Market mechanisms for regulation: Cap-and-trade and Obamacare

Jeffrey Frankel, 27 February 2014

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Markets can fail. But market mechanisms are often the best way for governments to address such failures. This has been demonstrated in areas from air pollution, to traffic congestion, to spectrum allocation, to cigarette consumption.

Markets for emission allowances – in which those firms that can cheaply cut pollution trade with those that cannot – achieve desired environmental goals at relatively low economic costs. As of a decade ago, that long-standing economic proposition had become widely recognised and put into action. Yet the political tide on both sides of the Atlantic has been against ‘cap-and-trade’ over the last five years.

In the US, the highly successful trading system for allowances in emissions of SO2 (sulphur dioxide) has all but died since 2012. In the EU as well, the Emissions Trading System was in effect overtaken by other kinds of regulation in 2013.

Cap-and-trade as a Republican policy

In the US, cap-and-trade was originally considered a Republican idea. Market-friendly regulation was pushed by those who thought of themselves as pro-market, rather than by those who thought of themselves as pro-regulation. Most environmental organisations were opposed to the novel approach; many of them thought it immoral for corporations to be able to pay for the right to pollute. The pioneering use of the cap-and-trade approach to phase out lead from gasoline in the 1980s was a policy of Ronald Reagan’s administration. Its successful use to reduce SO2 emissions from power plants in the 1990s was a policy of George H W Bush’s administration. The proposal to use cap-and-trade to reduce SO2 and other emissions further was a policy of George W Bush’s administration ten years ago under, first, the Clear Skies Act proposed in 2002, and then the Clean Air Interstate Rule of 2005 (see Schmalensee and Stavins 2013, pp.103-113).

The problem is not that cap-and-trade is a theoretical proposal from ivory-tower economists that cannot survive application in the real world. On the contrary, its performance in action surpassed expectations. The mechanism in the 1980s allowed lead to be phased out more rapidly than predicted and at an estimate savings of $250 million per year compared to the old-fashioned approach that did not permit trade (Stavins 2003). SO2 emissions were curbed at a much lower cost than even the proponents of cap-and-trade had predicted before 1995, let alone what the cost would have been under the old command-and-control approach. As expected, the electric power sector chose to close down those plants where it would have been most expensive to achieve pollution cuts. The flexibility of the cap-and-trade system also allowed the industry to take advantage of unexpected developments such as new scrubber technology and newly accessible low-sulphur coal, to a much greater extent than would have been possible without the market mechanism. (Among those explaining why costs came in so low are Ellerman et al. 2000).

The Republican candidate for president in 2008, Senator John McCain, had sponsored US legislative proposals to use cap-and-trade to address emissions of carbon dioxide and other greenhouse gases responsible for global warming. He had co-sponsored the Climate Stewardship Act with Senator Joe Lieberman in 2003 – it was defeated in the Senate by 55 votes to 43. They tried again as recently as 2007, but got no further. McCain continued to advocate a cap-and-trade approach to climate change during the 2008 presidential campaign.

The retreat from cap-and-trade

Republican politicians have now forgotten that this approach was ever their policy. To defeat the last major climate bill in 2009, they worked themselves into a frenzy of anti-regulation rhetoric. The American Clean-Energy and Security Act, sponsored by Congressmen Ed Markey and Henry Waxman, was passed by the House of Representatives that year, but not the Senate. The Republican rhetoric successfully stigmatised cap-and-trade. Schmalensee and Stavins (2013) sum it up: ‘It is ironic that conservatives chose to demonize their own market-based creation.’

This stance left in its place alternative approaches that are less market-friendly (Stavins 2011) – especially after court cases pointed out that the 1970 Clean Air Act and its 1990 Amendments were still the law of the land (originally signed into law by Republican Presidents Richard Nixon and George H W Bush, respectively, with large bipartisan congressional majorities both times).

The non-market alternatives – such as ‘command-and-control’ regulation requiring that particular energy sources or particular technologies be used – are less efficient. Nonetheless they are once again the dominant regime. The number of SO2 allowances specified by the cap-and-trade regime has not been adjusted since 2000. As a result, emissions since 2006 have been steadily declining below the ceiling. The cap is no longer binding. People aren’t willing to pay for something if they already have more of it than they need. So the price of emission allowances has fallen steeply, essentially hitting zero since 2012, which indicates that it no longer affects behaviour in the electric power sector (Schmalensee and Stavins 2013, p.106-07 and p. 114).

In Europe, the peak of cap-and-trade came ten years ago. The EU adopted the Emissions Trading System (ETS) in 2003, as a cost-effective way to achieve the commitments it had made under the Kyoto Protocol on Global Climate Change. It rapidly became the world’s biggest market in the trading of carbon allowances. But the ETS has in recent years been pushed aside by older ‘command-and-control’ approaches, in which the government dictates who should use which technologies, in what amounts, to reduce which emissions.

European directives say that 20% of energy must come from renewables by 2020. Renewable energy has been promoted by mandates and subsidies. These policies, along with excessive allocations, have collapsed the price of emissions permits in the ETS, because demand for the permits now falls short of any binding constraint. The price of carbon fell below 3 euros a tonne in April 2013, rendering the market almost irrelevant. It remains very low (5 euros a tonne). This in turn contributes to the burning of coal – the worst energy source, from the viewpoint of global warming or local pollution – which would not have happened if the central policy to address these problems were still a mechanism to put a price on carbon.

On top of that, the EU methods of encouraging renewables have proven ruinously expensive. This has been giving pause to European officials as they decide how to extend the 2020 framework to goals for 2030. The European Council will discuss this at a meeting scheduled for March 2014. The EU should abandon its numerical targets for renewables and go back to relying on the ETS, with whatever limits on permit quantities are necessary to keep the price up. This route can achieve greater progress at reducing Greenhouse Gas emissions at lower cost to the European economies.

There is nothing inevitable or irreversible about the recent trend away from cap-and-trade. Indeed in some parts of the world, such as China, governments seem to be moving in the direction of emissions trading as an efficient way to address global climate change (OECD 2013).

Even in the US, where it began, there are still grounds for hope. The Environmental Protection Agency is currently developing federal guidelines for state programmes to reduce CO2 emissions from power plants under the Clean Air Act [Section 111(d)]. As a good model for putting a price on carbon, the EPA should consider the cap and trade schemes that have been developed by the northeastern Regional Greenhouse Gas Initiative (RGGI), California, and some Canadian provinces. The RGGI began trading permits among large power plants in 2008 and continues to operate among nine northeastern states. California recently started an important new emissions trading system, though the Golden State is another example where policies to set standards for particular fuels or particular modes of power generation are in danger of undermining the emissions trading plan [“Assembly Bill 32”].

Parallels with Obamacare

One can draw an interesting analogy between the evolution of American political attitudes toward market mechanisms in the area of federal environmental regulation and Republican hostility to the Affordable Care Act, also known as Obamacare. The lynchpin of the programme is the attempt to make sure that all Americans have health insurance, via the individual mandate. But Obamacare is a market mechanism in that health insurers and health care providers remain private and compete against each other. As has been pointed out countless times, this was originally a conservative approach, designed to work via the marketplace: The alternative is to have the government either:

  1. directly provide the health insurance (a ‘single payer’ system, as in Canada; or under US Medicare for that matter); or
  2. directly provide the health care itself (‘socialised medicine’, as in the UK; or the US Veterans Administration hospitals).

The new approach was proposed in conservative think tanks such as the Heritage Foundation. It was enacted in Massachusetts by Republican Governor Mitt Romney. By the time President Obama adopted it, however, it had become anathema to Republicans, most of whom forgot that it had ever been their policy.

One can trace through the parallels between air and health care. The market failure in the case of the environment is that pollution is what economists call an externality – in an unregulated market, those who pollute don’t bear the cost. The market failure in the case of health care is what economists call ‘adverse selection’ – insurers may not provide insurance, especially to patients with pre-existing conditions, if they have reason to fear that the healthy customers have already taken themselves out of the risk pool.

Government attempts to address the market failure can themselves fail. In the case of the environment, command-and-control regulation is inefficient, discourages innovation, and can have unintended consequences. For example, CAFÉ standards (Corporate Average Fuel Economy) were partly responsible for the rise of the SUV. When ‘New Source Review’ requires that American power companies adopt the most stringent available control technology if they build a new power plant, they respond by keeping dirty old plants running as long as possible (Stavins 2006). In the case of health care, a national health service monopoly can forestall innovation and provide inadequate care with long waits. In general, the best government interventions are designed to target the failure precisely – using cap-and-trade to put a price on air pollution or using the individual mandate to curtail adverse selection in health insurance – and otherwise let market forces do the rest more efficiently than bureaucrats can.

American conservatives often talk as if the alternative they would prefer is no regulation at all. But few in fact would want to go back to the unbreathable pre-1970 air of Los Angeles, London or Tokyo. Even those few who might want to should recognise that most of their fellow citizens feel differently. Political reality shows that the alternative in practice is an inefficient rent-seeking system in which solar power, corn-based ethanol, and fossil fuels all get subsidies or mandates. Analogously, few conservatives in fact will say that they want hospital emergency rooms to turn away critically ill patients who lack health insurance. Even for those who might want this, reality shows that the alternative in practice is hospitals that give emergency care to those who lack insurance, whether because of personal irresponsibility or for reasons beyond their control, and then pass the charges on to the rest of us.

A third example is the Earned-Income Tax Credit (EITC). It was originally considered a conservative idea; an implementation of Milton Friedman’s proposed negative income tax, it was championed by Ronald Reagan as a pro-work market-friendly way of addressing income inequality. President Obama proposed expanding the EITC in his State of the Union address last month. But conservatives, again forgetting that it was their own creation, have opposed expansion of the EITC as verboten redistribution. So proposals to increase the minimum wage get more political traction as a way to address income inequality, even though that approach is more interventionist and less efficient.

Editor’s note: This is an extended version of an op-ed published at Project Syndicate. Comments may be posted there.

References

Ellerman, A D, P Joskow, R Schmalensee, J-P Montero and E Bailey (2000), Markets for Clean Air: The US Acid Rain Program, Cambridge University Press, Cambridge, UK.

International Carbon Action Partnership (2014), Emissions Trading Worldwide - ICAP Status Report 2014.

Littell, D (2014) “Putting a Price on Carbon,” Public Utilities Fortnightly, February.

OECD (2013), Effective Carbon Prices.

Schmalensee, R and R Stavins (2013), “The SO2 Allowance Trading System: The Ironic History of a Grand Policy Experiment”, Journal of Economic Perspectives 27(1), pp. 103-122.

Stavins, R (2003), “Experience with Market-Based Environmental Policy Instruments,” in K-G Mäler and J Vincent (eds), Handbook of Environmental Economics, Elsevier Science, Amsterdam, pp. 355-435.

Stavins, R (2006), “Vintage-Differentiated Environmental Regulation”, Stanford Environmental Law Journal 25(1), pp. 29-63.

Stavins, R (2011), “AB 32, RGGI, and Climate Change: The National Context of State Policies for a Global Commons Problem”, An Economic View of the Environment, 31 March.

 

Topics: Environment, Politics and economics
Tags: Cap-and-trade, environment, EU ETS, global warming, healthcare, market-based mechanisms, Obamacare, pollution, regulation

Jeffrey Frankel

Professor of Economics, Harvard Kennedy School

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