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Cap and Trade is Economics’ Answer to Climate Change

With 2020 marking the largest wildfire season for California[1] , a consequence largely of man-made climate change [2] , the threat of the climate crisis is proving itself to be existential each day. Policymakers have begun to pay attention to the means of mitigating the crisis – the idea of a carbon tax has taken the lead in the popular eye as one of the measures. The issue with the singular popularity of the carbon tax is that the solution of a problem as multifaceted as climate change cannot be one-dimensional; the ideal solution needs to be a hybrid of multiple policies, the best example of which we see in cap-and-trade.

As Abhijit Banarjee and Esther Duflo note in their book Poor Economics [3], “Talking about the problems of the world without talking about some accessible solutions is the way to paralysis rather than progress.” Climate policy might largely be an economic problem, but economic research on the same can hardly be called scarce.

Carbon emissions and climate change are something economists call a negative externality – a cost that someone unconnected from the activity which causes the externality incurs. A simple solution to such costs would be to punish activities which cause them. Generally, economists agree that the aforementioned carbon tax is a significant step forward [4] . The carbon tax is a stable tax per ton of carbon emitted in an activity – the tax generally translates to higher prices of goods and services which are carbon-intensive. Much like taxes on soda, the carbon tax is like a sin tax, it aims to dis-incentivize consumption (and by extension – production) of carbon. A tax of USD 70 per ton of carbon dioxide by 2030 could help many G20 countries hit their Paris Climate Agreement goals, according to an IMF working paper [5] . Such a tax would also help to counter the effects of road transportation, which is quickly becoming a massive contributor to global warming [6] . A hybrid of the carbon tax and cap-and-trade [7] is likely to be a better option than the former alone. The introduction of a market which punishes emissions might help more than the direct punishment of emissions alone.

Cap-and-trade, the lesser-known counterpart of the carbon tax, is a market-based system where companies and industries are allocated emission caps – a set amount of greenhouse gas they are permitted to emit – by the government. These caps are like tokens. They can be traded between companies; if a company has excess allowance they can sell the allowance to another company which has reached its cap for emission. The idea is to cap off the total emissions of a market by the creation of another market which deals in these government allocated allowances. This effectively incentivizes reduction of emissions to either maximize profits by selling excess allowances to those who have exhausted it or by dodging the need to buy excess allowances through means of curbing emissions. The government keeps on reducing the number of these permits overtime which further makes clean energy a favourable alternative to expensive carbon permits. As clean energy becomes cheaper, a manufactured increase in the price of carbon is bound to make clean energy a preferable option. Not only does this achieve the aim of reduced emissions, but it also does so without significantly harming industries.

Unlike what many argue, cap-and-trade does not have to be an alternative to the carbon tax – it can be an incredibly effective complement to it. To implement such a policy, political support is instrumental. It is natural to expect resistance from carbon dependent industries. An analysis by the Center for Climate and Energy Solutions* [8] informs us that when carbon allowances are allocated for free, political support for cap-and-trade rises. But a complete commitment to free allocation may come at the cost of losing out on revenue via auction. Globally, 70% of revenue via carbon allowance auctions were designated for funding green solutions [9] .

A market for allowances also pushes for innovation in industries, to discover ways to reduce carbon use. That the oil industry will face losses is inevitable (and desired) but industries which don’t heavily rely on carbon will be rewarded by default and those who switch to low carbon systems will emerge triumphant in profits.

It seems like a no-brainer economic policy to implement but there are specifics to be considered. Should offsets, activities (such as afforestation or even ceasing deforestation) by companies which contribute to reducing emissions, be factored into the allocation of carbon allowances? There are arguments which suggest this would do more harm than good. ProPublica, a public interest newsroom, argues that offsets are ineffective, to say the least [10]. Others claim that the integrity of offsets is hard to verify – whether offsets such as afforestation programs work in the long term is not always clear. Environmental justice advocates argue that offsets shift the geography of emissions, targeting poorer minorities [11]. On the other hand, is the idea that offsets incentivize reductions of emissions among industries with little scope of carbon trading and aid in financing climate mitigation programs outside the host nation.

There’s evidence that cap-and-trade works; the European Union claims that their cap-and-trade program – Emission Trading System (EU ETS) has reduced greenhouse gas emissions “by an average of more than 8%” [12] from 2005 to 2010. There is some evidence to suggest that cap-and-trade is incredibly self-reliant as well. In their paper, Robert Hahn and Robert Stavins [13] found that certain forms of cap-and-trade (including the aforementioned EU ETS) systems can perform efficient allocation of allowances and negotiation within interest groups without sacrificing the set environmental goal, it’s a market which requires little supervision and further regulation. Effectively, cap-and-trade is the best of economics rolled up in a policy. It is imperative that policymakers push for it to be considered at a global level – the opportunity cost of not doing so might be larger than any cost-benefit analysis can show.

*The analysis excluded CAT with offset systems.
By Adit Seth

References: 1.
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