Unlocking Cost Savings with Cap-and-Trade

Much was made last week about the flexibility of the EPA’s proposed new power plant regulations. According to EPA administrator Gina McCarthy, it “gives states the flexibility to chart their own customized path. There is no one-size-fits-all solution. Each state is different so each state’s path can be different.”

Perhaps most importantly, states would be able to meet their required carbon dioxide reductions by starting a cap-and-trade program, or by joining an existing cap-and-trade program like the one that is part of California’s AB32. This approach raises legal and administrative challenges, but it also could dramatically reduce costs by incorporating emissions reductions from other sectors.

For decades, economists have emphasized the efficiency gains associated with cap-and-trade and other market-based environmental policies. The economic argument for cap-and-trade is right out of Econ 101. Every textbook teaches this the same way and I have always thought that this is the best way to understand how cap-and-trade works.

In the video, I draw marginal abatement cost curves for two sectors. If you’d like, you can think of “Sector A” as fossil-fuel power plants and “Sector B” as all other sectors. I then show how incorporating this additional sector with a cap-and-trade program could reduce costs substantially. Cap-and-trade moves abatement from high-cost sectors to low-cost sectors, thus reducing the total cost of achieving a given level of reductions.

By the way, none of this hinges on exactly what these abatement cost curves look like. In fact, with cap-and-trade we don’t even have to know, ex ante, where to find the cheap abatement. By putting a price on carbon dioxide emissions you create an incentive for abatement in all sectors of the economy.  The price efficiently allocates abatement across and within sectors, and spurs innovation in new and sometimes unexpected technologies.

And while the theory is compelling, it is also important to emphasize that cap-and-trade is not some unattainable ideal that only exists in the classroom. Think back to 1990, when President George H.W. Bush signed into law the EPA’s cap-and-trade program for sulfur dioxide.  Between 1990 and 2004, sulfur dioxide emissions decreased by 36% — yielding $50 billion annually in benefits at a cost of less than $2 billion per year (here).  Economists have estimated that, relative to technology standards, the program reduced costs by as much as 90% (here).

We have practical experience with nitrogen oxides too. EI@Haas faculty Meredith Fowlie and Catherine Wolfram, along with EI@Haas alumnus Chris Knittel (MIT) have a paper measuring the potential cost-savings from a cap-and-trade program for NOx (here).  It turns out that NOx abatement from power plants is relatively expensive, like the “Sector A” in the video, while abatement from cars and other mobile sources is relatively cheap, like the “Sector B” in the video.  Consequently, they find that there would be enormous cost savings from equating marginal costs across the two sectors.

As Max explained with his “Yoga Theorem” last week, the less flexible you are, the more you will suffer.  This is exactly the case with the EPA’s proposed regulations. Nobody can predict with certainty exactly how much these regulations would cost, but economic theory is extremely clear on the benefits of making these policies as multi-sector, and as price-based as possible. In practice, every time we have implemented market-based environmental policies, they have ended up costing less than expected and there is every reason to believe this would work again for carbon dioxide. 

About Lucas Davis

Lucas Davis is an Associate Professor of Economic Analysis and Policy at the Haas School of Business at the University of California, Berkeley. His research focuses on energy and environmental markets, and in particular, on electricity and natural gas regulation, pricing in competitive and non-competitive markets, and the economic and business impacts of environmental policy.
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8 Responses to Unlocking Cost Savings with Cap-and-Trade

  1. Josh S. says:

    Thank you for this helpful overview, especially the video. To take this one step further, how do you recommend allocating the permits to emit?

    • Lucas Davis says:

      That sounds like a great topic for a future blog post. :)
      Meredith Fowlie has written several excellent papers on this topic.

      http://ei.haas.berkeley.edu/pdf/working_papers/WP234.pdf

      http://ei.haas.berkeley.edu/pdf/working_papers/WP207.pdf

      As she writes in the second paper, “In theory, provided standard assumptions are met, the efficiency properties of the permit market equilibrium are achieved regardless of whether permits are auctioned or grandfathered.” In other words, as long as your allocation is non-distortionary (i.e. not output-based updating), then the same efficient pattern of abatement is achieved regardless of who receives the permits.

  2. were actually harmful to man and the environment. Unlike CO2, Sulfur Dioxide and Nox are not released as broadly as CO2 or from as many sources as CO2. All human and animal activity releases CO2.

    To how many sources would we extend the credit? This is not a rhetorical question because the credits will be the product of a political process. Once the wheel starts turning there is no telling where it will stop. Will private individuals be given an allotment to trade? Why should we limit it to industrial scale emitters? Some of the easiest, cheapest reductions in emissions could be with private individuals.

    I would like to be able to reduce my footprint and sell the credits if I can sell the credit to another emitter who can’t afford to reduce his output as easily. I switched from a gas mower to a human powered reel mower last year – sell a credit for that? What if I change out my landscaping to something that stores more CO2 – credit for that? Telecommute? Ride a bike to the grocery store instead of driving? Raise my thermostat in the summer? What if I reduce my consumption of sodas in half? If I get myself in tip top shape and breath more slowly(therefore emitting less CO2), can I sell a credit to someone who can’t afford to get in shape?

  3. Christopher Willis says:

    It seems like this suggests that applying the new EPA standard only to power plants will not get the most bang for the buck unless it is also the industry where the cheapest abatement is possible. Moreover, that if power plants aren’t the cheapest place to reduce emissions, EPA should look to expand the standard to other emitting industries as quickly as possible…or have I misunderstood?

  4. Pingback: EPA and climate regulation: Mind the gaps |

  5. Pingback: OPINION: EPA and climate regulation - mind the gaps | CaliforniaCarbon.info

  6. Mike S. says:

    Cap & Trade can be good or bad depending on a few important design elements. The European ETS has been a learning experience, but has enriched polluting companies and not reduced emissions. A better system will regulate upstream companies, auction permits not give them away for free, return the revenues to households or individuals (the dividend model), and include an escalating price floor.

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