For decades, economists have emphasized the efficiency gains associated with market-based policies.
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.
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Suggested citation: Davis, Lucas. “Unlocking Cost Savings with Cap-and-Trade” Energy Institute Blog, UC Berkeley, June 9, 2014,
Lucas Davis is the Jeffrey A. Jacobs Distinguished Professor in Business and Technology at the Haas School of Business at the University of California, Berkeley. He is a Faculty Affiliate at the Energy Institute at Haas, a coeditor at the American Economic Journal: Economic Policy, and a Faculty Research Fellow at the National Bureau of Economic Research. He received a BA from Amherst College and a PhD in Economics from the University of Wisconsin. Prior to joining Haas in 2009, he was an assistant professor of Economics at the University of Michigan. 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.