Home > Uncategorized > A Quick Lesson in Cap-and-Trade

A Quick Lesson in Cap-and-Trade

Pollution is one of the few issues where government involvement may actually be prudent.  This is because there is a common property problem involved.  If I could snap my fingers and make everyone on Earth understand one economic concept it would be the Coase Theorem.  Luckily, this concept is not that complicated and it is essential to understanding common property problems like pollution so I will start with a brief explanation of the theorem.

The Coase Theorem states that when property rights are well-defined and transaction cots are zero, resources will be efficiently allocated (assuming free trade).  The basic idea is that if every valuable resources is owned by someone and can be traded at no cost, it will always end up being traded to the person with the highest value.  One interesting aspect of the theorem is that it doesn’t matter who owns it to begin with since it can be freely traded.  To see what I mean consider the following example.

Imagine you and I live on the Earth.  I own a factory and enjoy producing goods for sale, and you like breathing clean air.  When I produce goods, I pollute the air and impose an externality upon you.  If I “own” the air, meaning I have the right to pollute it as much as I want, then barring some intervention, I will produce goods until the marginal cost is equal to the marginal benefit.  The problem is that I don’t realize all of the costs.  Some of them take the form of dirtier air for you to breathe.  This will result in me producing more than the efficient amount.  However, if this is the case (and there are no transaction costs), then you can intervene by offering to pay me to produce less.  The maximum amount you are willing to pay will represent your marginal value of less pollution and this will then become incorporated into my production decision causing me to produce the efficient amount. 

Similarly, if you own the air (meaning you have the right to prevent me from polluting), then you would want me to produce zero.  This would be inefficiently low.  I would be willing to pay you to let me pollute.  You will be willing to accept no less than your marginal value of clean air.  This cost will again be incorporated into my production decision and I will end up producing the efficient quantity. Either way the quantity of goods and pollution is efficient.  The difference is that the resource (air) is valuable and the value of it accrues to its owner.  So if I own it, I am better off and if you own it you are better off. 

Now it is interesting to note that if you have only two parties, property rights can’t help but be well-defined.  Either you have the right to stop me from polluting or you don’t, in which case I have the right to pollute.  If my pollution affects multiple people there is a problem though.  If they all paid me their marginal values of clean air, it would work out efficiently.  The problem is that individually, they have no incentive to do this because their payment would have such an insignificant effect on my output that they would all prefer to pay nothing and let everyone else pay.  This is essentially a free rider problem and can be thought of as a transaction cost.  If you could allocate some portion of the sky to each person, the problem would go away but this is impossible because you can’t contain pollution to only the sections of the sky who agree to allow it.  In other words property rights cannot be well-defined in this way.  The problem is further complicated when you have multiple polluters but further discussion on this point is probably not germane.

The government has a unique ability do deal with problems like this because it can represent an entire population and essentially force each individual to take part in whatever action it takes.  Remember, this is the only thing governments can do that markets can’t.  Usually this is harmful but in the case of a free rider or common property problem, it can be beneficial.  There are two ways it can deal with this problem.  One is to apply a Pigovian tax.  This is essentially a tax on pollution which adds a marginal cost to the activity in order to distort the quantity back down to the efficient level in the same way as when I have to pay you for permission to pollute.  If the government chooses the right tax rate, then they will get the efficient outcome.  Of course choosing the right rate is not easy.

The other approach is a cap-and-trade regime.  This means that you cap the total amount of pollution at some level (ideally the efficient level) and let people trade the rights to it in a free market so that the rights find their highest value owners.  If you pick the right cap, you can get the same outcome as with the Pigovian tax but again, this level may be difficult to identify. 

Now you may imagine that a property rights nut like myself would be a big fan of a cap-and-trade plan, and you would be correct.  But here is how it should be done. 

Step 1:  Choose the level of the cap.

Step 2:  Hold a public auction for that amount of pollution rights.

Step 3:  Put the proceeds in the general fund to offset other taxes.

That’s it, simple huh?  How many thousands of pages do you think it would take to write that bill?  If we did that, we would give the government a new power, the power to choose the efficient quantity of pollution.  Of course normally I am against giving the government powers, but there is a reason for giving this power to the government and it is unlikely to be too destructive.  For the record I have little confidence in their ability to choose the right cap but we know we get the wrong one when we do nothing and at least it doesn’t undermine our freedom in a significant way.  Unfortunately, this is not what they will do.  The additional thousands of pages that will no doubt be in this bill will be for another purpose, one that gives them a power that does undermine our freedom in an important way.   

The reason government intervention regarding pollution is justified is that it is needed to represent a true collective interest.  The pollution affects everyone and the transaction costs are too high for them to mitigate this damage by themselves.  The value of the property rights generated by this system represent (in some sense) the cost of the pollution to the public.  So it makes sense for this value to be accrued by the public.  This is not what I predict will happen though.  Some funds may end up in the treasury but most if it will be captured by private interests.  This is because the government will assign the rights to people and then let them trade.  This means the people whom the government decides “deserve” the right to pollute will make money and the rest of us will lose.  This is the destructive power they are claiming, it is just another way of redistributing wealth.

Recall that the difference between me owning the sky and you owning the sky is in who has to pay whom and therefore in who captures the value of the sky.  With cap-and-trade, the government will invent a certain amount of pollution rights (which I have no problem with) and then hand them out to people they like (which I have a huge problem with).  They will do essentially two things with this power.  One will be to further line the pockets of their pals who contribute to their campaigns and the other will be to transfer wealth overseas to other countries that they consider unfortunate victims of the pollution caused by developed nations. 

Obama, famously remarked that cap-and-trade would cause energy rates to skyrocket.  Well, that’s basically the point of it, after all the problem is that energy is too cheap without it.  This wouldn’t necessarily be a bad thing because we would pay more for energy but we would get cleaner air and lower taxes.  The size of the cap could be adjusted so that what we get in the form of the first two would be greater than what we lose in the form of higher energy rates.  But this plan is going to transfer most of the benefits to certain private interests so we will get higher energy costs without saving any taxes.  Furthermore, there will be an incentive for them to set the cap too low to raise the price of the pollution rights and make their friends richer.  

The magnitude of the carbon crisis we face is certainly debatable.  I am not an expert on these things (although I know enough about statistics and academia to know that a lot of the research contributing to the alarm is highly questionable).  But if we do need an energy plan to deal with it, let’s have one that works for the public instead of giving government new ways to enrich special interests.

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  1. April 30, 2010 at 8:40 pm
  2. April 30, 2010 at 8:45 pm

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