An Introduction to Cap-and-Trade Climate Policy

Holmes Hummel, PhDhummelhh@mindspring.com

November 21, 2007

Using Musical Chairs: An Illustration of Managed Scarcity

Climate Science• Climate change is driven by greenhouse gases accumulating

in the atmosphere as a result of human activities.

• The U.S. is responsible for about 30% of the total accumulation since the Industrial Revolution – three times China and India combined.

• Climate change impacts are dangerous, and the Nobel Prize-winningIPCC scientists say 1/3 of all species are at risk.

• Burning fossil fuels – coal, oil, and gas – is the biggest driver of climate change, and it accounts for 85% of U.S. energy use.

• Most people in the U.S. believe something should be done to stop global warming – but what, and how?

References: IPCC Fourth Assessment Report, Summary for Policy Makers, 2007.Navigating by the Numbers, World Resources Institute, 2005. National opinion poll by Krosnik, Kopp, and Aldhous, 2007.

Climate Economics

• Today, consumers (and industries we support) dump an unlimited amount of greenhouse gases into the atmosphere for free.

• As a result, fossil fuel prices do not reflect their full cost.

• Life on Earth pays the ultimate price: more severe droughts, floods,fires and storms along with collapsing ecosystems and extinction.

• For this reason, some economists have called climate change “the greatest market failure in history.”

References: IPCC Fourth Assessment Report, Summary for Policy Makers, 2007. The Economics of Climate Change, Stern Review Report, 2006.

Climate Challenge

“If we’re not serious about this problem, then we’ve got much worse problems to start getting serious about…”

Just enough for one big play

Size of the entire industrial economy

None

U.S. carbon market worth more than $200 Billion

Disruption of many life support systems on Earth

Launch of a clean energy economy

Eliminate 500 Million Tons of CO2 Pollution Per Year

Climate PolicyTo curb emissions and avoid the worst climate change impacts, both national and international climate policies would encourage. . .

(a) consumers and investors to build a clean energy economy and reduce emissions by imposing a cost on greenhouse gases, and

(b) policy-makers to commit money to 1) help those hit hardest by climate change damages, and 2) invest in jobs and infrastructure to support the transition.

Mitigation

& Adaptation

Climate PolicyPolicy makers have 2 main options for putting a cost on greenhouse gas pollution:

(1) a carbon tax or “pollution fee”

(2) creating a market for carbon emissions

In order to stabilize global warming, fossil fuel prices would riseunder either policy.

Americans appear to have little appetite for a carbon tax.But there is also little understanding of the market-based alternative – a carbon cap-and-trade program.

How would it work?

Cap-and-Trade Climate Policy• “Cap-and-trade” means a government authority establishes a cap that

limits the total amount of pollution allowed, and then distributes permits for a “right to pollute” the global atmosphere,

which can be traded as private property.

• The amount of greenhouse gas emissions permitted declines each year, creating demand for a new commodity: carbon permits.

• When offered enough money (or faced with high enough costs), polluters who own permits (or need permits) will reduce their emissions.

• These trades establish a market price for greenhouse gas pollution.

A familiar game can help illustrate the concepts…

Got it?

Musical Chairs: A Helpful Analogy This game of managed scarcity can help illustrate the

following important concepts and issues:

• Banking• Borrowing

• Equity• Ethics

• Allocation• Auction

• Trading• Targets

• Leakage• Offsets

• Safety Valve• Spending

Musical Chairs: A Helpful AnalogyEach chair represents the “right to pollute”: one metric ton of carbon dioxide (1 mtCO2) or an equivalent amount of any other greenhouse gas

If you have a permit, you can have a chair.

Musical chairs

At the start of the game, everyone has a seat – because there are no limits on carbon emissions.

2008

All stick figures by Tormod Lund, GraffleTopia.com

Musical chairs

After the first year, a cap is imposed by limiting the amount of permits and making players compete for the permits available.

In our analogy, one player doesn’t have a chair…

2009

Would anyone be willing to trade their chair for $30?

Sure! For that price, I can finance an efficiency upgrade, eliminating my need for a pollution permit.

So, the market price for the “right to pollute” in the first year is $30 for one ton of carbon dioxide…

Using Market Incentives

At that price, some players may realize it would be more profitable to reduce their emissions and sell their permits.

Profit opportunities are a main driver for innovation and investment in the global economy today, and the climate challenge needs both.

2009

Using Market Incentives

If I could I build wind farms to replace mycoal power plants, then I could sell permits…

2009

Using Market Incentives

Hey, I made a profit by reducing my fossil fuel use and avoiding carbon emission costs!

2010

Achieving Reduction Targets

The purpose of the game is to reduce greenhouse gas emissions.

The game authority reduces the number of permits availableeach year until the ultimate target has been achieved.

2010

Achieving Reduction Targets

In a market, players leave when they find better options as costs rise.

Cap-and-trade lets players choose at what price they leave the game– and how they want to make that change.

$30$150$20

$100

$200$50

2050204020302020

Wind power

Rail TransportHybrid vehicle

Solar powerGreen buildings

Nuclear power

2010

Achieving Reduction Targets

Who will be the last greenhouse gas polluters left

in the game?

2050

Achieving Reduction Targets

The last ones remaining in the game are those who:A) can afford to pay the most, or B) have the least flexibility to change games.

The underlying assumption is that uses of fossil fuels for which people are willing to pay the most must be the most valuable.

To stabilize global warming, most uses of coal, oil, and gas will have to move to a different game: the clean energy economy.

2050

Achieving Reduction Targets

To avoid the worst climate impacts, the U.S. must eliminate at least 80% of its emissions by 2050.

Comparison of Two Leading Climate PolicyProposals in the 110th Congress (2007)

Warner-Lieberman

Chart modified for clarity

Stabilize at 450-550ppm

2050

Achieving Reduction Targets

There are no “time out” options between rounds.

As the cap tightens in each new round, fewer permits are available.

So, players with permits charge the buyers higher prices.

$90 $90$90SELLPRICE:

2020

Achieving Reduction Targets

$90 $90$90

How high can the price go?

As high as it takes to motivate one of us to

stand up.

2020

SELLPRICE:

So, is it cheaper for me to:

1. buy a permit from another player, OR

2. reduce my own emissions?

$90 $90$90

The Carbon Market at Work

SELLPRICE:

The Problem of “Leakage”

Either choice may be difficult for some energy-intensive businesses (e.g. aluminum, cement) competing in the global economy.

$90 $90$90

2020

SELLPRICE:

The Problem of “Leakage”

At higher carbon prices, I’ll need to close my cement plant – or move it to another country...

$90 $90$90

2050

SELLPRICE:

The Problem of “Leakage”

$90 $90$90

“Leakage” occurs when polluters move to avoid regulation – which is why an international agreement is so important.

SELLPRICE:

The Problem of “Leakage”“Leakage” occurs when polluters move to avoid regulation – which is why an international agreement is so important.

Otherwise, a national climate policy may drive jobs away and still not reduce global emissions.

$90 $90$90SELLPRICE:

The Problem of “Offsets”

$20 $20$20

Opposite to leakage, a player may find a business sector thatisn’t covered by the policy …

but has a lower cost opportunity to reduce emissions.

$15

Reducing methane

from hog farms

SELLPRICE:

Because all tons of carbon emissions affect the atmosphere the same, this offset could be accepted as equivalent to a permit.

The Problem of “Offsets”

$20 $20$20 $20

No one would have used this chair unless I went out

and bought it – and it’s just as good as any other!

SELLPRICE:

The Problem of “Offsets”

$20 $20$20

However, it can be difficult to verify that the player’s investment was responsible for those reductions – and that they actually happened.

Therefore, standards for offsets must be high to ensure the carbon reductions are real – and not “hot air.”

$20SELLPRICE:

The Problem of “Offsets”

$20 $20$20

China, India, and other countries have some very low cost opportunities to reduce emissions.

However, the U.S. Congress did not ratify the Kyoto Protocol that makes use of the Clean Development Mechanism for offsets.

$20SELLPRICE:

The Problem of a “Safety Valve”

$20 $20$20

Some companies want market-based policies, but not market risk.

SELLPRICE:

The Problem of a “Safety Valve”

$20 $20$20

Some companies want market-based policies, but not market risk.

My business cannot cope with the possibility that carbon prices might

exceed $20/mtCO2!

SELLPRICE:

The Problem of a “Safety Valve”

$20 $20$20

Some companies want market-based policies, but not market risk.

A “safety valve” would put a cap on the carbon price rather than on the emissions, allowing firms to protect their investments by buying unlimited pollution permits at a guaranteed maximum price.

SELLPRICE:

The Problem of a “Safety Valve”

$20 $20$20

Some companies want market-based policies, but not market risk.

A “safety valve” would put a cap on the carbon price rather than on the emissions, allowing firms to protect their investments by buying unlimited pollution permits at a guaranteed maximum price.

$20 $20 $20SELLPRICE:

The Problem of a “Safety Valve”However, a “safety valve” would effectively violate the cap on emissions, and convert the policy to a stable tax.

Anyone can burn as much coal as they’d like if they can pay the fee.

$20 $20$20 $20 $20 $20 $20 $20SELLPRICE:

The Problem of a “Safety Valve”With a “safety valve” on the price of carbon, the market drivers are weaker, making command & control policies even more important.

Building codes, fuel economy standards, renewable portfolio standards, tax laws, and other legal requirements are essential – as they are today.

$20 $20$20 $20 $20 $20 $20 $20SELLPRICE:

Banking

$90 $90$90 $90

Players who receive more permits than they need would liketo “bank” them.

By saving a spare permit, the player can to pollute that amount in a future year or to sell that permission to someone else in the future.

2015

2016

2017

SELLPRICE:

2020

Banking

$90 $90$90

$20

2015

2016

2017

I’m glad I reduced emissions and saved permits in earlier years – because now they

are worth much more!

SELLPRICE:

2020

BorrowingSimilarly, some people who lack sufficient permits to cover their pollution would like to “borrow” them from the permits they expect to receive in the future.

$90 $90$90 $90

I can’t afford this market. I’d rather borrow from the

future and hope that technology and business

opportunities get better…

SELLPRICE:

2020

Borrowing

$90 $90$90 $90

Didn’t Social Security and the national debt

get into trouble that way??

on credit,due 2025

SELLPRICE:

2020

Coverage and Distribution

Two critical aspects of cap-and-trade are determined by how each round begins:

1. Which polluters should be required to play?

2. Should polluters have to buy permits in an auction – or should they receive a free allocation of permits?

CoverageFor practical reasons, most proposals only require fossil fuel suppliers and large polluters to play directly.

As they pass on their costs, the rest of the economy is affected.

Oil Refineries

Coalcompanies

Natural Gascompanies

PowerPlants

Miningplants

Chemicalcompanies

Aluminumsmelters

Examples of “covered” pollution sources:

Though sales of coal, oil, and gas should decline as carbon prices rise,economists say less than 20% of the permits should be given for free to compensate those firms for additional profits they might have had otherwise.

Permits auctioned to “covered” companies

Free permitsallocated to fossil fuel

companies

$20 $20 $20 $20 $20 $20$0BUY:

Auctioning Permits vs Allocating for Free

Reference: Lawrence Goulder, Congressional Budget Office Conference on Climate Change, 2007.

By contrast, the Lieberman-Warner bill for U.S. climate policy proposes giving away more than half the permits.*

Those companies start out each round “sitting down” at no cost.

$0 $0 $0 $0 $20 $20$0BUY:

Auctioning Permits vs Allocating for Free

* Though portion would change over time, 1/4 are still free in 2050.

Auctioned permits bought by corporations

Free permitsallocated to corporations2012

Why is this a cause for concern?

1. Unfair competition: New players entering the market with innovative ideas have difficulty competing against pre-existing polluters who get free permits as a subsidy to diminish their political opposition.

Auctioning Permits vs Allocating for Free

$0 $0 $0 $0 $20 $20$0BUY:

Auctioned permits Free permits

Auctioning Permits vs Allocating for Free

$0 $0 $0 $0 $20 $20$0BUY:

Auctioned permits Free permits

Why is this a cause for concern?

2. Unearned windfall profits: In a carbon market, firms that buy permits in an auction will try to pass costs to customers, and others receiving a permit for free can sell their permits at that same price.

$0 $0 $0 $0 $20 $20$0BUY:

SELL: $20 $20 $20 $20 $20 $20$20

Unearned windfall profits Cost passed to consumers

Auctioning Permits vs Allocating for FreeWhy is this a cause for concern?

2. Unearned windfall profits: In a carbon market, firms that buy permits in an auction will try to pass costs to customers, and others receiving a permit for free can sell their permits at that same price.

A cap-and-trade policy with 100% auction avoids giving away unearned windfall profits and returns all proceeds to a

public policy process for spending decisions.

BUY:

Auctioning Permits vs Allocating for Free

All seats sold at auction to the highest bidders

How auction revenue is spent affects the speed and costof a clean energy revolution to avoid climate change catastrophes.

Spending

• Tax credits and Incentives – support for efficiency and zero carbon energy sources

• Research & Development – on the scale of a New Apollo Project or a Manhattan Project for zero carbon energy sources

• Low-income Households – committing at least 15% of all revenues to neutralizing impact of higher prices on fossil fuels and other goods

• Adaptation – helping vulnerable communities (1) avoid harm from climate change, and (2) recover from climate damages

• Green Collar Jobs – encouraging job development in the clean energy industry

x

With hundreds of billions of dollars being raised, expectations are high about who could benefit from climate policy – and how:

Concerns about Equity

Most unearned windfall profits would go to shareholders who are members of the top 10% most wealthy households in the U.S.

The top 10% of U.S. households already own 2/3 of the wealth,and the top 1% own half of that!

References: State of Working America, 2006; data from U.S. government agencies (Census, IRS, BLS)

A carbon tax and a cap-and-trade policy both would raise fossil fuel prices.

Prices of products and services that use fossil fuels would also rise.

This would impose hardship on low-income households unless the climate policy specifically includes “carbon cost rebate” measures funded with revenues raised from either a tax or a permit auction.

Concerns about Equity

Under either a carbon tax or a carbon cap-and-trade policy,wealthy people would be able to take advantage of their classprivilege to use more fossil fuels – both nationally and globally.

In order to withstand popular opposition to higher fossil fuel prices,any climate policy must be widely regarded as fair by a broad baseof beneficiaries.

Concerns about Equity

Is it ethical to privatize the sky and treat pollution as a commodity traded like private property?

Is it ethical to make a profit from carbon trading?

Will the complexity of a cap-and-trade system rival our tax system, opening similar opportunities for loopholes and favored treatment?

Would our political institutions be reliable to manage this massive new market over decades under tremendous pressure?

And if federal climate policy is not forthcoming from Congress fast enough…

What local, state, corporate, and regional policies for energy, agriculture, science, taxes, and trade could be pursued to meet the challenge?

Additional Questions to Consider

For Further Reference

The following public interest organizations have a strong focus on climate policy design and development in the U.S.:

World Resources Institute www.wri.org

Pew Center on Global Climate Change www.pewclimate.org

Resources For the Future www.rff.org

Union of Concerned Scientists www.ucsusa.org

Feedback on this illustrated introduction to cap-and-trade concepts is most welcome: hummelhh@mindspring.com.

x