Reality-free Cap and Trade?

Over at Prometheus, Roger Pielke picks on Nancy Pelosi:

Speaker Nancy Pelosi (D-CA) adds to a long series of comments by Democrats that emphasize cost as a crucial criterion for evaluating cap and trade legislation, and specifically, that there should be no costs:

‘There should be no cost to the consumer,’ House Speaker Nancy Pelosi (D., Calif.) said Wednesday. She vowed the legislation would ‘make good on that’ pledge.

Of course, cost-free cap and trade defeats the purpose of cap and trade which is to raise the costs of energy, …

Pelosi’s comment sounds like fantasy, but it’s out of context. If you read the preceding paragraph in the linked article, it prefaces the quote with:

Top House Democrats are also considering a proposal to create a second consumer rebate to help lower- and middle-income families offset the higher energy costs of the cap-and-trade program.

It sounds to me like Pelosi could be talking specifically about net cost to low- and middle-income consumers. It’s hard to get a handle on what people are really talking about because the language used is so imprecise. “Cost” gets used to mean net cost of climate policy, outlays for mitigation capital, net consumer budget effects, energy or energy service expenditures, and energy or GHG prices.  So, “no cost” cap and trade could mean a variety of things:

  1. If it means global net cost of climate policy including impacts, I agree – there’s overwhelming likelihood of a net benefit, if everyone plays. The net benefit to any one region from its individual actions only is much smaller and probably negative.
  2. If it means outlays for mitigation capital, there’s no free lunch. Many options are capital intensive. There will be costs and many will be up front.
  3. If it means net effect on consumer budgets, it’s quite possible to construct a cap and trade that’s welfare-neutral for low income groups – see the CBO analysis here, for example (Table 3, Allowance Auction and Lump Sum Rebate section). If total costs are positive, as they are likely to be for deep cuts, someone will have to pay.
  4. If it means energy expenditures, I think it extremely likely that cap and trade will drive them up in the near term. There might be a long term benefit from smoothing the transition away from conventional oil and gas (avoiding a crisis in 2030).
  5. If it means energy service expenditures, it’s not clear … efficiency could pick up a lot of slack, and lifestyle change could alter the meaning of services.
  6. If it means energy prices, they’re going up.

By any narrow metric, there will eventually be costs to cap and trade, borne by someone. However, you have to keep your eye on the ball, which is #1.

Update: a clear explanation of one interpretation of cost at Environmental Economics.

Many opinions, and some formal analyses, seem to suggest that climate policy will result in an economy just like the one we have now, but carbon free, with more jobs and stuff. I think that is a fantasy. The fantasy isn’t that we’ll be happy carbon free, but that the economy will look just like our current one. That ain’t gonna happen, any more than we’re all going to be tooling around the wilderness in hydrogen-powered Hummers. I think it’s possible to live better with less carbon, but it’s going to take changes in technology, institutions and lifestyle to enable that.

While we figure out how to make those big changes happen, we could be working on the first 20 or 30% of mitigation, which probably does have near-zero net cost, when non-climate externalities and other market failures (debated at least since the 70s) are taken into account. The trick is that in many cases you have to address those externalities and market failures directly, rather than relying only on the price signal alone, if you want to realize a net benefit.

The linked article cites other prevalent oddities in the current cap and trade legislation debate. For example,

Under the proposal, electric utilities would get free permits to emit carbon dioxide and other greenhouse gases for as long as ten years, after which they would gradually begin paying. In exchange, utilities would be required to shield consumers and businesses from higher electricity rates during that time. They would also make investments in conservation and renewable energy to lessen the industry’s reliance on coal.

“We’re going to have some of the money allocated to ratepayers,” said House Energy and Commerce Committee Chairman Henry Waxman (D., Calif.) “How much and what percentage, I don’t know.”

Under the proposal, which is still being negotiated, electric utilities would receive about 40% of the permits allotted under a cap-and-trade program designed to gradually cut carbon-dioxide emissions. That is roughly equivalent to the utility industry’s share of such emissions.

This reflects the reality of political power,  but not the reality of economics. First, I have a hard time compensating utilities for stranded assets. They’ve known that climate policy was coming for a long time, and should have invested accordingly. Their shareholders should be diversified, and should have priced carbon risk into their holdings. Compensation with free allowances just rewards moral hazard. The compensation is unlikely to flow to the least mobile factor of production – labor – which we should be thinking more about. Second, allocating permits equal to 100% of historic emissions – as this seems to suggest – drastically overcompensates for lost profits, creating a windfall, not harm to utilities. Third, even if regulators could force allowance value to be used for rate relief (unlikely to be achieved universally), rate relief is a dumb idea. It defeats the price signal to the consumer, and thus distorts the tradeoff between efficiency and supply investments. The whole point of trading is to let the price signal propagate through the economy broadly. If we’re not doing that, we should question the whole policy (I think this is the point Roger was driving at). The initial price of allowances is not going to be high enough to cause anything near the effects of the oil shock we’ve recently experienced, so why are we worrying about these transition effects at all?


Mr. Waxman also agreed to protect such trade-sensitive industries as cement and steel by granting them some permits without cost, the better to compete with rivals in other countries with less stringent rules. The measure is a priority of Rep. Mike Doyle, a Pennsylvania Democrat.

Again, this is the wrong way to go about things. It either (over)compensates overcompensates owners who should have known better, or defeats the price signal downstream. The right way to deal with trade competitiveness issues is border adjustments. Sure, the WTO will have a fit, but that’s no reason to aspire to a second-best solution. If trade policy stands in the way of internalizing legitimate externalities, trade policy should change.

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