals shout that it is the solution to climate change and if we want to stop global warming we must implement cap-and-trade. This, also, is not true. The conservatives respond back that anything that tries to reduce human-caused global warming will do nothing but retard economic growth and needless handcuff the energy and industry sectors. This, too, is not true.

For cap-and-trade to cause all this fuss, it must be something that people have strong opinions about, one way or another. But if you actually ask most of these people point blank, “So what is cap-and-trade?”, they look at you, look at each other, blink a few times, scratch their heads and then continue screaming about why it’s good or bad. I think it’s time to bring a little clarity to issue.

It’s unfortunate that cap-and-trade has been yanked into the global warming debate. The topic of human-caused global warming instantly causes blood pressure to spike, people’s faces to turn red and steam to come out of their ears. According to some, this issue is SETTLED and has been for a long time. If you don’t believe in global warming you either have your head in the sand or are just simply stupid. For the others, the issue is very clearly NOT settled and global warming advocates simply pick and choose their data and shout down any opposition in an effort to advance their extreme leftist agenda.

In the middle of all this, somehow cap-and-trade got put front and center. That’s really quite unfortunate because how can anybody become detached enough from the global warming fiasco to objectively look at cap-and-trade? They can’t. Right out of the chute cap-and-trade isn’t getting a fair shake.

I will attempt to give it the fair shake that it deserves. In order to do that, we must divorce cap-and-trade from global warming. Cap-and-trade has absolutely nothing to do with global warming, and as such, I will drop off the global warming debate right here and continue on without it.

In analyzing cap-and-trade, we must go back and look at its inspiration. In economics, it’s generally believed that the market is pretty much on auto-pilot. It will self-correct, automatically adjusting prices to equilibrate supply and demand; it will ensure that exactly the optimal amount of any product gets produced. This is great! The market does everything for us so we can just sit back and enjoy the show right? Well, no, not exactly. The market can fail, and does fail quite often. The three main areas of market failure are monopolies, public goods and externalities.

For our purposes, this article will focus only on the last two, public goods and externalities.

What is a public good? Using economic terms now, a public good is something that is non-rival and non-excludable. A good is non-rival if one’s use of the product doesn’t diminish another’s use of the product. For example, think of a fireworks show. Just because I am viewing the show, doesn’t mean there is less of it for you to view. A good is non-excludable if it’s impossible to keep somebody from using it. Think of sunlight. Once sunlight is provided, it’s impossible to limit who gets to enjoy it. Put these together and a public good is something everybody can equally use and something that, once it’s provided for one person, it’s provided for all.

National defense is the classic example of a public good. So why would this be a market failure? The market won’t adequately furnish national defense because there is no money to be made in it. If a private company provided national defense, once it’s provided, there is no way to charge people to use it. You can not just provide national defense for only those that pay for it. Once it’s provided, it’s provided. As such, people know they will be able to enjoy its benefits without paying for it. Why pay for something when you can get it for free? In economics we call this free-rider behavior.

Because of free-rider behavior, some essential services must be provided by the government.

What is an externality? Externalities can either be positive or negative. A classic definition of an externality is an unintended, non-market interdependency. All that means is that it’s something good or bad that is not reflected in prices. For example, let’s say you love going to the symphony. You pay money every weekend to hear the symphony play. A new neighbor moves in next door who just happens to be a classical pianist and she practices every Sunday. When she plays, you can hear her music through an open window and it brings you great joy. She is in effect enhancing your life without you having to pay for it. This is a positive externality.

A negative externality is something that causes you discomfort but you are not compensated in any way for it. For example, let’s say you are hiking in the mountains to your favorite waterfall. When you get there you find that somebody has placed a billboard at the base of the waterfall advertising bottled water. That sign has caused you great heartache because it has ruined your view of the waterfall. This is a negative externality.

Since the piano player is enhancing people’s lives by her music, we would want to encourage her to play more, by perhaps paying her $20 every time she plays. This is called a subsidy. Since the person who put up the billboard caused people to become worse-off, we would want to encourage them to put up fewer billboards. Government might do this with what is called an excise tax.

The person who put the billboard up only did so because he didn’t realize the full cost of his actions. If he knew it would cause you discomfort, that it might make you so mad that you would boycott his bottled water, he wouldn’t have put it up. Are all billboards bad? Of course not! Billboards serve a vital purpose by advertising products and generating revenue for the company.

There is definitely a social benefit to having billboards. If there were no billboards, you might not know that you could drink bottled water, thinking you were forever doomed to drink out of the tap. The first few billboards that are put up provide benefits that are greater than the costs. But when so many billboards are up that they are even at the base of waterfalls, then the social cost becomes greater than the benefit. The last billboard put up made you worse off, not better off. You would have preferred if that last billboard was never put up.

Negative externalities have this effect. Because the person putting up the billboards didn’t take into account the social cost, or the non-monetary cost, of his actions, he provides too many of them. He continued to provide them when marginal social cost exceeded marginal social benefit. If there was a tax on every billboard put up, it would force him to take into consideration the extra cost (the social cost) of his actions. As such, since it costs him more money to provide each one, he will provide less.

Before the tax, the quantity supplied was more than what people would have paid for if it were up to them. After the tax, by bringing the perceived cost up to the true cost, the quantity supplied is much closer to the amount people would have paid for to be supplied. The marginal social benefit of the billboards equals the marginal social cost of them. As such, the optimal quantity is produced.

Okay, so what the heck does all this have to do with cap-and-trade?

Cap-and-trade is a way to prevent a negative externality - pollution. When companies produce, they necessarily produce pollution also. But since pollution is a negative externality, they are inflicting a cost on society that is not reflected in their costs of production. Polluting is free. It goes into the air. Since air is a public good, there is no way to stop companies from polluting into it (air is non-excludable). As such the incentive is for companies to produce as cheaply as they can, and if that requires polluting more than they otherwise would, so be it.

The reason public goods are tricky is because it’s very hard to assign property rights to them. Who owns the air? If we could solve the ownership problem, pollution would no longer be a negative externality.

Let me illustrate the importance of property rights with a classic economic example. In the old days, it used to be common for towns to have a public square. As was the custom, farmers would put their sheep in the square to graze. Since nobody owned the property, everybody who wanted to let their sheep graze there could. A problem should already be in the back of your mind. This common property provided the incentive for farmers to put as much sheep as possible into the area and to let them graze for as long as possible. As such the grass would quickly be eaten. No farmer would want to pay or take the time to plant new grass because why should he waste his energy when the grass is only going to get eaten by other people’s sheep? Property held in common encourages over-consumption. The farmers want get their sheep into the square as quickly as possible to graze before all the grass is gone. The farmer would think that if I don’t let my sheep graze there, somebody else will, so I might as well. Common property encourages over-utilization and over-consumption. Such a system is clearly not sustainable. This is known as the “Tragedy of the Commons.” (The same argument can be made for commercial fishing in the ocean. It’s in each fisherman’s interest to catch as many fish as possible as quickly as possible before they are all caught by somebody else. Is it any wonder the oceans are being over fished? All because there are no property rights).

If the town square belonged to a single property owner, he could charge to let people graze their sheep on his grass. This would provide the incentive for him to re-seed as necessary and he could charge a high enough fee to ensure only those who truly value grazing would pay enough to do so. Just by implementing property rights has an unsustainable negative turned into a wealth-creating, sustainable positive.

So, if we could come up with a way to create property rights in the air, we could solve the problem of a negative externality and a public good (we could avoid the tragedy of the commons)!

Cap-and-trade entails the government auctioning off pollution permits. Each permit could be good for 1 ton of pollution. Those companies that see polluting as a critical part of their production process would buy as many permits as they needed. Those companies that were only polluting because they could, because the air was a public good, would instantly reduce their pollution and revise their production methods to something less wasteful. It would no longer be in their interest to intentionally pollute as much as they can in order to minimize the production process.

Since pollution is a negative externality, it means that the companies are producing too much of their product. They are not taking into account the full cost of their actions. They neglect the social cost they are inflicting by polluting. Just the act of seeing or smelling smoke makes us worse off. People want to look at beautiful mountains, not ugly smoke. If the firms took into account the full cost of their actions, they would realize that they are producing more of their product than people actually want (with more production comes more pollution, and people want less pollution, not more).

Does this mean that there should be zero pollution? Not likely, for can you imagine the costs of a world without pollution?! We wouldn’t have anywhere close to the amount of products and services we have today and those that were provided would be so expensive that nobody would be able to afford them.

Clearly there is a benefit to pollution. Companies and society just must find a way to make sure that companies pollute so long as the social benefits of doing so exceed the social costs. As it is right now, because pollution is free, companies produce too much pollution, so much so that the social cost of pollution exceeds the social benefit of it. Cap-and-trade remedies this.

Cap-and-trade forces companies to internalize the full cost of their actions by making them buy a pollution permit (thus eliminating the market failure of negative externalities). It solves the tragedy of the commons problem by creating property rights in the form of permits (thus eliminating the market failure of public goods).
Companies are then free to sell permits (or the right to pollute) to other companies. This creates the incentive for firms to produce at lowest cost.

For example, suppose all firms must reduce pollution by one ton per day. Company A finds that, for it to reduce emissions by 1 ton per day, it will cost an extra $1,000. Company B, however, finds that it can meet the requirement for only $100 per day. If companies are allowed to trade the right to pollute, Company B can make a profit by offering to reduce its pollution by 2 tons per day. Since the cost of reducing one ton of pollution for B is only $100, it can reduce its pollution by 2 tons, thus meeting A’s requirement and its own, for only $200. Company A will pay company B anywhere from $201 to $999 to reduce pollution by the extra ton. This way, Company A achieves the least-cost solution, because it’s cheaper to pay company B than it is to pay to reduce emissions. Company B achieves the least-cost option and actually makes a profit by reducing its pollution by two tons. And the requirement is achieved. Pollution has been reduced at the least cost possible and the marginal social cost of pollution equals the marginal social benefit, thus ensuring that the optimal amount of pollution is produced.

Cap-and-trade is the best option for reducing pollution. Pollution exacts a cost on society but there is no way to capture that cost. With tradable pollution rights, the government is involved to the minimal amount possible (only to auction the permits and provide a basic measuring and monitoring system, for most of the measuring and monitoring will be achieved by the market itself –there is money to be made by reducing costs!).

With tradable pollution rights, economic liberty is maintained because companies can decide for themselves what is in their interest and the best way to go about it, rather than being a slave to some regulation. With tradable pollution rights we are assuring that the optimal amount of pollution is being produced, and not an ounce more, all at the least possible cost.

Cap-and-trade is indeed an economists’ solution to a tricky problem. It maintains the integrity of the free-market while avoiding the excess burden and impreciseness of a tax. Cap-and-trade is truly a winning recipe, if only people could see it for what it is.