How to structure a cap-and-trade program
From an awesomely meaty article on cap-and-trade from The San Francisco Chronicle comes this pearl of wisdom (in bold at the bottom of the quote):
[T]he lesson of the acid rain program is to keep the plan simple and easy for all parties to understand.
"If it starts to employ a lot of special provisions to take care of every party’s special needs … and if it starts to look like the Chicago phone book, then throw it out," [RFF economist Dallas Burtraw] said. "A poorly designed market is worse than no market at all."
I’m not sure I’d go quite that far — a carbon market’s a pretty important thing, and I’d be willing to live with a less-than-perfect system if it’s the only one that’s politically feasible.
That said, amen to the virtues of simplicity! Obviously, when designing a cap-and-trade program, there will be all sorts of pressure to create special interest loopholes, or dole out goodies to favored constituencies. Over the short-term, that might seem like smart politics — but over the long-term, the political drawbacks of a clunky, unworkable program will far exceed any short-term benefits.
Take, for example, the idea of "grandfathering" the right to pollute — a process that would hand out future emissions rights based on past pollution levels.
As I’ve argued before, grandfathering raises all sorts of equity and fairness issues. But grandfathering is also terrifyingly complicated — which, in my view, is reason enough all by itself to avoid it.
To make grandfathering work in an economy-wide cap, the government will have to require firms to provide evidence of their past emissions — which would be a data-intensive morass for lots of companies. Plus, there will have to be some sort of system to give extra credit to firms that took steps years ago to reduce their emissions, so that they won’t be penalized compared with their more slow-moving competitors.
On top of that, there will have to be some sort of process to reduce the pollution allotments to companies that aren’t doing so well for other reasons. A company with a failing business model and plummeting sales may see its emissions fall, but only because it’s losing business to competitors. There’s simply no reason to grant emissions rights to a failing business — so calculations of profitability, productivity, and output may need to enter into any grandfathering system.
So grandfathering is simple — as long as every firm knows exactly how much they’re emitting, how much they would have emitted if they hadn’t taken steps to cut back, and how much they would emit for any given level of productivity by the firm. But if you don’t have all that, then grandfathering in an economy-wide cap will be an absolute mess.
And remember, the stakes involved are huge! Once we create a carbon market, emissions rights will be worth money — so pollution allotments could make or break a company’s bottom line. And to raise the stakes even higher: since the supply of emissions allowances will be fixed, any credits that a firm doesn’t get for itself could, in theory, go to their competitors. A company that fails to fight for its fair share will let its competitors gain an edge. (Time to lawyer up, CEOs!)
So to me, "grandfathering" is synonymous with "endless lawsuits." And it won’t serve anyone’s interests to create an emissions framework that virtually guarantees decades of legal wrangling over minutiae.
More generally, any cap-and-trade system that directly regulates lots of small- to mid-sized businesses is going to create all sorts of administrative hassles; yet a system that exempts emissions from such businesses just won’t be effective at reaching emissions targets.
An upstream, auction-based system — where fossil-fuel extractors or importers have to buy credits for the carbon content of their fuels as soon as those fuels enter the economy — seems to me to be the best way to keep the complexity of cap-and-trade under control. That system would reduce administrative hassles for downstream businesses, limit loopholes, eliminate squabbles over grandfathering — and, in the bargain, prevent lots and lots of litigation. That’s about as simple as cap-and-trade is going to get.