Command and Control vs. Cap and Trade

A few weeks ago, Shyam made an interesting point that has been bouncing around my mind. We were in the Union, and after buying an organically sourced soy milk product he said something to the effect of “I don’t want to have to do research about what are good (as in morally responsible) products/companies, I want everything to be already factored into the price.”

While I can’t be certain, and this was not the subject of conversation, I am still fairly confident that the idea of carbon taxes played into Shyam’s comment. Because the Nobel Prize for Economics was recently awarded to two climate economists, I will make this post about carbon taxes. Admittedly, I know little about the two economists who won, so instead I will turn to a research binge I did over the summer on this subject.

Let’s start with command and control regulation. Best available technology (BAT) is any regulation that requires companies to acquire (you guessed it) the best available technology to reduce emissions. A literal interpretation would require a company to acquire the technology or equipment without reference to a cost-benefit analysis. This is uneconomic. More frequently, BATs are interpreted in terms of practicable acquisition of technology, which is a bit of a gray area, and accordingly the policy is less effective. In the US, BAT terminology is used in the Clean Air Act and the Clean Water Act. This is clearly not a comprehensive list of command and control regulation, but rather just one example that is practiced in the context of the US.

Carbon taxes are an example of a market-based incentive away from carbon emissions, albeit a feeble one. Governments can unilaterally decide to implement a tax per ton of carbon dioxide released into the atmosphere. This is an example of a Pigovian tax, a tax used to discourage an activity based on the negative externalities an activity or good produces. Theoretically, the tax should be equal to the negative externality (the social cost) associated with that activity, so that the offending firm internalizes all of the cost. However, this method is largely ineffective. The social cost of carbon emissions is global, and governments only have the incentive to tax the social cost that is incurred within that country. With the exception of Sweden, this is exactly the result that is realized: carbon taxes are set far too low to be effective.

Cap and trade regulations create “tradable emission rights” (or pejoratively, “rights to pollute”) that allow economic agents to trade for carbon emissions in a market. The governmental authority sets a ceiling on what level of pollution is permissible, and then issues permits according to that ceiling. Economic agents can then trade them. This system incentivizes agents to reduce their carbon emissions, since they can then sell them to other agents that are not able to do so.

Additionally, the cost of emitting carbon would be captured in the price of any good that creates carbon emission. Let’s take Union soymilk as an example. It’s unlikely that the producer of that soymilk purchases any carbon permits directly. But it would have to buy transportation services to get its product to market, and it would pay higher prices for these services, as those firms would have to pay for permits or pay more for gasoline. This added cost would ultimately be passed on to the consumer. The emissions associated with that soymilk would be included in its price, eliminating the need for consumers to independently research the emissions effect of the soymilk. This would go for all goods and services.

Let’s suppose there are companies A & B in completely different industries. Let’s assume that technology is out there that will enable company A to reduce emissions by 75%, but at substantial and previously uneconomic cost X. Let’s assume that company B can reduce emissions by only 5% at cost X. Cap and trade in this example would make it economical for Company A to incur cost X and sell its surplus credits to company B (and others like it.) Cap and trade has the effect of incentivizing those agents that can reduce their emissions the most to do so, something that maximizes the effectiveness of emission-reducing spending.

However, there is a substantial need for all countries to implement cap and trade regulation. Without a functioning global market, high polluting agents would be expected to simply relocate to nations that do not tax pollutants. Since the negative externalities associated with emissions are global, this would imply no meaningful positive change.

There are also significant free rider problems associated. If country Z is responsible is responsible for 5% of total emissions, 95% of the benefit of any action it takes to reduce emissions would be captured by the rest of the world. Therefore, there would need to be concerted, global action to avoid free riding nations.

A fun and relevant example of successful cap and trade regulation is that of the EPA’s Acid Rain Program (ARP.) However, a chief difference in this program was that the environmental degradation was local and the United States was thus able to take unilateral action.

I confess to being biased in favor of a cap and trade solution, largely for reasons listed above. I will link a few articles that do not necessarily share my biases and are likely more compelling and informative than what I have shared here.

Here is a link to an article written by Gregory Mankiw that is in favor of carbon taxes rather than a cap and trade system. I found parts of the argument underwhelming, although in last week’s Econversation Shyam made a compelling argument in favor of carbon taxation (although I personally haven’t decided if I prefer it to cap and trade.) With respect to this article, Mankiw makes the point that emission rights might not be auctioned, which wouldn’t be ideal. However, he leaves the argument at that. Additionally, Mankiw doesn’t speak to the global nature of the emissions crisis, which would have to play into any system.


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