The public debate over the possible economic implications of addressing climate change has generated a lot of heat, but not much light. One area of confusion is the difference between the price of a tradable permit under a cap-and-trade system and the overall economic impact of the program. It is true that a cap-and-trade program is one way to put a price on greenhouse gas emissions (call these carbon emissions for shorthand); a carbon tax would be a different approach to achieve the same objective. However, most would agree that ending free pollution by pricing carbon is a necessary part of a comprehensive climate and energy program. Let’s dig into the issue of compliance costs and overall societal costs and benefits.
There are two main aspects of compliance cost under cap-and-trade: the cost of reducing emissions, and the cost of acquiring tradable permits (typically called allowances). To simplify, we’ll leave aside the cost of offsets, another option under cap-and-trade. Also to simplify, assume all allowances are auctioned.
Even if they are working to reduce emissions, most businesses are likely to continue to produce emissions and need allowances to cover them for many years. But the cost of acquiring allowances isn’t a real economic cost; the money spent to pay for them does not disappear. It accumulates as government revenue. The question is what to do with that revenue: It could be returned to regulated firms, but one of the principal insights in climate policy in recent years is that regulated businesses will be able to pass along much of these costs to consumers. For this reason, there is significant momentum to return the revenue from allowances to the people or to make investments that speed and smooth the transition to a low-carbon economy.
If the emissions market is functioning, the price of an allowance should be roughly equal to the cost of the most expensive ton reduced. That’s because if every ton of carbon has a cost, firms are likely to keep paying to reduce emissions, using every option open to them, until the options are so expensive that it is cheaper to buy allowances. But again, businesses will be able to pass along a large share of these costs. And many of the investments needed to reduce emissions will produce important benefits.
Greater reliance on clean, free domestic energy sources such as wind and solar power will mean greater energy security. Less fossil-fuel combustion will mean cleaner air, improved public health, lower health care costs, and improved worker productivity and performance by students in schools. A price on carbon will contribute to progress in clean technology by providing greater incentives for those who innovate, and this in turn will boost the prospects for American business in this rapidly growing global market. And of course, there is the enormous benefit of avoiding the damages, biophysical and economic, that would result from unabated planetary overheating.
Carbon prices do not reflect these broader socioeconomic effects, and they are almost invariably left out of economic modeling of climate policy that forecast future impacts, too. For more on that topic, see my report on economic modeling of California’s global warming law.
Chris Busch, Ph.D., is policy director of the Center for Resource Solutions, a nonprofit in San Francisco that creates policy and market solutions to advance sustainable energy.