Cap-and-Trade: A Fly in the Ointment? Not Really

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For more than two decades, environmental law and regulation was dominated by command-and-control approaches — typically either mandated pollution control technologies or inflexible discharge standards on a smokestack-by-smokestack basis.  But in the 1980s, policy makers increasingly explored market-based environmental policy instruments, mechanisms that provide economic incentives for firms and individuals to carry out cost-effective pollution control.  Cap-and-trade systems, in which emission permits or allowances can be traded among potential polluters, continue today to be at the center of this action.

Most recently, this has been in the context of deliberations regarding possible U.S. actions to reduced carbon dioxide and other greenhouse gas emissions linked with global climate change, as in HR 2454, the Waxman-Markey bill approved by the U.S. House of Representatives, as well as in proposals developing in the Senate.  (I have written a number of blog posts on this topic.  If you’re interested, please see:  “Opportunity for a Defining Moment” (February 6, 2009); “The Wonderful Politics of Cap-and-Trade:  A Closer Look at Waxman-Markey” (May 27, 2009); “Worried About International Competitiveness?  Another Look at the Waxman-Markey Cap-and-Trade Proposal” (June 18, 2009); “National Climate Change Policy:  A Quick Look Back at Waxman-Markey and the Road Ahead” (June 29, 2009).  For a more detailed account, see my Hamilton Project paper, A U.S. Cap-and-Trade System to Address Global Climate Change.)

But the transition from command-and-control regulation to market-based policy instruments has not always been easy.  Sometimes policy can outrun basic understanding, and the claims made for the cost-effectiveness of cap-and-trade systems can exceed what can be reasonably anticipated.  Among the factors that can adversely affect the performance of such systems are transaction costs.

In general, transaction costs — those costs that arise from the exchange, not the production, of goods and services — are ubiquitous in market economies.  They can arise from any exchange:  after all, parties to transactions must find one another, communicate, and exchange information.  It may be necessary to inspect and sometimes even measure goods to be transferred, draw up contracts, consult with lawyers or other experts, and transfer title.

In cap-and-trade markets, there are three potential sources of transaction costs. The first source, searching and information-collection, arises because it can take time for a potential buyer of a discharge permit to find a seller, though — for a fee — brokers can facilitate the process.  Although less obvious, a second source of transaction costs — bargaining and deciding — is potentially as important.  A firm entering into negotiations incurs real resource costs, including time and/or fees for brokerage, legal, and insurance services.  Likewise, the third source — monitoring and enforcing — can be significant, although these costs are typically borne by the responsible governmental authority and not by trading partners.

The cost savings that may be realized through cap-and-trade systems depend upon active trading.  But transaction costs are an impediment to trading, and such impediments thereby can limit savings.  So, transaction costs reduce the overall economic benefits of allowance trading, partly by absorbing resources directly and partly by suppressing exchanges that otherwise would have been mutually (indeed socially) beneficial.  But when transaction costs can be kept to a minimum, high levels of trading — and significant cost savings – are the result.

Since David Montgomery’s path-breaking work in 1972, economists have asserted that the post-trading allocation of control responsibility among sources and hence the aggregate costs of control are independent from the initial permit allocation.  This is an extremely important political property, but does this still hold in the presence of transaction costs?  This is a question I investigated in an article titled, “Transaction Costs and Tradable Permits,” which was published in the Journal of Environmental Economics and Management in 1995 (and which the publisher lists as one of the ten most cited articles in the journal’s history, going back to 1974).

The answer to this question is: “it depends.”  If incremental transaction costs are independent of the size of individual transactions, the initial allocation of permits has no effect on the post-trading allocation of control responsibility and aggregate control costs.  But if incremental transaction costs decrease with the size of individual trades, then the initial allocation will affect the post-trading outcome.

This is of great political importance, because it means that in the presence of transaction costs, the initial distribution of permits can matter not only in terms of distributional equity, but in terms of cost-effectiveness or efficiency.  This can reduce the discretion of the Congress (or other legislature or agency) to distribute allowances as they please (in order to generate a constituency of support for the program), and may thereby reduce the political attractiveness and feasibility of a cap-and-trade system.

Empirical evidence, however, indicates that transaction costs have been minimal, indeed trivial, in enacted and implemented cap-and-trade systems, including the U.S. EPA’s leaded-gasoline phasedown in the 1980s, and the well-known SO2 allowance trading system, enacted as part of the Clean Air Act amendments of 1990.

That’s good news, surely.  But nevertheless, going forward, choices between conventional, command-and-control environmental policies and market-based instruments should reflect the imperfect world in which these instruments are applied.  Such choices are not simple, because no policy panacea exists.

On the one hand, even if transaction costs prevent significant levels of trade from occurring, aggregate costs of control will most likely be less than those of a conventional command-and-control approach.  A trading system with no trading taking place will likely be less costly than a technology standard (because the trading system provides flexibility to firms regarding their chosen means of control) and no more costly than a uniform performance standard.

But the existence of transaction costs may make the choice between conventional approaches and cap-and-trade more difficult because of the ambiguities that are introduced.  With transaction costs — as with other departures from frictionless markets — greater attention is required to the details of designing specific systems.  This is the way to lessen the risk of over-selling such policy ideas and ultimately creating systems that stand the best chance of being implemented successfully.

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8 Responses to Cap-and-Trade: A Fly in the Ointment? Not Really

  1. Pingback: Cap-and-Trade : A Fly in the Ointment? « RFF Library Blog

  2. Gulzar says:

    Prof Stavins, while I am convinced that market-based approaches to controlling carbon emissions are definitely superior, i am inclined towards carbon taxes as a better alternative than cap-and-trade. I have posted on the same here

    http://gulzar05.blogspot.com/2009/08/why-carbon-taxes-may-be-superior.html

    In an increasingly globalized world and given the “global commons” nature of climate change issues, cap-and-trade poses problems of the sort highlighted by the “border adjustment” tariffs proposed under the US Climate Change Waxman-Markey Bill, on countries that fail to cap their greenhouse gas emissions by 2020. Even between countries following cap-and-trade policies, like say EU ETS and US (when the Bill is passed into law), harmonization is likely to become a potentially controversial issue (given the differences in the way permits were allocated).

    Carbon taxes, by being uniform in their application across all categories of carbon emitting products from across the world, avoids the aforementioned problems in cross-country trade. It can be easily integrated with the existing global trade policies under the WTO, without generating any market distortions.

    In fact, on trade grounds alone carbon taxes is a superior alternative. Even if the transaction costs are minimal in developed economies, with their more effective monitoring and enforcement mechanisms and smaller numbers of emission sources, they are likely to be large in developing economies for exactly the opposite reasons.

    I wanted to know your views on the relative merits of these two market-based options and which of the two is superior. In particular what are your views on the problems associated with the allocation of allowances and transaction costs (especially in developing economies)

  3. Gulzar,
    Thanks for your comment. In previous posts over the past few months, I have made many comments on the “choice” between carbon taxes and cap-and-trade. See my previous posts linked in the current post. In a future post, I may focus on the difference between these two market-based policy instruments in the climate context. As for the issue you raise, border adjustments in the form of border taxes would be just as prevalent in political proposals if carbon taxes were employed instead of cap-and-trade systems, indeed, they would be far more common. And the issue of the differing existing tax baseline in various countries would also arise.
    RS

  4. Suzi Kerr says:

    Dear Rob

    I agree that the detailed design of any system is important. I wanted to be sure however that people do not overestimate the importance of transaction costs in cap and trade markets. Monitoring and enforcement costs are not a cost of exchange but a cost of the regulation. Hence they are not a ‘transaction cost’. The same costs would appear in a tax system, or any command and control system also. The only time that monitoring and enforcement becomes a cost of exchange is in a baseline-credit or offset system where participants are regulated only if they trade and not otherwise. This is not what is proposed for most sectors in the US or other OECD countries. Also, as you know, the key to lowering negotiation costs is to have a liquid market where the market price is known. Carbon units are a homogenous commodity within each cap and trade market so the market should be pretty liquid once the regulations are clear and firms need to comply. As long as regulations don’t limit the tradeability of units this source of transaction cost should be minimised. I think people often inappropriately extrapolate from observed voluntary markets which are baseline-credit or offset systems and from the observed current very noisy and illiquid carbon markets which are largely dominated by policy uncertainty.

    Suzi Kerr, Visiting Professor in Economics, Stanford University

  5. From “Grasping Reality with Both Hands — The Semi-Daily Journal of Economist Brad DeLong: A Fair, Balanced, Reality-Based, and More than Two-Handed Look at the World:”

    Environmental Policy Cap-and-Trade Blogging: Mark Thoma Brings Rob Stavins to the Rescue

    Mark Thoma brings Rob Stavins to the table to provide a guide for the perplexed:

    Stavins: Waxman-Markley is Not a Massive Corporate Give-Away: This is a follow-up to the recent discussion between Brad DeLong and Greg Mankiw on the effects of giving away rather than auctioning carbon permits under a cap and trade system (see, e.g., here, here, here, and here). Mankiw begins with the premise that:

    Rather than auctioning the carbon allowances, the bill that recently passed the House would give most of them away to powerful special interests.

    But is it correct to classify the program as “giving most of them away to powerful special interests”? Here’s Harvard’s Robert Stavins who knows a thing or two about this topic. He notes that “it is remarkable (and unfortunate) how misleading so much of the coverage has been of the issues and the numbers surrounding the proposed allowance allocation.” He also says that “we should be honest that the legislation, for all its flaws, is by no means the “massive corporate give-away” that it has been labeled. On the contrary, 80% of the value of allowances accrue to consumers and public purposes”:

  6. Denny Ellerman says:

    Rob,

    I agree that transaction costs exist in cap-and-trade, that those costs can matter, and that it is important not to over-sell cap-and-trade. Nevertheless, one has to wonder whether the alternatives are what are being over-sold. In this context, three points are worth making.
    1. The transaction costs involved in prescriptive, command-and-control approaches are far from trivial and considerably greater for both public and private entities than those incurred by cap-and-trade.
    2. The bigger problem with the command-and-control approach is its effectiveness, which arises from the “fuzziness” of compliance with this approach. No matter how earnestly EPA tries there will always be exceptions because of plant idiosyncracies. One of the beautiee of cap-and-trade is the simple, binary, “no excuses” approach to compliance. Every ton of emissions must be covered. There can be no question of whether the mal-functioning of the scrubber, for instance, was justified, unavoidable, etc.
    3. As the EU ETS is showing, the point of regulatory obligation makes a difference in the transaction costs incurred by a cap-and-trade approach. If small sources are to be included, transaction costs will be significantly less with an upstream point of regulatory obligation than a downstream one. The downstream point of regulation for small stationary sources in the EU ETS appears to have imposed higher transaction costs on these sources than any conceivable cost savings from their inclusion in the program. Unfortunately, the course taken in the EU ETS to deal with this problem post-2012 is to allow opt outs provided the opted-out installation is subject to “comparably stringent” other regulations. If this option is taken up by these sources, somewhat more than half the sources covered by the EU ETS (accounting for considerably less than 5% of emissions) may leave the system. It is doubtful however that the transaction costs involved in the alternative will be any less and it is likely that the alternative will in fact not be as demanding. The road not taken, going upstream, would have removed all the transaction costs for these emitters while maintaining the price incentive at the expense of lower transaction costs incurred at the points of upstream regulation.

    Denny

  7. Denny,
    Looking at the time your comment was submitted, either you’re writing from Europe or having trouble sleeping (if the later, I would agree that reading my blog can be a good cure). In any event, thanks very much for your comment.
    I agree with all three of your points. I find your third point particularly striking, because it describes yet another problem caused by the EU decision to go downstream in its Emission Trading Scheme. Whereas the press and many in the U.S. policy community seem to focus on the EU ETS “over-allocation” in the pilot phase when seeking lessons to be learned for the U.S. from the experience of the EU ETS, I always emphasize a different lesson, namely, that a co2 cap-and-trade system ought to employ an upstream point of regulation.
    Thanks again for these three important points.
    Rob

  8. Here is the real problem – too many people in the world.

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