Why would the Obama administration allow new drilling in U.S. coastal areas, and what will it mean for greenhouse gas reductions? My colleague Frank Ackerman has a posting on the TripleCrisis blog today on off-shore drilling, peak oil, and how they relate to a carbon tax:

Solving our energy problems, without a change in direction, will lead to increasingly costly and environmentally destructive production – either deep offshore, or deep in the rocks below existing communities and watersheds. We need a tax (or a fee resulting from an allowance system) on energy, to keep the cost to consumers high enough to encourage conservation, while holding the price for producers low enough to discourage the pursuit of the worst fossil fuel deposits.

This is another way in which the distributional consequences of carbon permit giveaways (i.e., who gets the revenue – see Alejandro Reuss’ Public Goods posting from earlier this week) differ from those of permit auctions. A cap and trade system will increase the price of oil exploration only if businesses have to pay for their permits; if permits are given to the largest polluters for free, there will be no incentive to limit fossil fuel extraction from areas where underground reserves are not very rich and the environmental consequences of extraction are enormous.

Most economic analyses of “cap-and-trade” policies – under which the government sets a target amount of emissions and then issues tradable permits totaling that amount – take it for granted that it would not make any difference, in the reduction of emissions, if the government were to sell the permits or give them away. A 2008 report on cap-and-trade climate policies from the MIT Center for Energy and Environmental Policy Research puts it like this: “Economic theory suggests that the method of distributing emission allowances, i.e., through grandfathering or auctioning, will not affect an individual source’s output decisions or emissions.”

If firms always make optimal decisions, maximizing their profits, as mainstream “neoclassical” economists assume they do, this conclusion should be correct. It shouldn’t make any difference to a profit-maximizing firm whether, by reducing its emissions, it avoids the cost of buying emissions permits or reaps the benefit of selling permits. Either way, it will reduce emissions as long as the cost of doing so is less than the price of the permit.

But are real-life firms really the perfectly rational profit maximizers of the neoclassical economists’ imagination? Some insights from behavioral economics suggest they may not be, and therefore that they may react differently to a policy that makes them buy emissions permits compared to one that gives them permits for free.


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.

Climate policy, in Congress, has become synonymous with cap-and-trade proposals, spawning an endless and only occasionally illuminating debate. Is cap-and-trade the only affordable, market-friendly way to introduce a carbon price and harness the efficiency of the market? Or is it a sham that promotes bogus offsets in place of real emission reductions, and gives away valuable allowances to influential industries?

Here’s a different idea about what’s wrong with cap-and-trade in practice: The caps on emissions have frequently been set too high to make any difference. Both the claims of low costs for cap-and-trade policies and the complaints of their ineffectiveness could result from non-binding caps – that is, legal “limits” on emissions that are higher than the amount industry plans to emit. No change in behavior is required, and it’s no surprise that this lowers costs; it’s cheaper to do nothing than something.

In a careful analysis of existing programs, University of San Diego law professor Lesley McAllister found that some, such as Phase I of the EU’s carbon trading scheme, had caps that exceeded emission levels throughout the life of the program. In other cases, such as sulfur trading under the U.S. acid rain program, the caps were set much higher than emissions in the early years, so that banking of unused allowances postponed the effect of later, somewhat lower caps. The current recession has lowered production and emissions so much that some well-intentioned plans, such as the EU’s reduced cap for Phase II of carbon trading, may also turn out to be non-binding in practice.

The solution is to set emission caps low enough to actually require major investments in new, emission-reducing technologies (wasn’t that always the plan?); to limit banking of unused allowances; and to periodically revisit the caps, adjusting them downward whenever feasible. Or, of course, give up on cap-and-trade and try something different.

Lesley McAllister and I are both member scholars of the Center for Progressive Reform, a great source for analysis and commentary on a wide range of issues about public policy, law, and the environment.