Cap & Trade: Making Dollars & Sense

In a further attempt to prove that being a Republican is different from being Dubya, John McCain has called for a mandatory limit on greenhouse gas emissions in the United States and embraced the formation of a cap-and-trade system. McCain, Clinton, and Obama all support some form of cap-and-trade scheme in order to reduce carbon emissions.

As economists, we love this. For tree-huggers, sentiments are a little more mixed.

But first: why cap-and-trade makes economic sense. Because different firms face different marginal costs of abatement, requiring all firms to cut emissions by a given amount will not have the same costs across the board. However, if firms are allowed to trade permits, those facing the lowest costs of abatement will reduce emissions the most, while those facing higher costs will pay them to do so (see figure below).

Note: MB_emissions = MC_abatement

Type I firms face higher marginal costs of emissions abatement than Type II firms. Assuming an equal number of both types, each type would be required to reduce emissions to E/N if they did not trade permits. With trade, Type I firms would be willing to pay up to a for an additional permit. Likewise, Type II firms would be willing to sell a permit at a price of b. Trades will therefore take place as long as the marginal abatement costs to Type I firms exceed those faced by Type II firms, establishing the equilibrium price P_permits.

Both types of firms benefit from trading permits—Type I firms pay area D for permits, but save areas C+D in avoided abatement. Type II firms must pay area B in extra abatement costs, but receive A+B for the permits they sell. Therefore, A+C is the net social gain resulting from tradable emissions permits.

A tradable permit scheme therefore minimizes efficiency losses associated with the uncertainty of marginal benefit, but it also ensures that the government does not see large windfalls from rent associated with auctioning, that market forces determine where the allocations end up, and, most importantly, that emissions are reduced to a certain targeted value. The aggregate amount of emissions remains fixed at E*, which is a plus for tree-huggers.

However, because cap-and-trade only puts a limit on total emissions, concerns arise relating to localized pollution. As a result of trading permits, it is possible that certain areas will become more concentrated in terms of emissions. This can impose significant negative externalities on residents in these areas, and the local environment.

In addition, there is the larger issue concerning linkages between money and the environment: can we really put a price on pollution? Can we really grant the right to pollute?

I can't answer those questions, but from an economic standpoint, adopting a national cap-and-trade policy not only maximizes efficiency for firms facing different marginal costs of abatement, but also offers reduction in greenhouse gas emissions that we so desperately need.