Wednesday, July 29, 2009

Cap and Trade

Last month the U.S. House of Representatives narrowly passed the "American Clean Energy and Security" (ACES) Act, which would regulate the pollution that is responsible for global warming. The centerpiece of the bill is the establishment of a "cap and trade" system -- a market-based approach that was successfully used during the last two decades to reduce acid rain. Of course all markets have winners and losers, and how the rules are written determines which side you end up on.

The basic idea of a cap and trade system is simple. First you determine how much pollution can be allowed, and you limit or "cap" total emissions at that level. The cap is initially set slightly below current levels, and it is lowered slowly over time to the final goal. Polluting is no longer free -- every polluter must have permits to cover their emissions. Those who figure out how to reduce their emissions can sell or "trade" their permits to polluters who have more trouble meeting the new requirements. As the number of permits is reduced over time the market price goes up, creating an incentive to reduce your emissions and sell the permits for a profit. In 1990 a cap and trade system was established for sulfur, a common pollutant from coal burning that produces acid rain. Congress mandated a 50% cut in sulfur emissions over 20 years, but the cap and trade system worked so well that it only took 15 years to achieve the goal. Initial worries about the possible economic impact were revealed to be entirely wrong.

The ACES Act would establish a similar system for carbon, which arises primarily from burning fossil fuels and contributes to global warming. The bill requires carbon emissions to be 17% below 2005 levels by 2020, and 83% below 2005 levels by 2050. The long-term goal is based on a scientific assessment of what will be required to avoid the worst consequences of climate change. The short-term goal is somewhat disappointing, since emissions cuts are similar to compound interest -- the more we do early, the greater the long-term impact. The other important feature is how pollution rights are distributed -- the bill initially gives away 85% of the emission permits to energy companies and electric utilities for free! This fraction is gradually reduced to only 30% by 2030, but it still means huge potential profits for these businesses -- even though some of the revenue is required to be given to customers as rebates. The remaining permits are sold in an auction with most of the proceeds divided equally among all citizens and a small fraction reserved just for low-income families. The idea is to help offset the potential increase in energy prices.

An alternative vision for the carbon cap and trade system was outlined in the 2001 book "Who Owns the Sky?" by Peter Barnes. He believed that every American should get an equal share of the emission permits, and the energy companies should be required to buy them from us! The extra costs that the energy companies would inevitably pass on to consumers would be perfectly offset for the average customer by the extra income from selling the permits. Customers who found ways to decrease their energy consumption would end up making money -- providing a strong personal incentive for conservation and efficiency, which is one of the least expensive ways to reduce global warming emissions quickly.

This bill isn't perfect, but it's a step in the right direction. The Senate is expected to consider similar legislation sometime this fall. With luck a compromise bill can be signed into law before the international climate negotiations in Copenhagen this December.