Making sense of pollution markets

Trading carbon credits will clean up state better than heavy-handed regulation

Sunday, July 15, 2007
By Joe Nation

Here are my imaginary results from a public opinion survey taken in late June:

• Teenagers (and adults) who closely followed Paris Hilton’s jailhouse stint? 87%
• Adults who can name U.K.’s new Prime Minister? 4% (Sorry, Mr. Brown.)
• Californians who understand how a carbon market will reduce greenhouse gas (GHG) emissions? 1% (with a margin of error of 3%).

These are only imaginary, of course, but they may reflect the actual state of public opinion, especially as it relates to greenhouse gases and climate change.  How will a carbon market work?  Will it really reduce GHG?  And why are we heading in a direction that, as many say, gives the right to pollute for a price?

The explanation, once again, begins with the climate change policies we are developing.  The Kyoto Protocol, adopted by nearly 170 nations—but not the United States—established the first regulated carbon market.  AB 32, California’s Global Warming Solutions Act, is expected to lead to a carbon market in California.  Some activists, notably the Climate Protection Campaign, have even argued for personal carbon budgets (i.e. individual limits on GHG emissions).

This carbon market, synonymous with “cap and trade,” does allow pollution for a price.  But it limits the total by issuing (by fiat) maximum GHG emissions or by auctioning these pollution rights.  Either of those actions creates a market where emissions permits can be traded.

At first glance, a carbon market is like most other commodity markets, such as oil or wheat, or a consumer market for food, cars, MP3 players, and so on.  Sellers offer a product at a price; buyers offer to buy that product, and a market with fairly stable and predictable quantities and prices emerges.

Critics of a carbon markets object mostly on philosophical grounds, arguing that we can’t put a price on clean air, clean water, or climate change.  Instead, they advocate regulation.  But history has shown that regulation typically costs much more and may lead to poorer results.  For example, the Acid Rain trading program (a cap and trade system for Sulfur Dioxide emissions) has achieved nearly 100% compliance with program cost savings estimated up to 65% compared with a pure regulatory approach.

While a carbon market looks like most other markets, a more important question is precisely how a carbon market will reduce GHG emissions.  Some critics, in fact, suggest that a carbon market won’t actually reduce GHG emissions.

AB 32, California’s Global Warming Solutions Act, sets an economy-wide cap on GHG emissions.  In addition, individual entities will face annual GHG emission caps.  Let’s assume a very simple world with only two companies (called simply Company A and Company B), each with an emissions limit of 100 tons of CO2, the major greenhouse gas.  In the first year, economy-wide emissions are 200 tons.

Obviously, in this first year, there is no required reduction in greenhouse gases—we simply maintain the status quo.  But in subsequent years, because AB 32 calls for declining economy-wide emissions, each company will be forced to reduce their emissions.  Without that economy-wide cap and reduction, critics would be right: the carbon market would result in the trading of GHG emissions, but no overall reductions.

The overall reductions required by AB 32 are substantial: a return to 1990 emission levels by the year 2020, about a 35% reduction from where we are today.  In this simple example, that requirement translates into a cut of 35 tons for each company, or 70 tons total.  (The goal for California by the year 2050 is even more dramatic, nearly a 90% cut from today’s levels.)

Both companies in this example would likely begin to reduce their own CO2 emissions by installing solar panels, buying biogas digesters, improving insulation, and other measures.  In fact, each will try to reduce as possible because failing to reduce will result in stiff financial penalties.  In Europe’s system, for example, the penalty for failing to meet targets is currently about double the market price, and it jumps to five times that price in 2008.

Assume that Company A reduces its emissions by 50 tons, more than it’s fair share of 35 tons.  Assume also that Company B falls short, reducing only 20 tons.  (Company B probably fell short because the costs of reducing were far higher than for Company A.)  Since Company B has missed its reduction target, it must purchase the extra 15 tons from Company A.  In the end, Company A is rewarded, and Company B is penalized.

Under a regulated approach, Company A would have stopped reducing at 35 tons.  And Company B would have either been forced to reduce 35 tons (rather than 20) or face large fines.  That regulated approach may have led to the same result, but the costs would almost certainly have been higher.

Here’s the key point.   Each company has a financial incentive to reduce as much as possible.  That incentive will remain as long as overall reductions are required.

And here’s another key point.  As long as there is a declining cap, a carbon market will reduce GHG emissions more than a regulated approach, and those reductions will cost less.  That market does put a price on pollution, in this case, on GHG emissions.  However, contrary to criticisms, this market makes polluters pay more while the good guys pay less.  And that is exactly the approach needed to beat climate change.

Joe Nation a former member of the state Assembly from Marin County, teaches climate change at Stanford University.