A Challenge for Climate Negotiators, and an Opportunity for Scholars

As I have written in many previous essays at this blog, the challenges standing in the way of an effective international climate change agreement are numerous and severe.  It is also true that the prospects for a truly meaningful deal may be better now than at any time in the past decade or more.  That is the theme of a new article I’ve co-authored with my Harvard Kennedy School colleague, Joseph Aldy.  The article, “Climate Negotiators Create an Opportunity for Scholars,” was published in the August 31st edition of Science.

Changes emerged gradually from the Major Economies Forum on Energy and Climate in 2009, the Copenhagen Accord (2009), the Cancun Agreements (2010), and – most important – the Durban Platform for Enhanced Action (2011).  Together these have now increased the likelihood that the ongoing negotiations can move beyond the debilitating Annex I/non-Annex I dichotomy of the Berlin Mandate (1995), as codified in the Kyoto Protocol (1997); and instead develop a comprehensive legal regime for implementation in 2020 that includes all key countries, based upon a more nuanced and effective interpretation of the principle of “common but differentiated responsibilities and respective capabilities” from the original United Nations Framework Convention on Climate Change (UNFCCC, 1992).

In our Science article, Joe Aldy and I trace this history and describe several potential international climate policy architectures that could be consistent with the process and principles laid out in both the Durban Platform and the UNFCCC.  Our article is very brief, and so rather than trying to summarize it here, I encourage you to follow this link to read the essay in its entirety.

The negotiating teams are now tasked under the Durban Platform with identifying a new comprehensive policy architecture by 2015 (for 2020 implementation).  The negotiators are therefore hungry for new ideas, in particular for outside-the-box thinking.  This presents an important opportunity for researchers in universities, think tanks, and advocacy groups around the world.

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

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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Can Market Forces Really be Employed to Address Climate Change?

Debate continues in the United States, Europe, and throughout the world about whether the forces of the marketplace can be harnessed in the interest of environmental protection, in particular, to address the threat of global climate change.  In an essay that appears in the Spring 2012 issue of Daedalus, the journal of the American Academy of Arts and Sciences, my colleague, Joseph Aldy, and I take on this question.  In the article – “Using the Market to Address Climate Change:  Insights from Theory & Experience” – we investigate the technical, economic, and political feasibility of market-based climate policies, and examine alternative designs of carbon taxes, cap-and-trade, and clean energy standards.

The Premise

Virtually all aspects of economic activity – individual consumption, business investment, and government spending – affect greenhouse gas emissions and, therefore, the global climate. In essence, an effective climate change policy must change the nature of decisions regarding these activities in order to promote more efficient generation and use of energy, lower carbon-intensity of energy, and a more carbon-lean economy.

Basically, there are three possible ways to accomplish this: (1) mandate that businesses and individuals change their behavior; (2) subsidize business and individual investment; or (3) price the greenhouse gas externality proportional to the harms that these emissions cause.

Harnessing Market Forces by Pricing Externalities

The pricing of externalities can promote cost-effective abatement, deliver efficient innovation incentives, avoid picking technology winners, and ameliorate, not exacerbate, government fiscal conditions.

By pricing carbon emissions (or, equivalently, the carbon content of the three fossil fuels – coal, petroleum, and natural gas), the government provides incentives for firms and individuals to identify and exploit the lowest-cost ways to reduce emissions and to invest in the development of new technologies, processes, and ideas that can mitigate future emissions. A fairly wide variety of policy approaches fall within the concept of externality pricing in the climate-policy context, including carbon taxes, cap-and-trade, and clean energy standards.

What About Conventional Regulatory Approaches?

In contrast, conventional approaches to environmental protection typically employ uniform mandates to protect environmental quality. Although uniform technology and performance standards have been effective in achieving some established environmental goals and standards, they tend to lead to non-cost-effective outcomes in which some firms use unduly expensive means to control pollution.

In addition, conventional technology or performance standards do not provide dynamic incentives for the development, adoption, and diffusion of environmentally and economically superior control technologies. Once a firm satisfies a performance standard, it has little incentive to develop or adopt cleaner technology. Indeed, regulated firms may fear that if they adopt a superior technology, the government will tighten the standard.

Given the ubiquitous nature of greenhouse gas emissions from diverse sources, it is virtually inconceivable that a standards-based approach could form the centerpiece of a truly meaningful climate policy. The substantially higher cost of a standards-based policy may undermine support for such an approach, and securing political support may require weakening standards and lowering environmental benefits.

How About Technology Subsidies?

Government support for lower-emitting technologies often takes the form of investment or performance subsidies. Providing subsidies for targeting climate-friendly technologies entails revenues raised by taxing other economic activities. Given the tight fiscal environment throughout the developed world, it is difficult to justify increasing (or even continuing) the subsidies that would be necessary to change significantly the emissions intensity of economic activity.

Furthermore, by lowering the cost of energy, climate-oriented technology subsidies can actually lead to excessive levels of energy supply and consumption. Thus, subsidies can undermine incentives for efficiency and conservation, and impose higher costs per ton abated than cost-effective policy alternatives.

In practice, subsidies are typically designed to be technology specific. By designating technology winners, such approaches yield special-interest constituencies focused on maintaining subsidies beyond what would be socially desirable. They also provide little incentive for the development of novel, game-changing technologies.

That said, there is still a role for direct technology policies in combination with externality pricing, as I have argued in a previous essay at this blog.  This is because in addition to the environmental market failure (appropriately addressed by externality pricing) there exists another market failure in the climate change context, namely, the public-good nature of information produced by research and development.  I addressed this in my essay, “Both Are Necessary, But Neither is Sufficient: Carbon-Pricing and Technology R&D Initiatives in a Meaningful National Climate Policy.”

Back to Markets, and Some Real-World Experience

Empirical analysis drawing on actual experience has demonstrated the power of markets to drive profound changes in the investment and use of emission-intensive technologies.

The run-up in gasoline prices in 2008 increased consumer demand for more fuel-efficient new cars and trucks, while also reducing vehicle miles traveled by the existing fleet. Likewise, electricity generators responded to the dramatic decline in natural gas prices in 2009 and 2010 by dispatching more electricity from gas plants, resulting in lower CO2 emissions.

Longer-term evaluations of the impacts of energy prices on markets have found that higher prices have induced more innovation – measured by frequency and importance of patents – and increased the commercial availability of more energy-efficient products, especially among energy-intensive goods such as air conditioners and water heaters.

Experience with Externality Pricing

Real-world experience with policies that price externalities has illustrated the effectiveness of market-based instruments. Congestion charges in London, Singapore, and Stockholm have reduced traffic congestion in busy urban centers, lowered air pollution, and delivered net social benefits.  Likewise, the British Columbia carbon tax has reduced carbon dioxide emissions since 2008.

More prominently, the U.S. sulfur dioxide (SO2) cap-and-trade program has cut SO2 emissions from U.S. power plants by more than 50 percent since 1990, resulting in compliance costs one-half of what they would have been under conventional regulatory mandates.

The success of the SO2 allowance trading program motivated the design and implementation of the European Union’s Emissions Trading Scheme (EU ETS), the world’s largest cap-and-trade program, focused on cutting CO2 emissions from power plants and large manufacturing facilities throughout Europe.

And the 1980s phasedown of lead in gasoline, which reduced the lead content per gallon of fuel, served as an early, effective example of a tradable performance standard.

These positive experiences have provided ample reason to consider market-based instruments – carbon taxes, cap-and-trade, and clean energy standards – as potential approaches to mitigating greenhouse gas emissions.

The Rubber Hits the Road

The U.S. political response to possible market-based approaches to climate policy has been and will continue to be largely a function of issues and structural factors that transcend the scope of environmental and climate policy. Because a truly meaningful climate policy – whether market-based or conventional in design – will have significant impacts on economic activity in a wide variety of sectors and in every region of the country, it is not surprising that proposals for such policies bring forth significant opposition, particularly during difficult economic times.

In addition, U.S. political polarization – which began some four decades ago and accelerated during the economic downturn – has decimated what had long been the key political constituency in Congress for environmental (and energy) action: namely, the middle, including both moderate Republicans and moderate Democrats. Whereas congressional debates about environmental and energy policy have long featured regional politics, they are now largely partisan. In this political maelstrom, the failure of cap-and-trade climate policy in the Senate in 2010 was collateral damage in a much larger political war.

Better economic times may reduce the pace – if not the direction – of political polarization. And the ongoing challenge of large federal budgetary deficits may at some point increase the political feasibility of new sources of revenue. When and if this happens, consumption taxes – as opposed to traditional taxes on income and investment – could receive heightened attention; primary among these might be energy taxes, which, depending on their design, can function as significant climate policy instruments.

Many environmental advocates would respond that a mobilizing event will surely precipitate U.S. climate policy action.  But the nature of the climate change problem itself helps explain much of the relative apathy among the U.S. public and suggests that any such mobilizing events may come “too late.”

Nearly all our major environmental laws have been passed in the wake of highly publicized environmental events or “disasters,” including the spontaneous combustion of the Cuyahoga River in Cleveland, Ohio, in 1969, and the discovery of toxic substances at Love Canal in Niagara Falls, New York, in the mid-1970s. But note that the day after the Cuyahoga River caught on fire, no article in The Cleveland Plain Dealer commented that the cause was uncertain, that rivers periodically catch on fire from natural causes. On the contrary, it was immediately apparent that the cause was waste dumped into the river by adjacent industries. A direct consequence of the observed “disaster” was, of course, the Clean Water Act of 1972.

But climate change is distinctly different. Unlike the environmental threats addressed successfully in past U.S. legislation, climate change is essentially unobservable to the general population. We observe the weather, not the climate. Until there is an obvious and sudden event – such as a loss of part of the Antarctic ice sheet leading to a dramatic sea-level rise – it is unlikely that public opinion in the United States will provide the bottom-up demand for action that inspired previous congressional action on the environment over the past forty years.

A Half-Full Glass of Water?

Despite this rather bleak assessment of the politics of climate change policy in the United States, it is really much too soon to speculate on what the future will hold for the use of market-based policy instruments, whether for climate change or other environmental problems.

On the one hand, it is conceivable that two decades (1988–2008) of high receptivity in U.S. politics to cap-and-trade and offset mechanisms will turn out to be no more than a relatively brief departure from a long-term trend of reliance on conventional means of regulation.

On the other hand, it is also possible that the recent tarnishing of cap-and-trade in national political dialogue will itself turn out to be a temporary departure from a long-term trend of increasing reliance on market-based environmental policy instruments. Perhaps the ongoing interest in these policy mechanisms in California (Assembly Bill 32), the Northeast (Regional Greenhouse Gas Initiative), Europe, and other countries will eventually provide a bridge to a changed political climate in Washington.

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