by: Michael Hoexter

In Part 1, I called attention to the rapid shift in general economic policy in the last 6 months. I developed an outline of two distinct economic schools, one that holds up the ideal of a self-sufficient, self-regulating market and another that sees markets as having shortcomings that require government to supplement and regulate where the market fails. The first school might be called monetarist/supply-side and the second Keynesian with varying tendencies within that school. I highlighted how each of these schools is attached to a particular worldview or set of worldviews. The conflict within economics will necessarily have impacts on climate policy.

Reliance on Carbon Pricing:  Hanging Onto an Idealized View of Markets?

The Scottish inventor, James Watt, invented the steam engine, powered by coal, in the 1760's and 1770's. At that point in time, coal had already a long history as a heat source. Most accounts of the history of the industrial revolution and of modern economies downplay the importance of fossil fuels in spurring economic growth and the modern economy and focus on changes in end-use technologies. A post-carbon economy will require a revolution in our thinking about and focus on energy and how it is sourced.

Climate activists have been focused since the early 1990’s on instituting a cap and trade system that they feel, almost singlehandedly, would induce or compel economic actors to emit only up to a certain “cap” of greenhouse gas emissions. The Kyoto Protocol, ratified by 180 countries, is an attempt at an international cap and trade sysem. Both cap and trade and its near competitor, a carbon tax are “market-based” policy instruments that attempt to curb greenhouse gas emissions by assigning a price to greenhouse gases. The price will function as a signal (largely in the form of a disincentive) to market actors to change technologies and procedures to emit less carbon into the atmosphere. These policies are “market-based” because they rely on the pricing mechanism and allow market actors to decide how they reduce their emissions as opposed to more directive, so-called “command and control” regulations that tell market actors what exactly they must do. An environmentally-sensitized variation on the monetarist/free market worldview and policy orientation, the idea is that the private economic actors, mostly businesses, know best what to do if given the appropriate price signal.

Climate change concerns and a climate protection movement have emerged in the last two decades, an era of monetarist/free market dominance of economic policy and to a lesser extent the economics profession. Carbon taxes, though a tax and therefore viewed with suspicion by free market advocates, have a single “market-based” layer in introducing a carbon price into the calculations of market actors, a disincentive to which they can respond as they choose. Cap and trade systems add an additional carbon permit and offset trading market, in addition to introducing a (varying) price on carbon, so are doubly market-based. Despite these efforts made to introduce market-emulating mechanisms into environmental regulation, the political advocates of free markets are almost universally opposed to cap and trade, carbon taxes and direct regulation; they generally show themselves to be unconcerned about climate change and are more concerned about how any regulation will interfere with smooth and unhindered market functioning, which to them is the summum bonum (Latin for the highest ethical good).

Much discussion and dispute has been focused on the choice of which of the two main market-based instruments will do the heavy lifting in climate policy. The carbon tax assigns a price directly to carbon emissions and is levied directly by governments. It is relatively simple instrument, favored by many economists and some industries, but criticized by many climate activists who feel that it is insufficiently rigorous. Others have criticized a tax because it is politically unpalatable in an anti-tax era, still others because it does not in its initial designs utilize carbon trading. Despite this, two leaders in the climate protection movement, Al Gore and Jim Hansen, prefer an stringent carbon tax policy to the cap and trade systems proposed, though both have suggested that it should not represent a net increase in the overall tax burden by cutting other taxes or returning a dividend.

Carbon taxes and cap and trade can be distinguished as follows:  the cap and trade system sets the amount of allowable GHG pollution and, if permits are auctioned rather than given away, the price follows from the cap; a carbon tax sets the price which would limit emissions via the amount of direct economic losses inflicted or fear thereof on economic actors. In a cap and trade systems, punitive fines and potential criminal proceedings can follow from exceeding the permitted amount of pollution. A lower cap produces fewer and therefore more expensive permits (in an auction) and a higher carbon tax inhibits emissions because of their increased expense thereby leading economic actors to lower levels of emissions.

The revenues from both permit auctions and the carbon tax can be directed any number of different ways:  to offset or reduce other taxes, to be spent on carbon emissions reduction, or be returned to taxpayers in the form of a dividend. The latter idea is an effort to diminish the generally regressive income distribution effect of carbon pricing:  the carbon price will, percentage-wise, through higher prices for energy and high-carbon intensity represent a higher portion of the budgets of lower income families more than upper-income ones. The latter system is called a “cap and dividend” or a carbon tax dividend. As it has been developed, the basic carbon pricing “concept” does not recommend or entail any particular use for the funds collected, therefore the diversity of proposals.

Cap and trade regulations were originally applied as a way to incentivize power utilities to install sulphur dioxide emissions scrubbers on their coal fired power plants, like the unit attached to the smokestack above. While these emission scrubbers sometimes cost upwards of $1 billion, more than the original cost of some power plants, they significantly reduce acid rain but do not reduce carbon dioxide emissions. Ultimately the joint cost of complying with regulations and the technology itself is borne by utility ratepayers through increases in the cost of electricity, which ends up being an indirect route to pay for the positive externality of less acid rain.

Despite the support of some renowned climate activists for the carbon tax, during the years of the Bush Presidency support for a cap and trade system with 100% auction of permits and a tight, progressively more restrictive cap, has been considered to be the mark of serious action to stem carbon emissions. The historical model for greenhouse gas cap and trade systems were the systems introduced in North America in 1990 to limit the emission of acid rain causing pollution from power plants, called SOx emissions. Designed explicitly as an experiment in market based regulation and an alternative to directive regulation of power plants by governments, these power plants were incentivized to adopt SOx scrubbing technology by being allowed to pollute up to the number of permits that they purchased in a permit auction. If the power utility was able to emit less than the permits they purchased, they could sell these permits to firms that polluted more at a profit, introducing, per the market-oriented theory behind the program design, a profit motive into the process of adopting the emissions scrubber technology.

Carbon cap and trade systems are similar in design to SOx cap and trade systems but are many times larger in the scope of their application and also present market actors with a vastly larger number of possible choices to reduce or offset their emissions as compared to the SOx systems. The most rigorous cap and trade system uses 100% auction of pollution permits with a high reserve price and an aggressive overall pollution cap. The least aggressive gives out permits and has a “loose” or higher cap, which has been a criticism of the initial round of the Kyoto protocol. As compared to carbon taxes, a cap and trade system is much more complicated. However, there are hybrid systems that place pricing floors and caps on pollution permit prices, effectively offering a carbon price within a range, similar to a variable carbon tax.

Carbon Pricing and “Not Knowing” the Solutions

The premise of carbon pricing as a complete climate solution, as opposed to “command and control” regulation, is that regulators and the designers of a carbon pricing do not know the technological solutions to reducing carbon emissions, in keeping with the monetarist/free market tendency to view scientific knowledge as limited in scope and not generalizable. The market becomes a “black box” that produces innovation or favorable and/or efficient social results. In practical terms this could mean that designers of the policy are thought not to be cognizant of industry inside knowledge or that no one can know what the future will bring in terms of technological development. Entering into a carbon pricing system then means embarking on a technological and economic “voyage of discovery”.

If one believes that one knows or we know at least a portion of the technological solutions to reducing carbon emissions, carbon pricing would be in many instances a roundabout solution for supporting those solutions.

The Benefits and Limits of Carbon Pricing

In an era of lingering climate change denial and resistance by fossil fuel and industrial interests to change, the real consequences of carbon pricing policies have tended to be glossed over by its advocates. The thought has been “we must get this passed, no matter what”, “you’re for us or you’re against us”, or alternatively “this is the only politically realistic climate policy.” Usually these sentiments are applied to the more widely considered and discussed cap and trade systems.

Troubling though is the finding that these policies, in particular cap and trade systems, were selected because of allegiances to now-questioned but politically popular economic theories, rather than the real effectiveness of these policies. In a little noticed review, Gar Lipow has pointed out that straight “command and control” regulatory schemes in Germany and Italy reduced acid rain pollution far more than the US SOx cap and trade system upon which the Kyoto protocol and other cap and trade systems were based. In Germany SOx emissions fell 87%, in Italy 62%, while in the US in the same period they only fell 31%, with comparable disparities in the absolute levels of these pollutants on the two continents at the end of the study period (2001).

Furthermore, the notion that cap and trade systems spurred innovation has come under question by economists. Margaret Taylor in an analysis of patenting activity has found that patents related to emissions scrubbers for SOx were not significantly affected by the institution of cap and trade systems as opposed to a spate of other regulatory mechanisms worldwide. Studies have also shown that the costs to firms to reduce their SOx under a cap and trade systems as opposed to direct regulation were roughly equivalent.

If conventional regulation is simpler, about as costly, and substantially more effective than historical cap and trade systems, why the enthusiasm for cap and trade to tackle the far broader problem of carbon dioxide and GHG emissions? The coincidence of the now somewhat discredited political fashion for expanding market mechanisms to almost every social problem seems to account at least in part for the adoption of cap and trade systems during the market-focused 1990’s and early 2000’s.

Additionally the choice of cap and trade in the 1990’s may have seemed more justifiable out of a sense by international regulators of uncertainty about what the technological solutions to curbing carbon emissions might be. We have advanced since then in our understanding of workable technological solutions to reduce carbon emissions substantially, some which are now “marketable” and some of which require the help of supportive policies or regulations to make it on the markets. We have not arrived necessarily at definitive solutions for all technological carbon emissions reduction challenges but we have many adequate “starter” solutions.

Assessing the Benefits of Carbon Pricing


The Kyoto cap and trade system's Clean Development Mechanism or CDM, enables organizations from richer countries to fund carbon emissions reductions efforts in less developed countries to "offset" that organization's domestic emissions. At this project in Karnataka, India, field wastes are collected and used to generate electricity and heat, which otherwise would decompose in the fields. CDM has been an area of controversy because some CDM offsets have either not represented real emissions reductions or those projects were not truly "additional", meaning they would not have happened otherwise.

In our era of idealized and now somewhat disenchanted views of what markets are and how they function, it is difficult to make a neutral assessment of the benefits of carbon pricing especially cap and trade;  in other words, we have a somewhat “bipolar” conception of markets and the self-interested behavior upon which they rest. Not only is this a matter of perception but a deep economic and sociological problem:  we have no rigorous description of markets as institutions like other institutions so we tend to treat them as “sui generis”. If markets are unique it is more difficult to formulate how to reshape or re-energize them, if that is what is on the agenda.

Advocates of carbon pricing have tended to list the fact that cap and trade, in particular, is “market-based” as in-and-of-itself a recommendation of these instruments. If this is simply a matter of saying that it conforms to the monetarist economic fashion of the last three decades, then this is no longer such a recommendation, at least to many who are now viewing the economy of the recent past more critically. A finance-heavy economy dependent upon trading seems to have had more of a downside than its proponents and defenders would have had us believe.

Furthermore, beyond intellectual allegiances, if the trading element or market-based element was a signal to powerful economic interests that carbon regulation would potentially be a profitable instrument within some reasonable bounds this might be politically and ethically defensible. However if the rush to declare carbon regulations as market-based a signal that they might be corruptible instruments with the lure of windfall profits, this would appear unseemly and, in the end, defeat the purpose of carbon regulation, regulations that would raise energy and goods prices for all sectors within the economy.

Here I will attempt to abstract from the proposed structure of carbon pricing in both its carbon tax and cap and trade forms, the “socially useful” and politically defensible components of carbon pricing that go beyond theoretical commitment to the market mechanism:

  1. “Viral” - The influence of a carbon price could spread virally - as carbon pricing will be applied to energy and other basic goods, the price will effect all economic sectors and “work its way” into many unforeseen types of transactions that ultimately will influence carbon emissions.
  2. (Potentially) Global - A tradable carbon credit or permit could allow cross-border involvement and participation of less-developed countries in carbon sequestration and emissions reduction efforts (addressing the global nature of climate change).
  3. Incremental - Carbon pricing will encourage incremental changes based on the price level -  carbon pricing then will encourage energy efficiency, behavior changes with approximately equivalent costs, land use change, bio-sequestration, and small to mid-sized capital investments
  4. Monetary - Carbon pricing is directly attached to money and financial calculations, the most compact decision-making form for individuals and organizations. I have proposed a much more complex decision making tool for big, high-level decisions but a simple price fits relatively snugly into most existing financial instruments like cash flows, net present value, etc.
  5. Quasi-universal equivalent or signifier – Related to “2” and “4”, the carbon price can allow comparison and trade of equivalents between unlike activities like afforestation, energy efficiency and renewable energy. They all would be assigned a monetary value according to their impact on carbon emissions.
  6. Induces Action – changes in prices induce actions or the propensity to take action.
  7. Internalizing Carbon Externality – Of course, the main reason for the program, to attach to global warming gases an disincentive/incentive that creates a carbon market or carbon “line-item” in economic calculations.

The Limitations of Carbon Pricing

Even if we accept that policy is always co-produced by political and economic vogues and enthusiasms, there are troubling limits to relying exclusively or largely on carbon pricing to drive innovation or rapid deployment of clean technologies. Below are a listing of some questionable assumptions in and real constraints on carbon pricing.

1)    “Private actors know best” – For one, the assumption that businesses and individuals will know which solutions will work best for them to reduce emissions is flawed.  Most businesses will be following the recommendations of government sponsored studies of which technologies will work and which will not. Most businesses and families do not monitor and measure their GHG emissions as a matter of course, nor are they necessarily experts in the selection of new technologies, some of which will never have been deployed before on the market en masse. Furthermore, to become experts in the selection of technologies, firms will need to spend resources, potentially reduplicating the efforts of other firms, often outside the areas of their core competencies.

The price of goods and services is one of the primary attributes that influence buying decisions. A lower price means that buyers do not have to sacrifice as many other buying opportunities for the purchase in question. In a small segment of premium goods, a higher price may signal to some potential buyers higher quality or prestige. The hope in carbon pricing is that lower emissions goods and services will succeed in the marketplace against goods and services that represent higher carbon emissions.

 2)    “Price signal will be clear” – As a result of the above, both cap and trade and carbon tax systems will probably end up relying on large “look-up tables” of engineering analyses of different technologies and use some type of carbon emissions calculator to assess the degree to which they will be able to reduce greenhouse gases. The price “signal” will not be the original means by which firms will calibrate their efforts to reduce greenhouse gases but will instead be facing a series of capital investment decisions that will yield either discrete emissions reductions “equivalents” or a range of reductions depending upon their actual usage, which would need to be measured after the fact. Therefore the market in emissions will involve a series of translations of expected emissions reductions with actual reductions that independent monitors will verify. So the price signal will be felt over a period of time and will not be necessarily clear. Probably the most effective aspect of this signal would be the perception that in the future, economic losses will be very high as rises in the carbon price are anticipated, so the price signal may be most effective as a blunt instrument of fear.

3)    Politically feasible carbon price is low -  Almost all observers agree that carbon pricing, whether arrived at through permit auctions or via direct taxation, will not in the first years be particularly high. Expectations put pricing in the neighborhood of $15/tonne or less; the current worldwide price in the economic downturn is around $12/tonne . At this price level, some efforts to improve efficiency or purchase offsets will be inspired but the effect on energy prices will be minimal, the equivalent of 13 cents per gallon of gasoline or less. Most affected at this price level will be energy intensive industries which if subject to the carbon price will be incentivized to pursue energy efficiency measures. However at these low price levels not much action will occur though as a society we will start to “at least go in the right direction”. More impressive to businesses and private citizens would be the future threat of increases in this carbon price within the framework of an aggressively administered and supported program. Political sentiment may change enabling more aggressive and higher carbon pricing which will boost the effectiveness of the carbon price substantially.

4)    “Economic actors already have choice on the solutions market” The market paradigm is effective in the short term if market actors have a choice between two significantly different alternatives in terms of their carbon emissions that are made attractive or even tenable investments with the aid of the carbon price. Exceptions to this requirement are costless conservation measures and changes in behavior. Solutions need to be “on the market” or emerging onto the market for the price to actually effect decisions. The hope and theory in carbon pricing is that innovators will be providing these solutions that respond to demand from people and companies suffering or anticipating suffering from paying more for emissions-intensive products and energy. Demand for product innovation could be driven just as well or in addition by other mechanisms including straight energy taxes, conventional regulations, positive incentives, or government investment. In many sectors and technology areas, currently a very low or zero carbon alternative technology is either a) not yet on the market, b) requires a very high carbon price to be made competitive or c) requires the presence of technological preconditions, i.e. infrastructure, for the cleaner technology to function as an equivalent to existing polluting technologies. We see this in many elements of building the renewable electron economy and/or the Repower America plan. The carbon pricing model seems most appropriate to increasing energy and resource efficiency, the marketing of offsets, land-use changes or encouraging some behavioral changes by individuals rather than new paradigm development or infrastructure change. Energy efficiency or carbon offsets (which can be packaged in increments) allow for the incremental approach in the world of actual emissions reductions that matches the gradual increase of the carbon price.

5)    “Emitters are morally responsible for climate change” - While designers of carbon pricing schemes may deny that they are attaching a moral evaluation to the amount of carbon tax or pollution permits that a polluter pays, the market based system ultimately holds individual or individual corporate actors responsible for solutions and implies that the worst polluters will suffer the consequences of their polluting ways. Eventually some of the economic pain would be spread around but would depend upon the actions or inaction of the polluters. This focus on what I have called a “particulate” or atomized set of actors, denies the integrated or systemic view of an economy which demands certain products that historically have required carbon emissions. A strong ethical case can be made that those who demand goods and services that depend on fossil resources or GHG emissions are as responsible as the actual emitters. Co-responsibility through a systemic approach might augment or in some areas replace a model that turns on pinning responsibility on polluters. Both individual responsibility and societal co-responsibility should not be viewed as mutually exclusive alternatives.

6)    Carbon price will fluctuate dramatically (cap and trade) –  The instability of the carbon price under cap and trade will make long-term investments difficult because there will be substantial uncertainty about the costs over time of paying for permits or reducing emissions to be able to re-sell permits. Carbon prices, because of the economic slowdown and the dramatic drops in the price of fossil energy, have sunk from $30/tonne in the summer 0f 2008 to currently around $12/tonne. This will make calculating financial benefits of various emissions-reduction investments using instruments like net present value difficult if not impossible. Additionally, on the other side of permit auctions, if the proceeds of carbon auctions under cap and trade systems are used as a revenue source or dividend, it will be an unreliable revenue source. This will also make long-term investments that depend on revenues from carbon auctions difficult.

7)    Carbon pricing is, like all boosts in energy prices, regressive – As are all energy-related taxes or fees, carbon pricing is regressive, meaning that the resulting changes in prices will effect the middle class and the poor more than the rich. There are a number of suggestions about how to remedy this including returning all the resulting revenues as a flat dividend to people or to replace regressive taxes like the payroll tax with carbon taxes. The dividend idea will mute the price signal of the carbon price to some degree for the less advantaged.

8)    Non-specific and frontloaded promotion of more costly solutions – One of the intentions of carbon pricing is to “level the playing field” for renewable energy and other more expensive clean energy generation systems. However, the carbon price by raising the price of fossil fuels and contributing to raising the price of almost every good in society, will only spur the development of renewable energy at a high price level if purchasing decisions are made based largely on present or near-term cost. This is the equivalent of building a large and elaborate scaffolding around a tree to reach the top of it rather than using a ladder or a “bucket truck”.

9)    Unintended suppression of economic activity with poor calibration – If emissions reduction or energy efficiency technology is not ready or not affordable, there may be a net reduction in economic activity. This would reduce emissions but not as intended by cap and trade or carbon tax policy designers. There could be sector by sector systems that calibrate to a given market but this would defeat some of the intentions of a price on carbon and would increase complexity considerably. Business interests which want to do nothing about climate will use this as an excuse to try to delay or stop climate legislation.

10)    Ties climate policy and activism to the downside of climate change – The theory of carbon pricing is so relentlessly focused on the downside of climate change that it is left open what positive emissions-reducing activities would be funded by revenues from either a carbon tax or cap and trade auctions; the negative, punitive effect of the price signal alone is supposed to suffice. Disincentives outweigh incentives in carbon pricing systems; carbon pricing is designed to say “stop” to polluters (us). The negativity of this policy instrument is a political liability, as popular support for taking steps to address climate change is key in designing an effective policy.

11)    Assumes symmetry of opposites between problem and remedy – The mechanism of carbon pricing is structured as an economic force that is both symmetrically arrayed against and opposed to the emission of GHGs into the atmosphere. Carbon pricing is so relentlessly focused on emissions themselves that it may blind leaders and market actors to the possibility that the remedy for carbon emissions may be assymetrical with the problem itself. The solution may “reframe” the problem rather simply remain focused on the problem itself alone. For instance, related to “8” above, the remedy may be to invent new positive reasons to take action on climate and change our way of producing goods and services. While it is hoped in carbon pricing that the black box of the market will produce this new positive post-carbon society, there are reasons to believe that a more directive approach in certain areas may be necessary, especially with the tight timeframe given to us by climate scientists.

Lawrence Berkeley National Laboratory is one of a series of research laboratories funded in part or in full by the government, that have produced many scientific and technological innovations. In the innovation process, the market seems to have a greater role in the latter stages of development of scientific and technological ideas.

 12)    Technological innovation often originates outside of the market – The idealization of market mechanisms has attributed much innovation to the market when, in fact, non-market mechanisms have shepherded much technical innovation to the prototype stage or further. The market is treated by those who idealize it as a magical innovation “black box”. While fame and fortune are clear motivations for many innovators, the initial contexts or financing sources of innovation are often in government run laboratories or grants to university or industry scientists and engineers. With large capital goods, it is difficult for innovation to occur without the sponsorship, support, or regulatory approval of government. The presence “somewhere” of a market outlet for innovative ideas is often important but the market is not as much the site of innovation that was assumed in the context of the idealized market phenomenon.

13)    Value of third-party carbon traders unclear (cap and trade) – If we accept the idealized picture of the market, the role of third-party traders add liquidity to markets. However if we view markets as one mechanism among a number, third-party carbon traders may lead to businesses either paying too much or too little for permits and add to carbon permit price volatility. Additionally, the potential for bad or disengaged market actors manipulating markets increases, interfering with the ability of businesses to make long-term investments in carbon reduction technologies.

14)    “No one is in control” (cap and trade) – A cap and trade system sets up a complex system that is mandated by governments but runs in parallel to them and if it fails in some way, direct intervention is difficult; the carbon market is supposed to run on its own. Within the monetarist/free market worldview (amended to include the carbon emissions externality) the notion that “no one is in control” is a good thing, seeing that this frustrates what this group feels to be the power-hungry ambitions of governments. However, if we shift to the Keynesian or some “not anti-Keynesian” view that some government direction and regulation is necessary, the need for someone to be “at the switches” may be desirable in regulating carbon policy. This would speak for a carbon tax system, which could be changed quickly by legislative motion or executive fiat to better calibrate it.

Given the above, the carbon pricing instrument looks more limited in its scope of application than is usually discussed. Carbon pricing has some potential but expectations need to be tempered. As we shall see, a combination of a number of instruments is going to be more effective than loading every expectation onto carbon pricing policy.

In Part III, we will look at crucial market failures that are not adequately addressed by carbon pricing.

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