Eco-nomics: California's Carbon Market

California is in the process of creating perhaps the world's largest carbon market and, in so doing, putting economic theory to the test. Here is an excerpt from an article by Reuters' Rory Carroll:

"This is by far the most ambitious program to reduce greenhouse gas emissions in North America, and by some measures the world," said Franz Litz, a senior fellow at the World Resources Institute.

California regulators are convinced they have the data and intelligence necessary to improve upon the system running in the European Union, which has shown results but has also experienced theft and fraud.

California officials say the market is a key part of implementing a six-year-old law that requires it to slash its emissions back to 1990 levels by 2020.

California also has the advantage of being a very large state -- independent of the United States it would represent the world's eighth-largest economy.

It plans to launch its market in conjunction with the Canadian provinces of British Columbia and Quebec, and officials hope the market will one day draw in other U.S. states and perhaps even Europe.

So officials at the state's Air Resources Board (CARB) are confident it will have the liquidity necessary to reflect an accurate and predictable price.

Many businesses hoping to profit from the trading of carbon credits and major environmental groups agree with the state, saying the market will give power plants and factory operators the flexibility to decide how to reduce their output of the heat-trapping gases.

At the same time, they hope the market's incentives will ignite the ingenuity of the state's businesses, which will invent the clean energy technologies to be sold around the globe like so many Hollywood blockbusters.

Economists love cap-and-trade for a simple reason, it allows for the most efficient reduction of carbon emissions to achieve a target.  The ones that can do so at the lowest cost will and those that find it quite expensive will buy credits from the cheap reduction firms. Thus is the target met and the expense to the economy minimized.  But achieving such a market requires quite a lot of bureaucracy and (as the European experience has shown us) leaves a lot of room for fraud.

But if the California market is successful it will lower the fixed costs for other states who which to participate, for they only have to join in the California market rather than try and create their own from scratch.  There are still many legal and political challenges to the California market, however, so stay tuned.

Eco-Nomics: Carbon Taxes and Cap-and-Trade

An excellent primer on the similarities and differences and where the current legislation falls by Greg Mankiw in Sunday's New York Times. Here are the highlights:

During the presidential campaign of 2008, Barack Obama distinguished himself on the economics of climate change, speaking far more sensibly about the issue than most of his rivals. Unfortunately, now that he is president, Mr. Obama may sign a climate bill that falls far short of his aspirations. Indeed, the legislation making its way to his desk could well be worse than nothing at all.

Let’s start with the basics. The essential problem of climate change, scientists tell us, is that humans are emitting too much carbon into the atmosphere, which tends to raise world temperatures. Emitting carbon is what economists call a “negative externality”— an adverse side effect of certain market activities on bystanders.

The textbook solution for dealing with negative externalities is to use the tax system to align private incentives with social costs and benefits. Suppose the government imposed a tax on carbon-based products and used the proceeds to cut other taxes. People would have an incentive to shift their consumption toward less carbon-intensive products. A carbon tax is the remedy for climate change that wins overwhelming support among economists and policy wonks.

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What Mr. Obama proposed was a cap-and-trade system for carbon, with all the allowances sold at auction. In short, the system would put a ceiling on the amount of carbon released, and companies would bid on the right to emit carbon into the atmosphere.

Such a system is tantamount to a carbon tax. The auction price of an emission right is effectively a tax on carbon. The revenue raised by the auction gives the government the resources to cut other taxes that distort behavior, like income or payroll taxes.

So far, so good. The problem occurred as this sensible idea made the trip from the campaign trail through the legislative process. Rather than auctioning the carbon allowances, the bill that recently passed the House would give most of them away to powerful special interests.

The numbers involved are not trivial. From Congressional Budget Office estimates, one can calculate that if all the allowances were auctioned, the government could raise $989 billion in proceeds over 10 years. But in the bill as written, the auction proceeds are only $276 billion.

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How much does it matter? For the purpose of efficiently allocating the carbon rights, it doesn’t. Even if these rights are handed out on political rather than economic grounds, the “trade” part of “cap and trade” will take care of the rest. Those companies with the most need to emit carbon will buy carbon allowances on newly formed exchanges. Those without such pressing needs will sell whatever allowances they are given and enjoy the profits that resulted from Congress’s largess.

The problem arises in how the climate policy interacts with the overall tax system. As the president pointed out, a cap-and-trade system is like a carbon tax. The price of carbon allowances will eventually be passed on to consumers in the form of higher prices for carbon-intensive products. But if most of those allowances are handed out rather than auctioned, the government won’t have the resources to cut other taxes and offset that price increase. The result is an increase in the effective tax rates facing most Americans, leading to lower real take-home wages, reduced work incentives and depressed economic activity.

Most people I talk to don't really understand Cap-and-Trade and think it just represents a loophole for polluters. No, but I agree with Mankiw that these permits need to be auctioned and not given away. In fact this article described the sentiment of most economists I talk to (of all political persuasions). The differences in opinion among my conversants are in how much they are willing to compromise in the face of political reality. Has the Obama administration bowed too much? I think the most unfortunate reality is that people just don't understand what it is and what giving the permits away v. auctioning them means and for this I applaud Mankiw for a lucid description. I think if people really understood what was going on, the energy industry would not be able to hijack this process and we would see auctioning.