Carbon Cutting with Cap and Trade: A ‘Step in the Right Direction, but … Far from Ideal’

In the war on carbon dioxide, the chief culprit in global warming, taxes are out and “cap and trade” is in, as key legislation moves forward in the U.S. Congress.

But will the watered-down proposal work?

It could, most experts believe, if the final plan doesn’t have too many loopholes and inspires similar action in China, India and other big carbon emitters that have yet to jump on the global-warming bandwagon.

“Do I think the bills we are talking about would do the trick? I think so,” says Paul R. Kleindorfer, professor emeritus at Wharton and professor of sustainable development at INSEAD in France. “The standards are steep,” adds Matthew White, a professor of business and public policy at Wharton. “If you believe it’s worth spending a lot of money to clean up the environment, then this is a bill you would support.”

On May 21, the House Energy and Commerce Committee approved a 930-page bill, the American Climate and Energy Security Act, to cut carbon dioxide emissions to 17% below 2005 levels by 2020. If the bill’s current reduction goals were implemented, electricity costs would rise by 5% to 20% around the U.S., with costs going up more in areas heavily dependent on coal-powered generation, White estimates. That could cost the average household $100 to $150 a year. Gasoline prices could rise by 20 cents a gallon, costing the typical household $150 a year, he says.

The bill, generally supported by Democrats and opposed by Republicans, has a long way to go for final approval and could be blended with other environmental measures introduced in 2008. But the various bills appear to settle two controversial issues, giving the nod to the cap-and-trade approach over a carbon tax and providing for most permits to pollute to be issued at no cost rather than be sold at auction.

Many experts feel the measure, dubbed ACES, is the third-best approach to global warming, behind a tax or a cap-and-trade system that required polluters to pay for permits. But many concede the no-auction cap-and-trade alternative is the most politically feasible.

Subject to Misbehavior

Still, much is uncertain, says Noam Lior, professor of mechanical engineering and applied mechanics at Penn’s School of Engineering and Applied Science. He notes that the quality of emission monitoring would be the key to cap-and-trade success. The bill “is a very good step in the right direction, but it’s far from ideal. It’s quite confusing and also subject to a whole bunch of misbehavior,” he says, pointing out that many industries work hard to skirt regulations.

After years of debate, most scientists now agree that the world’s climate is warming, and that the release of carbon dioxide from the burning of coal, oil and other fossil fuels is the chief cause. Greater use of carbon-free alternatives such as wind, solar, nuclear and geothermal energy can help reduce the problem, but carbon fuels are expected to be essential to the world economy for many decades. Scientists and policy makers have been searching for ways to reduce reliance on carbon fuels and to reduce the carbon emitted when they are consumed.

The simplest approach is to place a tax on carbon emissions, giving manufacturers, power companies, automobile owners and other energy users a financial incentive to cut back or invest in cleaner technology.

A carbon tax would be fairly simple to administer and would generate revenue the government could use to support environmental research or to provide relief to those who would suffer most as fuel prices rose, such as the poor.

“If you just look at the general issue from a pure academic and economic point of view, then many people are supportive of taxes — without considering the politics,” says Eric W. Orts, director of Wharton’s Initiative for Global Environmental Leadership. “As a theoretical matter, there’s a lot to be said for taxes. But practically, I think, there are a lot of reasons it is not viable right now. First, ‘tax’ is a four-letter word in the United States.”

And there is no guarantee the tax revenue would not be diverted to other purposes.

“As soon as Uncle Sam is in the middle of that process — even though I’m a big fan of Uncle Sam — he kind of gets in the way,” Kleindorfer says.

For many, cap and trade is a more palatable alternative. “It’s really done as a political device,” says White, noting that cap and trade doesn’t look like a tax, even though it would increase energy costs, just as a tax would, as polluters pass costs on to consumers.

To work, cap and trade must lead to higher fuel costs; or else there would be no incentive to cut back. But it’s easier to sell the public on a “market-based solution” than a government-imposed tax, Kleindorfer says.

Under cap and trade, the government would set limits on carbon emissions — caps — and issue “credits” allowing factories, refineries and other energy users to emit given amounts of carbon dioxide. Typically, one credit conveys the right to emit one ton of carbon dioxide, about the amount created by burning 100 gallons of gasoline. Initially, 85% of credits would be issued for free, with specific allocations to given industries such as electricity utilities, car makers and oil refiners. The remaining credits would be auctioned at a minimum of $10 each.

Companies that find ways to emit less than they are allowed could sell their excess credits at market-based prices to firms that find reducing emissions too difficult or expensive. In theory, this means emission reduction is done by firms that can do so at the least cost, keeping the economic impact to a minimum. Over the years, the caps would be gradually reduced and more of the credits sold at auction, with prices presumably rising as supplies got smaller.

In the U.S., a cap-and-trade system has been used for nearly two decades to reduce emissions of sulfur dioxide, the cause of acid rain, to less than half of 1980 levels.

“That is widely considered to be one of the most successful environmental measures in the 20th century,” says White. “Cap and trade is more compatible with the capitalist system,” Lior says. “It works well with the sulfur dioxide emission control.”

Orts, however, notes that much of this success can be traced to technological breakthroughs that made it relatively cheap and easy to reduce sulfur dioxide emissions. Also, sulfur dioxide is washed out of the atmosphere by rain, limiting the effects to areas downwind of emitters like coal-burning power plants. Carbon dioxide is different, dispersing throughout the atmosphere from every release point to aggravate the problem worldwide.

Worldwide Remedy

It is essential, therefore, to have a worldwide remedy. That makes the tax approach difficult, since there is no international tax authority. Advocates say cap and trade is more suitable to a global problem because the credit-trading system can work across borders. An electric utility in China could buy permits from a cleaned-up oil refiner in the United States.

Cap and trade has been used to attack carbon dioxide in the European Union since 2005, in a process designed to meet member countries’ obligations under the 1997 Kyoto Protocol. Critics complained that the first two years of the program were ineffective because too many pollution credits were issued. Critics say the overabundance left little incentive to cut emissions.

But defenders say the second phase of the program, which began in 2007, has been much more stringent, and the program has led to formation of an active permit-trading market, which is essential to making the system work.

President Barak Obama has strongly advocated an auction system for carbon credits. Making companies pay for the right to pollute gives them an immediate incentive to clean up and would produce revenue the government could use to fund energy programs. But business groups have lobbied against auctions, arguing they would be too expensive, and lawmakers have backed off this requirement in order to get the legislation passed. The Obama Administration supports the bill in its current no-auction form.

That brought mixed reactions among environmentalists. Many were glad to see progress, others were infuriated. Greenpeace and several other environmental groups say they will not support the bill because it would cut carbon emissions to only 4% below 1990 levels rather than the 25% to 40% they say is needed. The bill’s goals for stimulating renewable electricity sources — 6% of electricity production by 2012 and 20% by 2020 — are inadequate, they say, and issuing pollution credits for free amounts to a “massive giveaway” to polluters.

“Despite the clear and present danger posed by global warming, there is precious little leadership on the issue here in America and abroad,” the groups said. “If America does not meet its responsibility to control greenhouse gas emissions, it would be an invitation to developing countries that they, too, can shirk their responsibilities — all but guaranteeing catastrophic climate change.”

Business groups like the U.S. Chamber of Commerce also criticize the bill, saying the credit allocation is unfair and that the program is too expensive.

Despite the plan’s shortcomings, cap and trade should work, says Kleindorfer, arguing this approach satisfies a worldwide clamor for a global warming policy, a general bias for market-based solutions over government programs and the fact that money is tight in the financial crisis.

While government would set the emission caps, industries and individual companies would be left to find their own ways to cut back, he says.

“There’s definitely an expectation that it will have to be markets and market-based institutions that bear the primary responsibility for moving ahead,” he notes, adding,

“The government sets the cap and industry does the trading.”

From his vantage point in Paris, he has seen rapid advances in carbon-reduction measures during the past four years, with a lively trading market for credits and widespread innovation in energy efficiency. “It’s just been astonishing to me just how much gold they have found,” he says. “You turn engineers loose with a dictate [to cut carbon emissions by 20%] and they come back and say, ‘What’s with this 20 number? How about 30 or 40? And what’s with 2020? How about 2015?”

If the U.S. passes the kind of legislation now moving through Congress, carbon trading will jump from a $118 billion market in 2008 to $500 billion in 2012, he predicts. Other experts say the market could exceed $2 trillion by 2020. The market-based system has spawned a range of carbon-credit players, including brokers, traders, consultants and financiers, and it has encouraged imaginative remedies that bring together companies in unrelated industries, Kleindorfer says.

The overarching goal is not just to cut emissions in the United States and Europe, but to get China, India and other major economies on board, he argues. For that to happen, the U.S., a top carbon polluter, must lead, and it has not been able to because former President George W. Bush, arguing that compliance would be too expensive, did not send the Kyoto Protocol to the Senate for ratification. Adopting cap and trade would vault the U.S. into a leadership role, Kleindorfer argues, especially if it were done before a December meeting in Copenhagen to replace the Kyoto Protocol, which expires in 2012.

“If you don’t have India, China and some of the other developing countries like Indonesia and Brazil opt in… then you’re not going to solve the problem,” Orts adds.

The bill still has to pass through other House committees before being presented to the full House for debate, possibly this summer. Then it faces a tough battle in the Senate, where a similar measure failed last year.

“This is a kitchen-sink bill at the moment and a lot is in flux,” White says. “So things could change.”

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