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Getting the Architecture Right: The Economic Implications of Cap and Trade Policy
Justus Stewart, 12 Jan 09

This isn't just about carbon ... it turns out that cap and trade could be the largest economic redistribution program the US has ever seen.

272888240_74c0f76706.jpgI attended a symposium a few weeks ago at Evergreen State College about preparing our communities for climate regulation. The keynote was a thought-provoking talk about the economic implications of cap and trade system design by Peter Dorman, an economist and professor at Evergreen. This post is based largely on his talk.

In the United States, after years of local climate action pursued in the absence of federal involvement, we are suddenly standing in the midst of an unprecedented opportunity. We need climate action, we need economic intervention, and we have federal leadership that just might understand how deeply they are interrelated.

It seems certain that federal action on climate will involve a cap and trade system. It is of primary importance that citizens understand what’s at stake in its design. This policy will impact citizens as individuals, and our economy as a whole. Personally, I have not had a full appreciation of the economic changes this one mechanism could bring. As Dorman points out, global economic growth has been driven by increasing carbon densities for 2000 years – that is the size of the historical trend we are attempting to shift. Cap and trade will trigger a massive transfer of dollars from certain losers to certain winners. We can be confident that the economic implications of system design are not lost on those parties.

“Harry and Louise x 25”
Here is a wonderful cautionary tale: in 1993, we had a young, passionate new president with a mandate to change the way the US dealt with health care. It was part of the platform he ran on, and people had hope that it would finally happen. But the administration failed to anticipate the strength of the opposition (mainly the insurance industry), who responded with an expensive and well-organized ad campaign - centered around the fictional couple Harry & Louise - aimed at frightening citizens away from supporting the policy. The plan went down like a lead zeppelin. What was at stake? Twelve billion dollars in potential losses, back when $12 billion was real money.

The annual estimated value of carbon permits in the first year of a nationwide cap and trade program is $300 billion. We have seen nothing yet… and I see that we are unprepared for that fight. We expect our exciting new administration to lead on this, and it may. But do we dare pit an Obama administration against the combined fury of the oil, coal, gas, and chemical industries (and agriculture, and automobiles, and etc…)? Who represents the counter-force to industry in this? Us. How do we ensure that our voice is heard?

A large part of the problem is the emphasis in current media stories on setting the targets – what percent reduction by what year. Dorman charges that this is entirely the wrong emphasis; climate science continues to evolve, so whatever targets we set now will be revisited later, more than once. The targets need to be set, but we don’t need to get them exactly right, right now. But the opposite is true for what matters: the architecture of the mechanism. Once put in place, it will be – must be – hard to change. If it is easy to change, it will keep changing and a market will never develop. Yet if we make it hard to change and design it badly, it will fail.

The Architecture of the Western Climate Initiative
Dorman turned his attention to laying out his criteria for what good policy architecture for cap and trade looks like. He then used those criteria to inspect the Western Climate Initiative (WCI). Eric de Place, senior researcher at the Seattle-based Sightline Institute, has written an excellent series on the WCI, including discussion of implications. It’s a must-read for anyone interested in digging deeper than I will go here.

The main question as it is currently asked is one of setting the scope of the permits – who will fall under the regulations of a cap and trade scheme? This tends to be done – it is in WCI – by economic sector. But sector-by-sector emissions rights are an inherently political decision about the relative value of industries. The danger here is that clout trumps science. That’s a fail.

“US to Auction 100 percent of Emissions Permits, in Cap and Invest System”
So if it’s not the emissions targets, and it’s not the industries affected, what is the big question that we should be asking? What should the media headline include? We should be discussing the two most important points of system design: the percentage of emissions permits that will be auctioned, and how auction revenue will be disbursed.

These are the big stories, because the success or failure of a cap and trade system depends on getting these things right. According to Dorman, the best system will be fair, efficient, and transparent; will address the issue of price spikes (price signals are good, price spikes are bad); will auction 100 percent of credits/ permits; will recycle all auction revenue to the public; and will not allow offsets.

I’ll unpack these statements, briefly, one at a time:
1. Fair, efficient, and transparent
This is accomplished by making the regulations as comprehensive and upstream as possible. In practice this means regulating carbon as it enters the United States, so that the market – rather than politicians – determines who gets to emit how much.

2. Price spikes
In Dorman’s view, regulatory mechanisms for anticipating and addressing price spikes don’t need to be included in the cap and trade regulation itself. After all, price increases are part of how cap and trade works. But there needs to be some means of addressing prices that have escalated beyond a social/political standard.

3. 100% auction
The way a cap works is to drive down emissions by driving up prices of permits that allow the holders to emit. As those prices are transferred to consumers, we decrease our carbon consumption – this is how the carbon market works. So as Dorman says, rising energy prices will mean money leaving our pockets … where will that money go? There are two options: if the permits are given away, the money stays with the businesses, as profits; if the permits are auctioned, the money is reclaimed by the government. It is useful to think of cap and trade (in its function) as a sales tax. Prices for goods and energy will rise, and the impact will be regressive, hitting the poorest hardest. How will these impacts be dealt with? With revenue from the auctioning of permits. No auction, no revenue.

4. Revenue Recycling
If there is revenue, it should be returned to households -- that’s revenue recycling. There are many differing opinions about how to best spend this money, with some advocating investment in specific programs, and some encouraging redistribution to the workers and businesses most affected. Dorman’s point here was interesting – that if we expect this program to survive, it must be exceptionally fair, with all of the money being recycled, in an equal amount to every citizen.

5. No offsets
Voluntary offsets are good. They represent efforts by citizens and businesses to pay for emissions-reducing projects. But as part of a cap and trade system, Dorman argues that “they create incentives for both the companies buying the offsets and the companies whose investments are being subsidized by the offsets to exaggerate their carbon benefits, and their additionality can never be fully determined.” (Additionality is itself a concept that not everyone supports, but that’s another post.)

Now, keeping these arguments in mind, let’s examine how the WCI design recommendations address each one:

1. The WCI is sector-based; non-comprehensive and downstream. Dorman described the process as a “free-for-all wrangle between business sectors to determine who gets to burn the most carbon.” Sightline’s de Place is more optimistic, reminding me that the WCI will cover more emissions than either the RGGI or the EU cap and trade market (recently written up here). In that sense, the WCI is fairly comprehensive. However, its shortfalls are that different business sectors are treated differently, with phased-in timelines, differential auction rates, and other unequal treatment.

2. The WCI only requires that 10 percent of the permits be auctioned, meaning up to 90 percent could be given away. See the point above about the importance of auctioning all the permits.

3. Up to 49 percent of reductions can be offset. Ditto for offsets.

4. The stakeholders throughout the process have been predominantly businesses. An indication, in Dorman’s opinion, of whose opinion mattered in crafting this agreement.

5. The economic analysis performed on the WCI focused on impacts to business. The more important question of economic impacts on households was not measured. This stands in clear contrast to what Dorman calls the “most elementary economic principles for evaluating a public policy” i.e. its impact on average citizens.

So how much does this matter to households? To you and me? If, as Dorman put it, life before cap and trade has been about trying to get meaningful action, then life after will be all about dealing with the many implications of higher prices for damn near everything.

In an analysis by Boyce & Riddle in 2007 on the distributional impacts of carbon regulation on households, researchers found the following: with no revenue recycling, the lowest economic quintile lost about 10 percent of their income due to higher prices. With revenue recycling, they gained nearly 15 percent, while the highest quintile lost only about 2.5 percent.

This isn’t just about carbon… it turns out that cap and trade could be the largest economic redistribution program the US has ever seen.

Now it’s important to point out that the WCI is not the final word – the states are crafting their own systems. And while we hope that they go further, recent news stories do not make me hopeful here in Washington. But even that is not the final word – I started this post discussing a federal cap and trade system. But we risk much if we pin our hopes on the federal government correcting our mistakes.

We talk about this kind of legislation as though we knew what we were talking about. But 2050 is 40 years away. We should be thinking hard about where and how much we can compromise. We need to be thinking about policy sustainability. We’re attempting to put in place a program on the scale of Social Security. We have to get it right.

Justus Stewart is an urban planner and designer living in Seattle. He currently works on climate planning for local governments. Justus' main interest is the overlap and interrelation of fields usually held as separate.

Photo of smokestacks, credit: flickr/Broken Haiku, Creative Commons license.

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I'm dismayed that Worldchanging chose to run a hastily written story based primarily on one source - the lecture of a perfectionistic professor. I've noticed a trend in many blogs such as Worldchanging. The bloggers often rely heavily on one source and leave a good measure of objectivity at the door.

The article is incomplete and one-sided at best.

1) The Western Climate Initiative is the most comprehensive greenhouse gas (GHG) cap and trade program proposed in the world to date. It will cover approximately 90% of the economy wide emissions in the WCI region. The states and provinces in WCI represent 20% of the US economy and 70% of the Canadian economy. It does cover specific fuels "upstream" if - such as gas and diesel. These are two of the major fossil fuels consumed in the country.

It sounds like the author and professor want a perfect program from day one - a nearly impossible task as evidenced by a history of environmental markets (such as the acid rain program, grazing permits in the US, and other GHG emission permit programs). Given the pace of climate change, asking for perfection now is most certainly the enemy of real progress to address the climate crisis.

2) Putting a price on carbon: controlling price spikes is a decent idea and getting cap and trade right is a must. The author is right here - the government should create a fair, transparent, and efficient market. Successful cap and trade programs should not, however, embrace a government that "jumps in and fixes or controls price spikes" at any time. Economist see such interventions as manipulative, unfair and inefficient.

Cap and trade programs control prices by building in flexibility - such as low cost GHG offsets, the banking of allowances for future years, trading or selling allowances, or buying permits from other programs like RGGI or the EU ETS.

3) National experts agree that offset projects can work when they are done properly. Offsets projects can be measured and verified for key criteria including additionality ( GHG offsets promote innovation and cost effective solutions in sectors like forestry and agriculture. This means that more people and more sectors may benefit from this new environmental market.

4) Diverse stakeholders and members of the public, 7 states, 4 provinces, technical experts, and many environmental groups shaped the design of WCI. The author and Professor Dorman decided not to do their homework on this point.

Ask leading members of the National Wildlife Federation in Seattle, Climate Solutions, the Sierra Club, staff at a public utility such Seattle City Light or Worldchanging's own Eric de Place if businesses had undue or predominant influence on the WCI. Representatives from these respected organizations helped shape the design of a solid cap and trade program called WCI.

To see the diverse groups, individuals, and businesses that commented on and participated in the Western Climate Initiative, visit

5) Members of the WCI conducted a multitude of economic analyses and built a sound economic model. The WCI design specifically calls for new revenue to assist low income consumers and to invest in important projects in energy efficiency, renewable energy and public transit. Boyce and Riddle (2007) address a national program (a different apple altogether). WCI is not a top down national program. It is a regional program that recognizes the importance of helping low income groups. WCI also recognizes the importance of investing in a green economy and new jobs right NOW.

The author also neglects to mention that WCI will increase the role of the auction over time - to as high as 100%.

Next time around, I hope Worldchanging will choose to present a more balanced approach and analyze WCI through an objective lens.

Posted by: Eli on 12 Jan 09

Thanks for your comments; I know many people who believe the WCI is as well-designed a cap and trade policy structure as we could have gotten. Some think that as currently structured, it will fail – time will tell.

A few specific points about the post:

1. It is a write-up of a lecture from someone who is critical of the WCI, and why those criticisms matter – your request for objectivity misses the point entirely. (This is precisely why I recommended Sightline’s piece – theirs is a more objective (and more complete) overview, for them that wants more info.)

2. Perhaps more importantly, this is not primarily an analysis of the WCI. If you will refer back to the title, it is about the huge economic stakes in getting a well-designed cap and trade policy at the federal level – a point on which we agree. The WCI is used to illustrate some common design flaws because I know it better than RGGI or the EU agreement, both of which might have made better examples.

3. It is very dangerous to let poor architecture stand now because it can be fixed later. I am sensitive to your accusation of perfectionism – it kills progress. But if we build in industry-friendly policies now – low auction, high offsets – then we just push the fight into the future. These ideas won’t be any easier to implement down the road, especially if costs have risen for other reasons. My principle point is not that WCI is awful (it’s not) or that it needs to be perfect now (no such thing) but that citizens need to understand what’s at stake for their economic future, and they need to understand what a good cap and trade policy looks like. If we allow a federal policy to be crafted that gets too much wrong, it won’t survive.

4. Finally, please be thoughtful about who you are accusing of sloppiness or laziness. As for me not doing my homework, please see points 1 & 2. As for Professor Dorman, he is a contractor for the Sightline Institute on the WCI, and one of those ‘economists’ you referenced earlier. You may disagree with his opinion, but he knows what he’s talking about.

Posted by: justus on 13 Jan 09

Great discussion. You sure have it right that there will be monumental opposition. But there are cracks showing. Banks and insurance companies are already taking the cost of carbon into account. And the head of Exxon Mobil recently expressed his preference for carbon taxation, rather than cap and trade.

I might be inclined to agree. I think a revenue-neutral carbon tax (with rebates) might be easier and have a higher degree of perceived fairness. Since we're talking politics, perceived fairness might end up being more important if it gets the program passed.

Cap and trade rules would be byzantine. But a simple slowly-phased-in across-the-board carbon tax would be easier to swallow. People would start getting checks right away, and as the taxes went up, so would the checks. People would still have an incentive to save money by switching to lower-carbon energy.

Far less bureaucracy would be required. As carbon reductions took hold, the tax rate could be tweaked on an annual basis. That seems a lot simpler than what's being proposed with cap and trade: You can't even get out of the starting gate--issuing initial permits--without a huge food fight. On the heels of recent scandals, the idea of a carbon-permit market also seems too much like another opportunity for corruption.

Posted by: BlackSun on 14 Jan 09

First, let's understand that most of the world's pollution is caused by the utilization of fossil fuels; for transportation, power generation, and chemical production. And Carbon Dioxide production is enhanced by over 6 Billion people, and the meat animals used to provide food.
Then, let's recognize that the supply of such fuels are finite; that additions to reserves of these products may have paused years ago and many believe we have reached or have passed the tipping point wherein new discoveries and production are higher each year.
How then, to persuade energy "consumers," which in this case includes business and government, to properly value the energy product, which in view of steadily decreasing supplies, must be relegated to the "highest value usage?"
In my opinion, and in the opinion of energy economists, a straightforward "energy tax" on the different types of energy, with the proceeds directed at only alternative energy projects which, with technological support can stand on their own economically, or with minimal use of subsidies from an energy tax. Nuclear, wind, solar, water all fill this definition.
Well-designed mass transit, underground primarily, could easily help reduce the need for the types of road building projects that benefit a class of consumers-drivers, both commercial and personal, at the expense of others.
The fossil fuel tax must be high enough to generate the funds necessary to complete ten percent of the infrastructure each year, so that at the end of ten/fifteen years there is a working, viable "neutral consumption compared to base year 2009" Program, and potentially substantially lowered consumption of fossil energy at the same time in the U.S. And, world wide if other major industrialized nations adopt a similar approach. It is helpful to point out that per capita energy consumption is highest in the U.S. and lower almost everywhere else, primarily because other countries instituted energy taxes, primarily on transportation fuels, some years ago, effectively reducing transportation consumption substantially, as well as supporting and subsidizing alternative power generation sources, France, for instance, generates almost eighty percent of it's power generation from nuclear power plants, Japan, Korea, Germany, and others have already recognized the rationality of this approach and are taking more steps every day to increase alternative energy inputs in their systems.
If we adopt the direct taxing of energy at the distribution point approach, we can expect some need for energy credits on behalf of consumers; we should offer no such credits to business, institutional, and industrial users, any costs absorbed by them will be quickly reflected in retail and wholesale prices, and will encourage mightily their demonstrated ability to reduce cost components of their production and distribution processes.
If a well-designed plan is instituted we can expect reasonable progress towards the ten/fifteen year plan.
There will be mistakes, to be sure; there will be delays for certain, but if the overall plan for mass transportation, alternative power generation, and transportation efficiencies are adopted and rigorously managed, we can expect great results.
It's worth while to mention here the potential for "Cloud Commuting" and "Cloud Education" and other Cloud" infrastructure processes to save up to fifty percent of the time and energy now spent driving and commuting to work; the endless hours of transportation and horrible schedules for children that would be alleviated by cloud education, and so much more. A useful portion of the energy tax could easily help develop a whole new generation of workers and those being educated, to the degree that Work as we now view it will be forever changed, for the better. Education would become truly that, the ability to think and organize, plan and execute.
Once the "facts" are learned, then they provide the framework for the thinking process, which mentoring through Cloud could easily provide.
I have written about Cloud in a blog entry ( "Cloud Computing and the Economy."
All in all, direct taxing of energy most efficiently provides the rationale for reduced consumption and increased production on non-polluting alternatives through the proper use of the revenues generated.
Unfortunately, "cap and trade" or other versions of the same thinking, while admittedly offering some small hope for pollution and carbon emission plateaus, are not the answer, More specifically, they represent a tax on consumers, a transfer of wealth to pollution producers (how can that be O.K.?), and most importantly, a disincentive to the kinds of alternative energy and pollution-reducing results that a direct energy tax would provide.

Posted by: Barry Dennis on 17 Jan 09

Today is my lucky day :)
My mom had promised me to gift a nintendo wii this christmas. But I got it for free, yeee. While looking for some place where I could get it cheap or with some discount, I found this website which offered a chance to win nintendo wii, as a special christmas promotion. All I needed to do was to enter my mobile number to enter into the contest. And yup, I won it. Lucky me. Now I am thinking what to ask my mom as a gift. :P
What do you guy's suggest?

Posted by: Marie on 18 Dec 09

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