Two Notable Events Prompt Examination of an Important Property of Cap-and-Trade

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In December of 2010, a group of economists and legal scholars gathered at the University of Chicago to celebrate two notable events. One was the fiftieth anniversary of the publication of Ronald Coase’s “The Problem of Social Cost” (Coase 1960).  The other was Professor Coase’s 100th birthday.  The conference resulted in a special issue of The Journal of Law and Economics, which has just been published (although it is dated November 2011).

My frequent co-author, Robert Hahn (of the University of Oxford), and I were privileged to participate in the conference (a video of our presentation is available here).  We recognized that the fiftieth anniversary of the publication of Coase’s landmark study provided an opportunity for us to examine one of that study’s key implications, which is of great importance not only for economics but for public policy as well, in particular, for environmental policy.

The Coase Theorem and the Independence Property

In our just-published article, “The Effect of Allowance Allocations on Cap-and-Trade System Performance,” Hahn and I took as our starting point a well-known result from Coase’s work, namely, that bilateral negotiation between the generator and the recipient of an externality will lead to the same efficient outcome regardless of the initial assignment of property rights, in the absence of transaction costs, income effects, and third party impacts. This result, or a variation of it, has come to be known as the Coase Theorem.

We focused on an idea that is closely related to the Coase theorem, namely, that the market equilibrium in a cap-and-trade system will be cost-effective and independent of the initial allocation of tradable rights (typically referred to as permits or allowances). That is, the overall cost of achieving a given emission reduction will be minimized, and the final allocation of permits will be independent of the initial allocation, under certain conditions (conditional upon the permits being allocated freely, i.e., not auctioned). We call this the independence property. It is closely related to a core principle of general equilibrium theory (Arrow and Debreu 1954), namely, that when markets are complete, outcomes remain efficient even after lump-sum transfers among agents.

The Practical Political Importance of the Independence Property

We were interested in the independence property because of its great political importance.  The reason why this property is of such great relevance to the practical development of public policy is that it allows equity and efficiency concerns to be separated. In particular, a government can set an overall cap of pollutant emissions (a pollution reduction goal) and leave it up to a legislature to construct a constituency in support of the program by allocating shares of the allowances to various interests, such as sectors and geographic regions, without affecting either the environmental performance of the system or its aggregate social costs.  Indeed, this property is a key reason why cap-and-trade systems have been employed and have evolved as the preferred instrument in a variety of environmental policy settings.

In Theory, Does the Property Always Hold?

Because of the importance of this property, we examined the conditions under which it is more or less likely to hold — both in theory and in practice.  In short, we found that in theory, a number of factors can lead to the independence property being violated. These are particular types of transaction costs in cap-and-trade markets; significant market power in the allowance market; uncertainty regarding the future price of allowances; conditional allowance allocations, such as output-based updating-allocation mechanisms; non-cost-minimizing behavior by firms; and specific kinds of regulatory treatment of participants in a cap-and-trade market.

In Reality, Has the Property Held?

Of course, the fact that these factors can lead to the violation of the independence property does not mean that in practice they do so in quantitatively significant ways.  Therefore, Hahn and I also carried out an empirical assessment of the independence property in past and current cap-and-trade systems: lead trading; chlorofluorocarbons (CFCs) under the Montreal Protocol; the sulfur dioxide (SO2) allowance trading program; the Regional Clean Air Incentives Market (RECLAIM) in Southern California; eastern nitrogen oxides (NOX) markets; the European Union Emission Trading Scheme (EU ETS); and Article 17 of the Kyoto Protocol.

I encourage you to read our article, but, a quick summary of our assessment is that we found modest support for the independence property in the seven cases we examined (but also recognized that it would surely be useful to have more empirical research in this realm).

Politicians Have Had it Right

That the independence property appears to be broadly validated provides support for the efficacy of past political judgments regarding constituency building through legislatures’ allowance allocations in cap-and-trade systems. Governments have repeatedly set the overall emissions cap and then left it up to the political process to allocate the available number of allowances among sources to build support for an initiative without reducing the system’s environmental performance or driving up its cost.

This success with environmental cap-and-trade systems should be contrasted with many other public policy proposals for which the normal course of events is that the political bargaining that is necessary to develop support reduces the effectiveness of the policy or drives up its overall cost.  So, the independence property of well-designed and implemented cap-and-trade systems is hardly something to be taken for granted.  It is of real political importance and remarkable social value.

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4 Responses to Two Notable Events Prompt Examination of an Important Property of Cap-and-Trade

  1. Ed Reid says:

    Professor Stavins,

    A very thoughtful and well documented analysis. Thank you.

    I regret that you did not address the successful US CO2 emissions reduction bill in the US House (Waxman-Markey) and the failed US CO2 emissions reduction bills in the US senate (Kerry-Boxer and Kerry-Lieberman). I realize that doing so might well have been impolitic, since all three bills were designed to deviate significantly from the independence principle, by virtue both of the proposed allowance sales and the allocation of some portion of the proceeds of those allowance sales to incentivizing the installation of specific non-emitting equipment. This latter feature of all three bills would have been exacerbated by state RPS requirements, as has been the case in the EU.

    It appears to me that a straightforward cap, declining at a pre-determined rate over an established time period to a final cap, is much like a freshly cut evergreen tree. However, once that evergreen tree is festooned with electric lights, ornaments, tinsel, etc. it loses most of its intrinsic appearance and becomes what is now politically correctly identified as a “holiday tree”. The three bills dealt with in the US Congress appear to have been “holiday trees”, decorated for some indeterminate holiday.

    I believe it is also important, in the context of a multi-decadal program for which some of the technology to achieve the ultimate reductions required by the final cap is unavailable, or requires major investments, or long construction periods, or protracted regulatory approval, etc. and involves alterations to or replacement of assets with multi-decadal economic lives, that longer term strategies for allowance trading must be taken into account. I realize that this approach complicates the analysis significantly. However, this is the reality within which electric utilities must function when facing CO2 emissions reductions to the levels which would apparently be required to “stabilize” the climate, assuming that such an outcome is necessary and achievable.

  2. Stressed Chef says:

    A comment on Ed Reid’s comment – it seems odd to me to argue that the allocation of some (and eventually many) permits under Waxman-Markey et al by auction was a violation of the independence principle. The Coasian idea, overly stripped back, is that with a market and no transaction costs the initial allocation of resources will not prevent them being deployed in their highest value use – because that would-be-user will be prepared to pay top dollar for the resource. Auctioning is pretty firmly consistent with this, except instead of the state giving away the emissions right for someone else to sell on or use, the state sells it itself. Either way, free allocation or auctioning, the resource ends up being put to its highest value use (with some fairly important assumptions about transaction costs). Auctioning has different mechanics to free allocation, but it can be part of a very similar political strategy since auction revenues can be allocated to meet social, regional or sectoral imperatives.

    The use of auction revenue does raise questions; it can be used in ways that are essentially neutral in terms of overall abatement costs (tax cuts, debt reduction, social spending; your views on the broader utility of these things may vary); in ways that lower overall costs (well-targeted spending on emissions-related matters that may be not/weakly addressed by cap-and-trade due to coverage limitations or market failures beyond the lack of a carbon price; some innovation initiatives may qualify, for instance); or in ways that increase overall costs (poorly targeted abatement spending, or spending that directly counteracts the carbon price incentive such as consumption-linked energy rebates (better options include output-linked rebates for businesses or flat social transfers)).

    Waxman-Markey, Kerry-Boxer and Kerry (Graham) Lieberman had various strengths and weaknesses, and the energy rebate elements for households and non-energy intense businesses should have been much better structured (the output based updating allocation system for more energy intensive industries was pretty good). But the auctioning element was not a design flaw violating the political logic of cap and trade that Robert outlines above – it was another way of doing the same thing: ensuring that the limited and declining stock of emissions rights wind up in the highest-value uses, greatly reducing the long-term costs of a long-term transition to a low-emissions economy.

  3. Pingback: Economics and Politics in California: Cap-and-Trade Allowance Allocation and Trade Exposure : Common Resources

  4. Pingback: Remembering Ronald Coase’s Contributions : Common Resources

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