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Column: Harness the marketplace to help the environment

 
Published July 10, 2015

Pope Francis has gotten a much-needed conversation on climate shifted into high gear. His recent encyclical, Laudato Si, makes the case that climate change is a reality, and it argues against overreliance on the actions of unregulated markets for solutions to this global problem.

While in Latin America last week, he called attention to the link between poverty and climate change, noting that the poor are the most vulnerable to changed weather patterns. His message was seen as a sharp criticism of Ecuadorian President Rafael Correa's decision to expand the country's oil exploration operations.

Many contemporary conservatives in the United States also oppose this message — some resorting to empty rhetoric claiming that the pope is Marxist, socialist, antigrowth, etc., as if such catcalls lend credence to their denials of climate change. His detractors like to assume the label of "conservative," but for the most part are simply antigovernment, opposed to any form of regulation or taxation. True conservatives, by contrast, understand markets well enough to know that well-designed regulation is required when pollution is a byproduct of economic activity.

A way forward for both the pope and for antigovernment conservatives would be to reconsider a cap-and-trade program to address pollution control. Economic principles show that when markets work with the wrong prices, they actually encourage the gas emissions that we must reduce. Those same principles also demonstrate the power of markets to raise living standards when the prices are right. Therefore, the remedy is to get the prices right, not to scrap market solutions.

By creating a market in emission rights, a cap-and-trade program forces firms to treat the climate as the scarce good it really is. To make the market work, the government sets an enforceable limit (a cap) 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 own. For a firm to pollute above its cap, some other firm must pollute below its cap. Firms that want to pollute more must buy additional permits from firms willing to sell their permits and to pollute less (the trade). This trade keeps the total pollution unchanged.

In a cap-and-trade system, pollution rights have a price determined in the same manner that markets determine the price of all scarce resources, that is, by 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 permits establishes the price of the right to pollute.

For any market to work, resources must be economically scarce: People must consider the cost of the resources they use. Economic scarcity is automatic in the markets for labor and loanable funds; however, in the case of pollution rights it is necessary for the government to create the prerequisite scarcity.

Once a market in emission rights is established, cap-and-trade provides an additional advantage: It induces innovation for improved emission control. Because trade in pollution establishes a market price for permits, firms have an ongoing profit 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 result being both increased profit and greater environmental protection.

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An alternative to cap-and-trade is a carbon tax on each unit of greenhouse gas emissions. Economists tend to prefer this approach because taxes generate revenue for the government and are easier to implement. Rather than set the quantity of pollution and letting the market set the price of permits, under the carbon tax program the regulator sets the price and lets the market set quantity. Either method uses market forces to bring about a reduction in emissions.

Advocates of cap-and-trade have a tough educational job due to the opposition of both the pope and antigovernment conservatives. The pope's opposition is that the "cap" provides polluters with a "license to pollute," while the antigovernment conservative opposition arises out of the disproven belief that markets will efficiently regulate emissions without government intervention.

The strongest argument in favor of market-based pollution control is that, when they work with the right prices, markets are the only known nondictatorial way to coordinate the incentives of billions of people toward the goal of improving living standards while at the same time limiting greenhouse gas emissions.

William L. Holahan, far left, is emeritus professor of economics at the University of Wisconsin at Milwaukee. Charles O. Kroncke, retired dean of the College of Business at UW-M, is also retired from USF. They are co-authors of "Economics for Voters." They wrote this exclusively for the Tampa Bay Times.