Cap-and-Trade

Cap-and-Trade

A cap-and-trade system starts by specifying the desired level of emissions (the cap), then allows markets to determine the price of emissions permits. If technology makes it cheaper to produce clean energy, then the price of those permits will fall. In fact, a main goal of cap-and-trade is to create an incentive to produce cleaner energy.

For a cap-and-trade system, an important distributional concern is how the initial levels of permits are allocated. Should a factory that has been belching black smoke for years be allocated a large number of permits that it can sell by cleaning up its act? One worry is that because such laws do not get passed instantaneously, polluters would delay cleanup, hoping for a bigger initial allocation. The allocation rule therefore matters both for who bears the costs and for what firms do before the system begins.

Readers might ask why we are putting so much emphasis on economic incentives in this domain, when we raised questions of the possible downsides of making patients pay for a portion of their health care expenses through deductibles and co-pays. That is a fair question. Our ambivalence about the importance of giving health care consumers incentives to economize on their use of doctor visits and prescription drugs stems from the evidence suggesting they are not very good at making these trade-offs. An economist would say that patients do not know their own health “production function.” We do not want people who have had a heart attack to cut back on their drug regimen because their car broke down this month and they can’t tell whether the hypertension drug is doing anything for them.

At the consumer level, the relation between energy consumption and behavior is at least somewhat more transparent. Raising the thermostat in the summer and lowering it in the winter has clear effects, which, by the way, could be made even more salient and transparent. In other domains, prices could help signal the implicit emissions, associated with consumption, that are less obviously related to climate change. For example, raising beef for consumption is one of the most greenhouse-gas-intensive ways of producing food. (Cows’ “emissions” are not friendly to the environment, and the land required as pasture could have been used in some other manner that is friendlier to the environment.) If the price of beef goes up, even American Humans will eat fewer burgers.

The more important reason we favor economic incentives to deal with this problem is that much of the behavior that needs to change is conducted by firms. If firms see high prices for carbon emissions, they will have every incentive to innovate on every possible front, from producing Teslas to the plant-based Impossible Burger.

In exploring economic incentives, we have focused on taxes and cap-and-trade, but there are alternative ways to align incentives. Political leaders (and some climate researchers) in many nations have called for subsidies, which in some circumstances might have the same effects as taxes, but which might be far more palatable to the public, because they offer gains and do not impose losses. For example, the authors describe US subsidies for electric cars alongside gasoline taxes that were low compared with those in many other countries. This reflects a political judgment. The circumstances in which subsidies are an appropriate policy instrument raises complex questions that we do not engage here. Although we believe that subsidies can play an important role, they are inherently a patchwork approach, and let there be no doubt: someone has to pay for them.