Design Issues in Climate Policy: How Cap-and-Trade Took Center Stage
Bryan K. Mignone

Over the last several years, attention to climate change has grown in dramatic and often unexpected ways. This heightened interest is fully apparent in the 110th Congress, where no fewer than seven economy-wide cap-and-trade bills have been introduced. Why have almost all legislative proposals to date focused on cap-and-trade over other potential policy instruments? This seemingly arbitrary choice is actually part of a story that began almost two decades ago.

In a historic 1990 vote, U.S. lawmakers amended the Clean Air Act and established what would become one of the most significant and successful tradable permit systems in history. Over a 10-year period, the new provisions of Title IV substantially reduced sulfur dioxide and nitrogen oxide emissions — well-established causes of acid rain — and did so while saving the economy an estimated $1 billion annually in compliance costs relative to less flexible alternatives.

Before the establishment of these rules, regulators tended to favor “command-and-control” approaches, in which emitters were forced to meet inflexible emissions reduction mandates or specific technology standards, or pay the price. But the success of the 1990 amendments effectively made command-and-control policies subordinate to market-based approaches. Indeed, the legacy of the sulfur dioxide program remains the single most important backdrop for understanding attitudes toward environmental regulation in the United States today.

In the current climate policy debate, advocates of cap-and-trade — the generic label given to approaches that cap the overall emissions of a particular pollutant and issue or sell tradable allowances to emitters — typically highlight the success of the sulfur dioxide program alongside two other perceived advantages: the increased potential for eventual harmonization with other international trading schemes, particularly the evolving EU system, and the certainty with which the domestic environmental objectives can be realized.

On the other hand, advocates of a tax system, the other major type of market-based policy, suggest that an explicit and stable carbon price would offer similar incentives to prioritize low-cost abatement opportunities, while also providing greater investment clarity, a predictable ceiling on the overall economic impact and a natural barrier to market manipulation.

In reality, either type of policy can be designed to yield an efficient outcome. The two alternatives differ primarily in the type of protection they offer against future economic uncertainty. A cap-and-trade system provides certainty in the emissions reduction goals at the expense of certainty in the market price of carbon, while a tax provides exactly the opposite. The preference for one scheme over the other will thus depend on subjective judgments about which type of certainty is deemed to be more important to overall social welfare.

When weighing the tradeoffs between these two types of uncertainty, however, any theoretical conclusions are likely to be overshadowed by political reality. In the case of climate change, the majority of stakeholders on both sides — to the extent that they support mandatory regulation at all — have largely coalesced behind the idea of cap-and-trade.

Environmentalists prefer cap-and-trade because specific emissions reduction goals can only be guaranteed by imposing explicit caps. Organized labor, on the other hand, supports cap-and-trade because flexibility in the permit allocation system and incentives for international action (tied to the cap levels) offer some protection against factories and jobs moving overseas. Similarly, the power industry supports cap-and-trade because such flexibility diminishes the risk of large compliance costs and unpopular rate hikes.

How will the environment fare in all of this? In theory, a cap-and-trade system should make it easier for regulators to decide on the specific quantitative provisions, by separating the science of the problem from everything else. In practice, the science is not so easily separated, because the schedule of domestic reductions depends on several subjective judgments about what constitutes a “safe” level of atmospheric carbon dioxide and what we mean by a “fair” distribution of burden between nations, among other things.

Such ambiguities open the door to further modification. If the choice of targets ultimately rests on a series of subjective economic or political judgments, one cannot avoid making these aspects of the problem explicit. By far the most prevalent concern among stakeholders is the potential for producers to face high compliance costs — and by extension, for consumers to face high energy prices — during the early years of a new policy. For this reason, several of the bills now under consideration in the Senate include specific provisions to constrain the costs of the policy, either by allowing additional permits to be printed or by allowing permits to be “borrowed” from the future.

These design elements and many others will continue to be debated as the full Senate prepares to consider economy-wide cap-and-trade legislation in the months ahead. While a variety of outcomes are possible, the success of any solution will be measured by how well it balances the demands of environmental integrity against the demands of economic and regulatory clarity. In this way, the practical and political may ultimately find a way to align.

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