In his State of the Union address, President Barack Obama proposed the creation of a cap-and-trade system to control the amount of greenhouse gas emissions resulting from our national energy use. Unfortunately, since then he has had to shelve this proposal for now since there was no hope that this Congress will pass such a program. So on June 25, he announced that the Environmental Protection Agency would impose strict emission limits on power plants and other manufacturing polluters.
It is a shame that cap-and-trade could not be implemented in the current climate. Perhaps it is not well understood that this idea originated among conservative economists. Thanks to President George H.W. Bush, we have a highly successful cap-and-trade program to curtail sulfur-dioxide (acid rain) emissions implemented as a key part of the 1990 amendments to the Clean Air Act.
Cap-and-trade is a two-part policy aimed at solving a problem that the market does not solve on its own. The government creates a market mechanism in emission rights, forcing firms to treat the atmosphere as the scarce good it really is.
First, the caps: The government sets an enforceable limit on a firm's allowable emissions by issuing a limited number of permits to pollute. Firms can only pollute an amount corresponding to the number of permits they have been awarded. Second, the trade: To pollute above its cap, a firm must purchase additional permits from other firms. The firm that sells the rights must pollute less than its originally assigned cap, such that total pollution remains unchanged by this exchange of rights.
Once the government establishes the permit system, trade in permits mimics market forces. If an electric power company in Ohio values sulfur dioxide emissions less than does an electric power company in West Virginia, the Ohio firm can sell its pollution permits to the West Virginia firm, and in so doing both firms improve their profits without changing the total amount of pollution drifting into Canada.
To illustrate: Suppose the Ohio firm values a pollution permit at $5 and the West Virginia firm values it at $10. If the sale is for any price between $5 and $10, both firms benefit. For example, a price of $7 would yield a gain of $3 to the West Virginia firm and $2 to the Ohio firm. The total amount of pollution remains unchanged; the Ohio firm now finds it more profitable to cut pollution and the West Virginia firm saves money by emitting more sulfur dioxide.
In the cap-and-trade system, pollution rights have a price determined in the same manner that markets determine the price of all scarce resources: supply and demand. Just as the supply and demand of labor establishes prices called wages and the supply and demand of loanable funds establishes prices called interest rates, the cap-and-trade system allows a market to form so that the supply and demand of pollution rights establishes the price of the right to pollute. While the markets for labor and loanable funds develop naturally since labor and funds are scarce, the government must create the prerequisite scarcity for pollution rights.
But the advantage of cap-and-trade does not end there. Because trade in pollution establishes a market price for permits, firms have an ongoing incentive to improve their emission-reducing equipment. If a firm can pay less for pollution-reducing equipment than it pays for pollution permits, then it has a strong incentive to do so; the end result being greater environmental protection.
An alternative way to establish prices for pollution without using cap-and-trade is simply to tax pollution such as CO2 emissions.
A carbon tax would impose a price for each unit of CO2 emitted. Economists tend to prefer emissions taxes over cap-and-trade for two reasons. First, taxes generate revenue for the government that can be used to clean up environmental damage done by polluters that are no longer in existence. Second, emissions taxes are easier to implement. Conservatives tend to oppose pollution taxes since it involves taxes and government. Since cap-and-trade is already a proven method and involves less direct involvement of government, it is more likely to be implemented in an ideologically mixed Congress.
Cap-and-trade works in principle and in practice. It is an efficient mechanism for controlling pollution. In addition to the existing cap-and-trade market for controlling acid rain emissions, California has established a state cap-and-trade program for controlling greenhouse gas emissions, and the European Union has created the largest cap-and-trade program in the world.
William L. Holahan is emeritus professor of economics at the University of Wisconsin-Milwaukee. Charles O. Kroncke, retired dean of the College of Business at UW-M, also recently retired from USF. They are co-authors of "Economics for Voters." They wrote this exclusively for the Tampa Bay Times.