Pay to Pollute: The Commerce of Carbon

In the past fifty years, greenhouse gas emissions have almost quadrupled from 1.6 billion to 6.5 billion tons (see graph right). This unprecedented growth of pollution over the past few decades is thought to be the main contributor to everyone’s favorite sometimes myth, global warming. In efforts to combat these rising levels of pollution, especially carbon emissions, many countries like Brazil, the United States, and most of the European Union have adopted emissions trading schemes that limit the amount of carbon and similar greenhouse gases produced by power plants or their industrial corporations. The process assigns monetary values to “carbon credits” which companies can buy or sell. This is designed to present an economic incentive for polluting less as companies that reduce their emissions can sell their excess carbon credits for cold hard cash.
In the United States, President George W. Bush’s “Clear Skies” initiative concentrates its efforts to reduce emissions of SO2 (sulfur dioxide), NOx (nitrous oxides), and mercury from power plants (see graph left). According to the White House, the United States government uses a cap-and-trade system to regulate emissions without having to get too involved. The government “caps” the level of emissions allowed in the country and doles out allowances to individual companies. Certain levels have to be maintained and then reduced at predetermined deadlines. Companies that reach the reduced levels before the deadline are allowed to “trade” their extra credits on the market to plants that have not reached their reduction levels. Personally, I like the cap-and-trade model. It solves an environmental problem with an economic solution. The most basic laws of economics determine the best allocation of credits and ensure maximum efficiency in reducing pollution. Self-interest, not federal sanctions, motivates companies to be more environmentally friendly. In addition, the cap-and-trade method allows the government to take a hands-off approach. Instead of wasting billions of dollars on litigation and manpower, the government simply has to set the limits, distribute the allowances, and make sure each plant has enough allowances to get them through the year. To contrast directly, the cap-and-trade program has “achieved reductions at two-thirds the cost of achieving the same reductions” using the previous system of regulation and penalty over the past ten years.
This glowing picture of emission trading systems founded on solid economics seems to good to be true, and according to some, like the Sierra Club, it is just that. An article from the Sierra Club states that the “Clear Skies” proposal actually increases pollution levels. In contrast with the previous “Clean Air Act,” “Clear Skies” loose[ns] the cap on NOx pollution to… an increase of 68 percent” and SO2 pollution 225 percent from “Clean Air.” Since this information comes from studies performed by the U.S Environmental Protection Agency, it is difficult to refute. Related to the high caps in the “Clear Skies” proposal, The United States government, as well as the EU with their Emissions Trading Scheme and the UN’s Clean Development Mechanism, has come under fire recently due to recent claims from Professor Catrinus Jepma of the University of Amsterdam that these systems have failed to provide “…the excepted benefits due to a collapse in the price of carbon credits.” In short, the governments deciding how many carbon credits allowed overestimated. The high emission caps have led to a surplus of carbon credits in the market, and in accordance with economic modeling, the price of the carbon emissions has dropped dramatically. All the way back in May of last year, it was revealed that countries using the European Trading Scheme, think “Clear Skies” for the EU, had set caps too high “resulting in fewer firms than expected having to buy credits.” This led to a drop of the price of carbon credits from thirty Euros to less than five. If the price of credits drops too low, the incentive to reduce pollution drops next to nothing as reducing emissions will result in profits next to nothing when sold on the market. This in turn directly influences companies’ decisions to research new ways to reduce emissions more efficiently. This, however, is not a failure of the economic system but a failure of the governments setting the limits. By setting a limit too high, a government does not constrain the firms enough and the whole process fails to achieve market equilibrium.
As an economist, I believe in the “invisible hand” of the free market. Left alone and under the proper constraints, I think that the cap-and-trade system will lead to the most efficient use of resources to reduce pollution. You catch more flies with honey in the same way you catch more people with the promise of money than the fear of litigation.