Cap-and-Trade, Carbon Taxes, and My Neighbor’s Lovely Lawn

The recent demise of serious political consideration of an economy-wide U.S. CO2 cap-and-trade system and the even more recent resurgence in interest among policy wonks in a U.S. carbon tax should prompt reflection on where we’ve been, where we are, and where we may be going.

Lessons

Almost fifteen years ago, in an article that appeared in 1998 in the Journal of Economic Perspectives, “What Can We Learn from the Grand Policy Experiment?  Lessons from SO2 Allowance Trading,” I examined the implications of what was then the very new emissions trading program set up by the Clean Air Act Amendments of 1990 to cut acid rain by half over the succeeding decade.  In that article, I attempted to offer some guidance regarding the conditions under which cap-and-trade (then known as “tradable permits”) was likely to work well, or not so well.  Here’s a brief summary of what I wrote at the time:

(1)  SO2 trading was a case where the cost of abating pollution differed widely among sources, and where a market-based system was therefore likely to have greater gains, relative to conventional, command-and-control regulations (Newell and Stavins 2003). It was clear early on that SO2 abatement cost heterogeneity was great, because of differences in ages of plants and their proximity to sources of low-sulfur coal. But where abatement costs are more uniform across sources, the political costs of enacting an allowance trading approach are less likely to be justifiable.

(2)  The greater the degree to which pollutants mix in the receiving airshed or watershed, the more attractive a cap-and-trade (or emission tax) system will be, relative to a conventional uniform standard. This is because taxes or cap-and-trade can – in principle – lead to localized “hot spots” with relatively high levels of ambient pollution. Some states (in particular, New York) tried unsuccessfully to erect barriers to trades they thought might increase deposition within their borders.  This is a significant distributional issue.  It can also be an efficiency issue if damages are nonlinearly related to pollutant concentrations.

(3)  The efficiency of a cap-and-trade system will depend on the pattern of costs and benefits. If uncertainty about marginal abatement costs is significant, and if marginal abatement costs are quite flat and marginal benefits of abatement fall relatively quickly, then a quantity instrument, such as cap-and-trade, will be more efficient than a price instrument, such as an emission tax (Weitzman 1974).  With a stock pollutant (such as CO2), this argument favors a price instrument (Newell and Pizer 2003).  However, when there is also uncertainty about marginal benefits, and marginal benefits are positively correlated with marginal costs (which, it turns out, is a relatively common occurrence for a variety of pollution problems), then there is an additional argument in favor of the relative efficiency of quantity instruments (Stavins 1996).

(4)  Cap-and-trade will work best when transaction costs are low (Stavins 1995), and the S02 experiment showed that if properly designed, private markets will tend to render transaction costs minimal.

5)  Considerations of political feasibility point to the wisdom of proposing trading instruments when they can be used to facilitate emissions reductions, as was done with SO2 allowances and lead rights trading, less so for the purpose of reallocating existing emissions abatement responsibility (Revesz and Stavins 2007).

(6)  National policy instruments that appear impeccable from the vantage point of Cambridge, Massachusetts, Berkeley, California, or Madison, Wisconsin, but consistently prove infeasible in Washington, D.C., can hardly be considered “optimal.”

Implications for CO2 Policy

In the same article, I noted that many of these issues could be illuminated by considering a concrete example:  the “current interest” in applying cap-and-trade to the task of cutting CO2 emissions to reduce the risk of global climate change.  Some of the points I made in this regard in my 1998 article were:

(a)  The number of sources of CO2 emissions are vastly greater than in the case of SO2 emissions as a precursor of acid rain, where the focus could be placed on a few hundred electric utility plants.  Feasibility considerations alone argue for market-based instruments (cap-and-trade or taxes) to achieve meaningful reductions of CO2 emissions.

(b)  The diversity of sources of CO2 in a modern economy and the consequent heterogeneity of emission reduction costs bolster the case for using cost-effective market-based instruments.

(c)  As the ultimate global-commons problem, CO2 is a truly uniformly-mixed pollutant.  With no concern for hot spots, market-based instruments present none of the problems that can arise in the case of localized environmental threats.

(d)  Any pollution-control program must face the possibility of emissions leakage from regulated to unregulated sources. This would be a severe problem for an international CO2 program, where emissions would tend to increase in nonparticipant countries. Furthermore, it raises concerns for the emission-reduction-credit (not cap-and-trade) system in the Kyoto Protocol known as the Clean Development Mechanism (CDM).  Such an offset system can lower aggregate costs by substituting low-cost for high-cost control, but may also have the unintended effect of increasing aggregate emissions beyond what they would otherwise have been, because there is an incentive for adverse selection: sources in developing countries that would reduce their emissions, opt in, and receive credit for actions they would have taken anyway.

(e)  Although any trading program could potentially serve as a model for the case of global climate change, I argued that the trading system that accomplished the U.S. phaseout of leaded gasoline in the 1980s merited particular attention. The currency of that system was not lead oxide emissions from motor vehicles, but the lead content of gasoline. So too, in the case of global climate, great savings in monitoring and enforcement costs could be had by adopting input trading linked with the carbon content of fossil fuels. This is reasonable in the climate case, since – unlike in the SO2 case – CO2 emissions are roughly proportional to the carbon content of fossil fuels and scrubbing alternatives are largely unavailable, at least at present.

(f)   Natural sequestration of CO2 from the atmosphere by expanding forested areas is available (even in the United States) at reasonable cost (Stavins 1999).  Hence, it could be valuable to combine any carbon trading (or carbon tax) program with a carbon sequestration program, although this will raise significant challenges in regard to monitoring and enforcement.

(g)  In regard to carbon permit allocation mechanisms, auctions would have the advantage that revenues could be used to finance reductions in distortionary taxes.  Free allocation could increase regulatory costs enough that the sign of the efficiency impact could conceivably be reversed from positive to negative net benefits (Parry, Williams, and Goulder 1999).  On the other hand, free allocation of carbon permits would meet with much less political resistance.

The Necessity of Market-Based Instruments:  Cap-and-Trade or Carbon Taxes

I concluded that developing a cap-and-trade system for climate change would bring forth an entirely new set of economic, political, and institutional challenges.  At the same time, I recognized that the diversity of sources of CO2 emissions and the magnitude of likely abatement costs made it equally clear that only a market-based instrument – some form of carbon rights trading or (probably revenue-neutral) carbon taxes – would be capable of achieving the domestic targets that might eventually be forthcoming.

In other words, my conclusion in 1998 strongly favored a market-based carbon policy, but was somewhat neutral between carbon taxes and cap-and-trade.  Indeed, at that time and for the subsequent eight years or so, I remained agnostic regarding what I viewed as the trade-offs between cap-and-trade and carbon taxes.  What happened to change that?  Three words:  The Hamilton Project.

The Making of an Advocate

For those of you who don’t know, the Hamilton Project is an initiative based at the Brookings Institution that – according to its web site – “offers a strategic vision and produces innovative policy proposals on how to create a growing economy that benefits more Americans.”

In 2007, the Project’s leadership asked me to write a paper proposing a U.S. CO2 cap-and-trade system.  I responded that I would prefer to write a paper proposing the use of a market-based CO2 policy, describing the two alternatives of cap-and-trade and carbon taxes.  I explained that I was by no means opposed to the notion of a carbon tax, having written about such approaches for more than twenty years.  Indeed, I noted, both cap-and-trade and carbon taxes would be good approaches to the problem; they have many similarities, some tradeoffs, and a few key differences.

The Hamilton Project leaders said no, they wanted me to make the best case I could for cap-and-trade, not a balanced investigation of the two policy instruments.  Someone else would be commissioned to write a proposal for a carbon tax.  (That turned out to be Professor Gilbert Metcalf of Tufts University – now on leave at the U.S. Department of the Treasury – who did a splendid job!)  Thus, I was made into an advocate for cap-and-trade.  It’s as simple as that.

Giving It My Best Shot

I argued in my Hamilton Project paper (which you can read here) that despite the tradeoffs between the two principal market-based instruments that could target CO2 emissions, the best (and most likely) approach for the short to medium term in the United States was a cap-and-trade system, based on three criteria:  environmental effectiveness, cost effectiveness, and distributional equity.  Although my position was not simple capitulation to politics, I argued that sound assessments of environmental effectiveness, cost effectiveness, and distributional equity should be made in a real-world political context.

I said that the key merits of the cap-and-trade approach were, first, the program could provide cost-effectiveness, while achieving meaningful reductions in greenhouse gas emissions levels.  Second, it offered an easy means of compensating for the inevitably unequal burdens imposed by a climate policy.  Third, it provided a straightforward means to link with other countries’ climate policies.  Fourth, it avoided the political aversion in the United States to taxes.  Fifth, it was unlikely to be degraded – in terms of its environmental performance and cost effectiveness – by political forces. And sixth, this approach had a history of successful adoption and implementation in this country over the past two decades.

I recognized that there were some real differences between taxes and cap-and-trade that needed to be recognized.  First, environmental effectiveness:  a tax does not guarantee achievement of an emissions target, but it does provide greater certainty regarding costs.  This is a fundamental tradeoff.  Taxes provide automatic temporal flexibility, which needs to be built into a cap-and-trade system through provision for banking, borrowing, and possibly cost-containment mechanisms.  On the other hand, political economy forces strongly point to less severe targets if carbon taxes are used, rather than cap-and-trade – this is not a tradeoff, and is why virtually no environmental NGOs have favored the carbon-tax approach.

In principle, both carbon taxes and cap-and-trade can achieve cost-effective reductions, and – depending upon design — the distributional consequences of the two approaches can be the same.  But the key difference is that political pressures on a carbon tax system will most likely lead to exemptions of sectors and firms, which reduces environmental effectiveness and drives up costs, as some low-cost emission reduction opportunities are left off the table.  But political pressures on a cap-and-trade system lead to different allocations of the free allowances, which affect distribution, but not environmental effectiveness, and not cost-effectiveness.

I concluded that proponents of carbon taxes worried about the propensity of political processes under a cap-and-trade system to compensate sectors through free allowance allocations, but a carbon tax would be sensitive to the same political pressures, and should be expected to succumb in ways that are ultimately more harmful:  reducing environmental achievement and driving up costs.

Of course, such positive political economy arguments look much less compelling in the wake of the defeat of cap-and-trade legislation in the U.S. Congress and its successful demonization by conservatives as “cap-and-tax.”

A Political Opening for Carbon Taxes?

Does the defeat of cap-and-trade in the U.S. Congress, the obvious unwillingness of the Obama White House to utter the phrase in public, and the outspoken opposition to cap-and-trade by Republican Presidential candidate Mitt Romney indicate that there is a new opening for serious consideration of a carbon-tax approach to meaningful CO2 emissions reductions?

First of all, there surely is such an opening in the policy wonk world.  Economists and others in academia, including important Republican economists such as Harvard’s Greg Mankiw and Columbia’s Glenn Hubbard, remain enthusiastic supporters of a national carbon tax.  And a much-publicized meeting in July at the American Enterprise Institute in Washington, D.C. brought together a broad spectrum of Washington groups – ranging from Public Citizen to the R Street Institute – to talk about alternative paths forward for national climate policy.  Reportedly, much of the discussion focused on carbon taxes.

Clearly, this “opening” is being embraced with enthusiasm in the policy wonk world.  But what about in the real political world?  The good news is that a carbon tax is not “cap-and-trade.”  That presumably helps with the political messaging!  But if conservatives were able to tarnish cap-and-trade as “cap-and-tax,” it surely will be considerably easier to label a tax – as a tax!   Also, note that Romney’s stated opposition and Obama’s silence extend beyond disdain for cap-and-trade per se.  Rather, they cover all carbon-pricing regimes.

So as a possible new front in the climate policy wars, I remain very skeptical that an explicit carbon tax proposal will gain favor in Washington, no matter what the outcome of the election.  Note that the only election outcome that could lead to an aggressive and successful move to a meaningful nationwide carbon pricing regime would be:  the Democrats take back control of the House of Representatives, and the Democrats achieve a 60+ vote margin in the Senate, and the President is reelected.  A quick check at Five Thirty Eight (Nate Silver’s superb election forecast website at the New York Times) and other polling web sites makes it abundantly clear that the probability of such Democratic control of the White House and Congress is so small that it’s hardly worth discussing.

What About Fiscal Policy Reform?

A more promising possibility – though still unlikely – is that if Republicans and Democrats join to cooperate with either a Romney or Obama White House to work together constructively to address not only the short-term fiscal cliff at the end of this calendar year, but also the longer-term budgetary deficits the U.S. government faces, and if as part of this they decide to include not only cuts in government expenditures, but also some significant “revenue enhancements” (the t-word is not allowed), and if (I know, this is getting to be a lot of “if’s”) it turns out to be easier politically to eschew increases in taxes on labor and investment and therefore turn to taxes on consumption, then there could be a political opening for new energy taxes, in particular, (drum roll ….) a carbon tax.

Such a carbon tax – if intended to help alleviate budget deficits – could not be the economist’s favorite, a revenue-neutral tax swap of cutting distortionary taxes in exchange for implementing a carbon tax.  Rather, as a revenue-raising mechanism – like the Obama administration’s February 2009 budget for a 100%-auction of allowances in a cap-and-trade scheme – it would be a new tax, pure and simple.  Those who recall the 1993 failure of the Clinton administration’s BTU-tax proposal – with a less polarized and more cooperative Congress than today’s – are not optimistic.

Nor is it clear that a carbon tax would enjoy more support in budget talks than a value added tax (VAT) or a Federal sales tax.  The key question is whether the phrases “climate policy” or “carbon tax” are likely to expand or narrow the coalition of support for an already tough budgetary reconciliation measure.  The key group to bring on board will presumably be conservative Tea Party Republicans, and it is difficult to picture them being more willing to break their Grover Norquist pledges because it’s for a carbon tax.

Research

Even if the much-ballyhooed political opening for carbon taxes is largely illusory, the opening for policy wonks is real.  And here is where action is happening, and should continue to happen.  At some point the politics will change, and it’s important to be ready.  This is why economic research on carbon taxes is very much needed, particularly in the context of broader fiscal challenges, and it is why I’m pleased to see it happening at Resources for the Future, Harvard University, and elsewhere.

Bottom Line

I would personally be delighted if a carbon tax were politically feasible in the United States, or were to become politically feasible in the future.  But I’m forced to conclude that much of the current enthusiasm about carbon taxes in the academic and broader policy-wonk community in the wake of the defeat of cap-and-trade is – for the time being, at least – largely a manifestation of the grass looking greener across the street.

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Both Are Necessary, But Neither is Sufficient: Carbon-Pricing and Technology R&D Initiatives in a Meaningful National Climate Policy

For many years, there has been a great deal of discussion about carbon-pricing – whether carbon taxes or cap-and-trade – as an essential part of a meaningful national climate policy.  It has long been recognized that although carbon-pricing will be necessary, it will not be sufficient. Economists and other policy analysts have noted that policies intended to foster climate-friendly technology research and development (R&D) will also be necessary, but likewise will not be sufficient on their own.

Some recent studies and press accounts, which I reference below, have identified these two approaches to addressing CO2 emissions as substitutes, rather than complements.  That is fundamentally inconsistent with decades of research, and so my purpose in this essay is to set the record straight.

Carbon Pricing:  Necessary But Not Sufficient

First of all, why is there so much talk among policy analysts and policy makers – not simply among academics – about carbon‑pricing as the core of a meaningful strategy to reduce CO2 emissions?  Why, in fact, is this approach so overwhelmingly favored by the analytical community?  The answer is simple and surprisingly pragmatic.

First, there is no other feasible approach that can provide meaningful emissions reductions, such as the 80 percent reduction in national CO2 emissions by 2050 that was part of the legislation passed by the U.S. House of Representatives and proposed in the Senate and part of the Obama administration’s conditional pledge under the Copenhagen Accord.  Because of the ubiquity and diversity of energy use in a modern economy, conventional regulatory approaches –standards of various kinds – simply cannot do the job.  Only carbon pricing – either in the form of carbon taxes or cap-and-trade – can significantly tilt in a climate-friendly direction the millions of decentralized decisions that are made in our economy every day.

Second, carbon-pricing is the least costly approach in the short term, because abatement costs are exceptionally heterogeneous across sources.  Only carbon-pricing provides strong incentives that push all sources to control at the same marginal abatement cost, thereby achieving a given aggregate target at the lowest possible cost.

Third, it is the least costly approach in the long term, because it provides incentives for carbon-friendly technological change, which brings down costs over time.

For these reasons, carbon-pricing is a necessary component of a truly meaningful national climate policy.  [I’ve written about this in many previous blog posts, including on June 23, 2010, “The Real Options for U.S. Climate Policy.”]  However, although it is a necessary policy component, carbon-pricing is not sufficient on its own. This is because there are other market failures that dilute the impacts of price signals on decision makers.

Technology R&D Policies:  Also Necessary, Also Not Sufficient

The most important of these “other market failures” is the public good nature of information.  Companies carrying out research and development (R&D) incur the full costs of their efforts, but they do not capture the full benefits.  This is because even with a perfectly-enforced system of intellectual property rights (such as patents), there are tremendous spillover benefits to other firms.  Decades of economic research – much of it by my former colleague and co-author, Professor Adam Jaffe, now Dean of Arts and Sciences at Brandeis University – has analyzed with empirical (econometric) analysis the remarkable degree to which inventions and innovations by one firm provide valuable information that leads to new inventions and innovations by other firms.

So, firms pay the costs of their R&D, but do not reap all the benefits.  The existence of this positive externality of firms’ R&D – or put differently, the public-good nature of the information generated by R&D – means that the private sector will carry out less than the “efficient” amount of R&D of new climate-friendly technologies in response to given carbon prices.  Hence, other public policies are needed to address this “R&D market failure.”

New path-breaking technologies will be needed to address climate change, and public support for private-sector or public-sector R&D will be crucial to meet this need.  But, at the same time, to address the climate-change market failure itself (that is, the externality associated with greenhouse gas emissions), carbon pricing will be necessary, for all of the reasons I gave above.  This is an application of an important and fundamental principle in economics:  two market failures require the use of two policy instruments.

Empirical analyses have repeatedly verified this crucial point – that combining carbon-pricing with R&D support is more cost-effective than adopting either approach alone.  Included in this set of studies are the following:  Carolyn Fischer (Resources for the Future) and Richard Newell (U.S. Energy Information Administration, on leave from Duke University), “Environmental and Technology Policies for Climate Mitigation”; Stephen Schneider (late of Stanford University) and Lawrence Goulder (Stanford University), “Achieving Low-Cost Emissions Targets”; and Daren Acemoglu (MIT), Philippe Aghion, Leonardo Bursztyn, and David Hemous (Harvard University), “The Environment and Directed Technical Change.”

Complements, Not Substitutes

An interesting, recent column, “Next Step on Policy for Climate,” by David Leonhardt in the New York Times (October 13, 2010, p. B1) might give some people the mistaken impression that technology policies are an adequate, even sensible substitute for carbon-pricing.  That was not the intended message of the column.  In fact, Leonhardt – perhaps the leading economic journalist writing today in the United States ­– indicates clearly in his column that he is skeptical of the notion of thinking of technology subsidies as an adequate substitute for carbon-pricing (in particular, cap-and-trade).  And in a follow-up post at the New York Times’ Economix, he makes clear that “these two policies are not mutually exclusive.”

Nevertheless, Leonhardt’s original column (which included a very nice profile of my colleague, Professor Michael Greenstone of MIT) focused attention on a recent report –  a report that could give the false impression that technology policies would be a sensible substitute for serious carbon-pricing.  The report in question – “Post-Partisan Power” – received significant coverage, primarily because of its sponsorship:  a combination of a prominent Republican-oriented Washington think tank, the American Enterprise Institute (AEI), and an equally prominent Democratic-oriented Washington think tank, the Brooking Institution (and a third partner, the Breakthrough Institute, a California-based environmental think tank).

The report may well garner some bi-partisan political support, because it promises a free lunch of painless, win-win solutions, a promise that will resonate with many elected officials.  Indeed, the report’s sub-title is “how a limited and direct approach to energy innovation can deliver clean, cheap energy, economic productivity, and national prosperity.”  What’s not to like? And the authors are presumably smart and politically shrewd.  I know that’s the case with the AEI author, Steven Hayward, who I debated last year in the pages of the Wall Street Journal.

To its credit, the report lays out a menu of policies intended to stimulate carbon-friendly technological change, ranging from $500 million of Federal government funding of K-12 curriculum development and teacher training to $25 billion annually of direct Federal funding of energy innovation.

For the reasons I explained above (the “R&D market failure” and the “carbon emissions externality”), both direct technology R&D policies and serious carbon-pricing are necessary, but neither is sufficient on its own.  Unfortunately, this new report ­­– and some of the press coverage surrounding it – makes the claim that such direct government funding of technology innovation is a sufficient and sensible substitute for meaningful carbon-pricing.  That claim is both unfortunate and wrong, as it is supported neither by sound reasoning nor empirical research, as I have described above.

Again, many of the individual technology policy recommendations offered by the AEI-Brookings-BI report are worthy of serious consideration (as a complement, not a substitute for an economy-wide carbon-pricing policy).  But the specifics – indeed, much of the meat – are missing.  “Reform the nation’s morass of energy subsidies” – yes, but exactly which subsidies (all of which have important political constituencies behind them) will be eliminated?  “Recognize the potential for nuclear power” – yes, and both the House and Senate carbon-pricing schemes would have provided tremendous incentives for nuclear power investment.

Overall, there should be concern about how all of this will be funded.  Where will the $25 billion per year come from?  The report appropriately states that this should not come from general revenues, and thus add to the Federal debt.  “Phasing out current subsidies for wind, solar, ethanol, and fossil fuels” could be meritorious on its own, but how much does this generate, and does it even pass a political laugh-test?  Interestingly, beyond this, despite considerable rhetoric about moving beyond debates about carbon-pricing, the report recommends that in order to avoid adding to the Federal debt, it would be necessary to impose new taxes, including increased royalties for oil and gas extraction, a tax on imported oil, a tax on electricity sales, and a “very small carbon price” (presumably from a modest carbon tax or unambitious cap-and-trade system).

The actual numbers would be helpful, and the political feasibility remains a serious question.  The political challenges that emerged in the effort to pass cap-and-trade climate legislation will not magically disappear if there’s an attempt to induce Congress to approve $25 billion in funding.  As Tom Friedman noted on October 12th in the New York Times, Congress has not come close to fully funding the outstanding requests for about $4 billion for ARPA-E (energy) research.

More broadly, despite the attraction of the AEI-Brookings-BI proposal as a potential complement to carbon-pricing (and I am serious that the proposal is of value in that context), one has to be very careful about comparing proposed new policies in idealized form (for example, precisely the right subsidies eliminated and precisely the right new subsidies introduced) with real policies with all their warts (for example, the cap-and-trade bill that was passed by the House last year).  Making such comparisons can lead to flawed analysis and misleading results.

This is not a new issue.  Robert Hahn and I wrote about this generic problem nearly 20 years ago in an article (“Economic Incentives for Environmental Protection:  Integrating Theory and Practice”) which appeared the American Economic Review Papers and Proceedings (May 1992).  At the time, our concern was that this mistake was being made not by the opponents but by the supporters of cap-and-trade and other (then essentially untested) market-based instruments.  We worried that “many analysts use highly stylized benchmarks for comparison that ignore likely political realities,” and suggested that an appropriate “comparison would be between actual command-and-control policies and either actual trading [cap-and-trade] programs … or a reasonably constrained theoretical … program.”

Likewise today, when carrying out comparisons of policy alternatives, it is fine to compare two theoretical, idealized alternatives, or to compare two real-world policies, but it is problematic and usually misleading to compare a theoretical, idealized policy of one type with a real-world example of another type of policy.

The Bottom Line

Carbon-pricing – whether carbon taxes or cap-and-trade – will be an essential part of any truly meaningful national climate policy.  Likewise, to address the “R&D market failure,” direct technology innovation policies will also be required.  Both are necessary.  Neither is sufficient.  These are complements, not substitutes.

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Postscript: Four years ago, the U.S. Congressional Budget Office (CBO) — widely recognized for its non-partisan, first-rate research — produced a study on the same topic as the AEI-Brookings-BI report, but did so with rigor and without ideology.  The CBO report — Evaluating the Role of Prices and R&D in Reducing Carbon Dioxide Emissions (September 2006) — was prepared by Dr. Terry Dinan, a long-time, respected CBO economist, and was peer reviewed by an impressive set of academic and other experts.  Sadly, the CBO paper received little press coverage, despite its high quality and its relevance.  For anyone interested in the topic of this post, particularly those who disagree with my theme, I hope you will read the CBO report.

Also, a reader of this blog post sent me a paper by David Hart and Kadri Kallas (from MIT’s Energy Innovation working paper series) that examines “Alignment and Misalignment of Technology Push and Regulatory Pull.” It’s worth reading in the context of combining carbon pricing and technology R&D policies.

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AB 32, RGGI, and Climate Change: The National Context of State Policies for a Global Commons Problem

Why should anyone be interested in the national context of a state policy?  In the case of California’s Global Warming Solutions Act (AB 32), the answer flows directly from the very nature of the problem — global climate change, the ultimate global commons problem.  Greenhouse gases (GHGs) uniformly mix in the atmosphere.  Therefore, any jurisdiction taking action — whether a nation, a state, or a city — will incur the costs of its actions, but the benefits of its actions (reduced risk of climate change damages) will be distributed globally.  Hence, for virtually any jurisdiction, the benefits it reaps from its climate‑policy actions will be less than the cost it incurs.  This is despite the fact that the global benefits of action may well be greater — possibly much greater — than global costs.

This presents a classic free-rider problem, in which it is in the interest of each jurisdiction to wait for others to take action, and benefit from their actions (that is, free-ride).  This is the fundamental reason why the highest levels of effective government should be involved, that is, sovereign states (nations).  And this is why international, if not global, cooperation is essential. [See the extensive work in this area of the Harvard Project on International Climate Agreements.]

Despite this fundamental reality, there can still be a valuable role for sub-national climate policies.  Indeed, my purpose in this essay is to explore the potential for such state and regional policies — both in the presence of Federal climate policy and in the absence of such policy.  I begin by describing the national climate policy context, and then turn to sub-national policies, such as California’s AB 32 and the Regional Greenhouse Gas Initiative (RGGI) in the northeast.  My focus is on how these sub-national policies will interact with a Federal climate policy.  It turns out that some of the interactions will be problematic, others will be benign, and still others could be positive.  I also examine the role that could be played by sub-national policies in the absence of a meaningful Federal policy, with the conclusion that — like it or not — we may find that Sacramento comes to take the place of Washington as the center of national climate policy.

The (Long-Term) National Context:  Carbon-Pricing

I need not tell readers of this blog that virtually all economists and most other policy analysts favor a national carbon‑pricing policy (whether carbon tax or cap-and-trade) as the core of any meaningful climate policy action in the United States.  Why is this approach so overwhelmingly favored by the analytical community?

First, no other feasible approach can provide truly meaningful emissions reductions (such as an 80% cut in national CO2 emissions by mid-century).  Second, it is the least costly approach in the short term, because abatement costs are exceptionally heterogeneous across sources.  Only carbon-pricing provides strong incentives that push all sources to control at the same marginal abatement cost, thereby achieving a given aggregate target at the lowest possible cost.  Third, it is the least costly approach in the long term, because it provides incentives for carbon-friendly technological change, which brings down costs over time.  Fourth, although carbon pricing is not sufficient on its own (because of other market failures that reduce the impact of price signals — more about this below), it is a necessary component of a sensible climate policy, because of factors 1 through 3, above.  [I’ve written about carbon-pricing in many previous blog posts, including on June 23, 2010, “The Real Options for U.S. Climate Policy.”]

But carbon-pricing is a hot-button political issue.  This is primarily because it makes the costs of the policy transparent, unlike conventional policy instruments, such as performance and technology standards, which tend to hide costs.  Carbon-pricing is easily associated with the dreaded T-word.  Indeed, in Washington, cap-and-trade has been successfully demonized as “cap-and-tax.” As a result, the political reality now appears to be that a national, economy-wide carbon-pricing policy is unlikely to be enacted before 2013.  Does this mean that there will be no Federal climate policy in the meantime?  No, not at all.

The (Short-Term) National Context:  Federal Regulations on the Way or Already in Place

Regulations of various kinds may soon be forthcoming — and in some cases, will definitely be forthcoming — as a result of the U.S. Supreme Court decision in Massachusetts v. EPA and the Obama administration’s subsequent “endangerment finding” that emissions of carbon dioxide and other greenhouse gases endanger public health and welfare.  This triggered mobile source standards earlier this year, the promulgation of which identified carbon dioxide as a pollutant under the Clean Air Act, thereby initiating a process of using the Clean Air Act for stationary sources as well.

Those new standards are scheduled to begin on January 2, 2011, with or without the so‑called “tailoring rule” that would exempt smaller sources.  Among the possible types of regulation that could be forthcoming for stationary sources under the Clean Air Act are:  new source performance standards; performance standards for existing sources (Section 111(d)); and New Source Review with Best Available Control Technology standards under Section 165.

The merits that have been suggested of such regulatory action are that it would be effective in some sectors, and that the threat of such regulation will spur Congress to take action with a more sensible approach, namely, an economy-wide cap‑and‑trade system.  However, regulatory action on carbon dioxide under the Clean Air Act will accomplish relatively little and do so at relatively high cost, compared with carbon pricing.  Also, it is not clear that this threat will force the hand of Congress; it clearly has not yet done so.  Indeed, it is reasonable to ask whether this is a credible threat, or will instead turn out to be counter‑productive (when stories about the implementation of inflexible, high‑cost regulatory approaches lend ammunition to the staunchest opponents of climate policy).

It’s also possible that air pollution policies for non‑greenhouse gas pollutants, the emissions of some of which are highly correlated with CO2 emissions, may play an important role.  For example, three‑pollutant legislation focused on SOx, NOx, and mercury could have profound impacts on the construction and operation of coal‑fired electricity plants, without any direct CO2 requirements.  Without any new legislation, a set of rules which could have significant impacts on coal-fired power plants are now making their way through the regulatory process — including regulations affecting ambient ozone, SO2/NO2, particulates, ash, hazardous air pollutants (mercury), and effluent water.

There is also the possibility of new energy policies (not targeted exclusively at climate change) having significant impacts on CO2 emissions.  The possible components of such an approach that would be relevant in the context of climate change include:  a national renewable electricity standard; Federal financing for clean energy projects: energy efficiency measures (building, appliance, and industrial efficiency standards; home retrofit subsidies; and smart grid standards, subsidies, and dynamic pricing policies); and new Federal electricity‑transmission siting authority.

Even without action by the Congress or by the Administration, legal action on climate policy is likely to take place within the judicial realm.  Public nuisance litigation will no doubt continue, with a diverse set of lawsuits being filed across the country in pursuit of injunctive relief and/or damages.  Due to recent court decisions, the pace, the promise, and the problems of this approach remain uncertain.

Beyond the well‑defined area of public nuisance litigation, other interventions which are intended to block permits for new fossil energy investments, including both power plants and transmission lines will continue.  Some of these interventions will be of the conventional NIMBY character, but others will no doubt be more strategic.

But with political stalemate in Washington on carbon-pricing or national climate policy, attention is inevitably turning to regional, state, and even local policies intended to address climate change.

Sub-National Climate Policies

The Regional Greenhouse Gas Initiative (RGGI) in the Northeast has created a cap‑and‑trade system among electricity generators.  More striking, California’s Global Warming Solutions Act (Assembly Bill 32, or AB 32) will likely lead to the creation of a very ambitious set of climate initiatives, including a statewide cap‑and‑trade system (unless it’s stopped by ballot initiative — Proposition 23 — or a new Governor, depending on the outcome of the November 2010 elections).  The California system is likely to be linked with systems in other states and Canadian provinces under the Western Climate Initiative.  Currently, more than half of the 50 states are contemplating, developing, or implementing climate policies.

In the presence of a Federal policy, will such state efforts achieve their objectives?  Will the efforts be cost-effective?  The answer is that the interactions of state policies with Federal policy can be problematic, benign, or positive, depending upon their relative scope and stringency, and depending upon the specific policy instruments used.  This is the topic of a paper which Professor Lawrence Goulder (Stanford University) and I have written, “Interactions Between State and Federal Climate Change Policies” (National Bureau of Economic Research Working Paper 16123, June 2010).

Problematic Interactions

Let’s start with the case of a Federal policy which limits emission quantities (as with cap-and-trade) or uses nationwide averaging of performance (as with some proposals for a national renewable portfolio standard).  In this case, emission reductions accomplished by a “green state” with a more stringent policy than the Federal policy — for example, AB 32 combined with Waxman-Markey/H.R. 2454 — will reduce pressure on other states, thereby freeing, indeed encouraging (through lower allowance prices) emission increases in the other states.  The result would be 100% leakage, no gain in environmental protection from the green state’s added activity, and a national loss of cost-effectiveness.

Potential examples of this — depending upon the details of the regulations — include: first, AB 32 cap-and-trade combined with Federal cap-and-trade (H.R. 2454) or combined with some U.S. Clean Air Act performance standards; second, state limits on GHGs/mile combined with Federal CAFE standards; and third, state renewable fuels standards combined with a Federal RFS, or state renewable portfolio standards combined with a Federal RPS.  A partial solution would be for these Federal programs to allow states to opt out of the Federal policy if they had an equally or more stringent state policy.  Such a partial solution would not, however, be cost-effective.

Benign Interactions

One example of benign interactions of state and Federal climate policy is the case of the Regional Greenhouse Gas Initiative (RGGI) in the northeast.  In this case, the state policies are less stringent than an assumed Federal policy (such as H.R. 2454).  The result is that the state policies become non-binding and hence largely irrelevant.

A second example — that warms the hearts of economists, but appears to be politically irrelevant for the time being — is the case of a Federal policy that sets price, not quantity, i.e., a carbon tax, or a binding safety-valve or price collar in a cap-and-trade system.  In this case, more stringent actions in green states do not lead to offsetting emissions in other states induced by a changing carbon price.  It should be noted, however, that there will be different marginal abatement costs across states, and so aggregate reductions would not be achieved cost-effectively.

Positive Interactions

Three scenarios suggest the possibility of positive interactions of state and Federal climate policies.  First, states can — in principle — address market failures not addressed by a Federal carbon-pricing policy.  A prime example is the principal‑agent problem of insufficient energy‑efficiency investments in renter‑occupied properties, even in the face of high energy prices.  This is a problem that is best addressed at the state or even local level, such as through building codes and zoning.

Second, state and regional authorities frequently argue that states can serve as valuable “laboratories” for policy design, and thereby provide useful information for the development of Federal policy.  However, it is reasonable to ask whether state authorities will allow their “laboratory” to be closed after the experiment has been completed, the information delivered, and a Federal policy put in place.  Pronouncements from some state leaders should cause concern in this regard.

Third, states can create pressure for more stringent Federal policies.  A timely example is provided by California’s Pavley I motor-vehicle fuel-efficiency standards and the subsequent change in Federal CAFE requirements.  There is historical validation of this effect, with California repeatedly having increased the stringency of its local air pollution standards, followed by parallel Federal action under the Clean Air Act.  This linkage is desirable if the previous Federal policy is insufficiently stringent, but whether that is the case is an empirical question.

Thus, in the presence of Federal climate policy, interactions with sub-national policies can be problematic, benign, or positive, depending upon the relative scope and stringency of the sub-national and national policies, as well as the particular policy instruments employed at both levels. [For a more rigorous derivation of the findings above, as well as an examination of a larger set of examples, please see my paper with Stanford Professor Lawrence Goulder, referenced above.]

But comprehensive Federal carbon-pricing policy appears to be delayed until 2013, at the earliest.  And it is possible that pending Federal regulatory action under the Clean Air Act will be curtailed or significantly delayed either by the new Congress or by litigation.  Therefore, it is important to consider the role of state and regional climate policies in the absence of Federal action.

Sub-National Climate Policies in the Absence of Federal Action

In brief, in the absence of meaningful Federal action, sub‑national climate policies could well become the core of national action.  Problems will no doubt arise, including legal obstacles such as possible Federal preemption or litigation associated with the so‑called Dormant Commerce Clause.

Also, even a large portfolio of state and regional policies will not be comprehensive of the entire nation, that is, not truly national in scope (for a quick approximation of likely coverage, check out a recent map of blue states and red states).

And even if the state and regional policies were nationally comprehensive, there would be different policies of different stringency in different parts of the country, and so carbon shadow‑prices would by no means be equivalent, meaning that the overall policy objectives would be achieved at excessive social cost.

Is there a solution (if only a partial one)?  Yes.  If the primary policy instrument employed in the state and regional policies is cap-and-trade, then the respective carbon markets can be linked.  Such linkage occurs through bilateral recognition of allowances, which results in reduced costs, reduced price volatility, reduced leakage, and reduced market power.  Good news all around.

Such bottom‑up linkage of state and regional cap‑and‑trade systems could be an important part or perhaps even the core of future of U.S. climate policy, at least until there is meaningful action at the Federal level.  In the meantime, it is at least conceivable — and perhaps likely — that linkage of state‑level cap‑and‑trade systems will become the (interim) de facto national climate policy architecture.

In this way, Sacramento would take the place of Washington as the center of national climate policy deliberations and action.  No doubt, this possibility will please some, and frighten others.

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P.S.  For those of you interested in the topic of this blog post, you may also find of particular interest a conference organized by the University of California, taking place in Sacramento on October 4th, “California’s Climate Change Policy:  The Economic and Environmental Impacts of AB 32.”  You can learn more about it by clicking on this link.

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