Pay to Pollute: The Commerce of Carbon

In light of former Vice President Al Gore’s award winning campaign to battle global warming, the public has stumbled across a very inconvenient truth. In the past fifty years, greenhouse gas emissions have almost quadrupled from 1.6 billion to 6.5 billion tons. (See graph below right) This unprecedented growth of pollution over the past few decades is thought to be the main contributor behind 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 emissions can sell excess carbon credits for cold hard cash. Though currently fraught with problems, with the right direction, carbon credits could be the currency that buys a better future.

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 below left) According to the White House, the act will emplace “a dynamic regulatory approach – emission caps and trading – that provides power plants with flexibility to reduce emissions in the least costly way.” The government “caps” the level of emissions allowed in the country and doles out allowances to individual companies via an auction. Certain levels have to be maintained and then reduced at predetermined deadlines. In the United States, Clear Skies calls for a reduction from 16.3 million tons of all emissions to 6.6 million tons by 2010 and then 4.7 million tons by 2018, a total reduction of 72%. 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 and distribute the allowances. To contrast directly, the EPA declares that the cap-and-trade program has “achieved reductions at two-thirds the cost of… 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 too good to be true, and according to the Sierra Club, it is just that. 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’s Emissions Trading Scheme and the UN’s Clean Development Mechanism, has come under fire 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, governments setting limits 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 insignificant profits when sold on the market. This in turn directly influences companies’ decisions to research new ways to reduce emissions more efficiently. However, this is not a failure of the economic system but a failure of the governments’ ineffectual limits, as seen in the success of the Brazilian model. By setting limits too high, the 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. Under the proper constraints, I think that the cap-and-trade system will lead to the most efficient use of resources to reduce pollution. The cash incentive of selling surplus credits should encourage industries with already low levels of emissions to invest in R&D to reduce their emissions even further and even provides the capital to do so. Alternatively, the blow to the wallet buying more credits entails should deter companies with high emissions from cutting corners when reducing their carbon footprint. Ultimately, the only way to motivate big business is to provide an incentive that they understand, money. Though the problems surrounding carbon credits are significant right now, I feel the modeling of the system is sound with only the deficiencies of the governments setting limits holding it back. With proper revisions, the country can get right back on the track towards saving the environment.