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Cap & Trade – The Pitfalls

By Wei Seng

Cap and trade... away our future?

Annie Leonard of The Story of Stuff project has come up with a (relatively) new video about the problems of a oft-recommended solution to climate change: cap and trade. While in Economics we learn that such measures that involve the market are the best way to deal with the problem, it is arguable whether we can use economic measures to solve a problem supposedly created by the theories of economics.

Cap and trade, or emissions / carbon trading, is where the government imposes a limit on the amount of carbon dioxide that can be emitted into the atmosphere (a cap) and firms that emit carbon dioxide in their production processes would be issued permits by the government so as to be allowed to pollute, with the number of permits fixed within the limits and with fewer of these permits issued over time so as to reduce the amount of carbon dioxide emitted. Companies that effectively cut down on emissions can then sell excess permits to other firms that are unable to do so (the trade part), hence theoretically creating incentives to reduce emissions.

The problems arise in the details and implementation, as Annie Leonard claims. First she takes issue with the fact that these permits are issued for free rather than sold to the firms (cap and give-away), which might not give as much incentive to cut pollution as opposed to the government selling the permits so that the firms have added incentive to cut down on emissions (adding a stick - the need to buy even basic amounts of permits to pollute - on top of the carrot - the sale of excess permits as a result of reducing emissions). The money raised from selling the permits can then be used for policies to combat climate change (such as developing a clean energy economy).

She then raises the problem of offsetting, and how firms also have the incentive to cheat, through false claims of emissions reductions, so as to profit from the scheme. The example Leonard used is when a firm in Indonesia (Sinar Mas) cut down primary forest and then planted oil palm trees on it, the firm claimed offset credits that can then be sold to other firms to allow other firms to pollute. The cutting down of the forest was not accounted for under the scheme, but the planting of the oil palm trees were. Unfortunately, the cutting down of primary forest would have created emissions to more than offset the amount of carbon dioxide reabsorbed by the oil palm trees. Firms can also make false claims about intentions that allow them to bankroll the credits and continue just as usual.

But what she is most miffed about is that the cap and trade scheme distracts people from real solutions, and that the rush to implement cap and trade without a global agreement to police it in developing countries where many of these firms operate (not coincidentally, many of these countries have lax environmental legislation and regulation). She champions for government regulation of carbon dioxide, i.e. not to resolve carbon emissions through the market system, not to protect business as usual but instead impose stricter laws against carbon emissions. She is vague about the details but presumably measures that can be introduced by the government could include a carbon tax.

It is often hotly debated whether economics can be effectively used to combat the environmental problems we face. The theories and concepts we learn in economics, from rational decision-making to the invisible hand and profit-maximization, can supposedly be applied in ways such as cap and trade. However we also learn about market failure, and how the government will have to step in sometimes. Detractors (in America's case, the Republicans / conservatives) believe that government failure is the problem and place greater faith in the markets, but I agree with Leonard when she says that we "cannot solve a problem with the thinking that created it". Both the government and markets have to rethink in the face of the climate change crisis and cannot stick to business as usual.

James Hansen, in an article in The New York Times around the time of the Copenhagen climate change summit last December, agrees that cap and trade does nothing much for the environment or energy security of America, only to allow "polluters and Wall Street punters to fleece the public out of billions of dollars". He uses more concrete arguments than Leonard, with his assertion that logically carbon prices would collapse if everyone were to emit below the cap, hence eliminating the incentive to reduce emissions. Many concessions were also issued such that many coal plants could be excused from the regulations and trading, which would then defeat the whole purpose and objective of reducing carbon emissions. And while there can be an "optimal" / "socially efficient" level of pollution in the atmosphere, can there be an optimal amount of people affected by diseases associated with the burning of coal for power generation? Hansen also raises Leonard's concerns about offsets.

Hansen offers a more concrete solution: fee and dividend. It works like a carbon tax, jacking up the costs of goods that are more pollutive, but there is an added dividend: money collected goes back to the public, whereby they can then make individual decisions about whether to buy the less-pollutive (and technically speaking cheaper / lower-taxed) product. It encourages individual action, and that every effort counts, unlike cap and trade which while operating on a national and technically speaking larger scale, mainly affects the producer and does not engage consumers directly in the quest for a cleaner environment.

I would advise watching the video as well as reading the article by Hansen, to get a better idea about cap and trade. Cap and trade is in itself quite a complicated mechanism that I cannot fully explain, and while Leonard recognizes that cap and trade might be seen as an acceptable compromise solution for both environmentalists and economists, we should not let cap and trade distract us from other solutions out there that can truly solve the environmental problems we face.