Cap and Trade 101

Marlon G. BoarnetProfessor of Public Policy

Director of Graduate Programs in Urban Planning and Development

University of Southern California

July 10, 2010

• An externality occurs when a market transaction affects a party who neither pays not gets paid

Externalities

Q (Televisions)

MPC

D = MPB

$

Qp

MPC = marginal private cost

MPB = marginal private benefit

Q = quantity consumed (purchased)

Private Markets

• An externality occurs when a market transaction affects a party who neither pays not gets paid

Externalities

Q (Televisions)

MPC

D = MPB

$

Qp

MPC = marginal private cost

MPB = marginal private benefit

Q = quantity consumed (purchased)

Private Markets

= MSC

= MSB

MSC = marginal social costMSB = marginal social benefit

• An externality occurs when a market transaction affects a party who neither pays not gets paid

Externalities

MPC

D = MPB

$

Qp

MPC = marginal private cost

MPB = marginal private benefit

Q = quantity consumed (purchased)

Markets with ExternalitiesMSC

Q* Q (Driving)MSC = marginal social costMSB = marginal social benefit

Social cost exceeds social benefit for these trades

Photos: SQ AQMD and Los AngelesTimes

Regulatory Approaches

• Price Controls (taxes)– Example: Value Pricing on

SR-91• Quantity Controls

(mandated limits)– Example: Clean Air Act

compliance• Emission Clean-Up

(mandated technology)– Examples: Catalytic

Converters; Unleaded Fuel

MPC

D = MPB

$

Qp Q (Driving)

Social cost exceeds social benefit for these trades

MSC

Q*

Tax = (MSC – MPC)

Mandated emissions limit

Efficiency of Regulatory Approaches (Theory)

• Price Controls (taxes) and Quantity Controls (mandated limits)– Both lead to efficient externality reduction (to point

where social costs of activity = social benefits)– Difference is in information available to regulator

• Emission Clean-Up (mandated technology)– Can regulator “pick” the right technology?– Why not let market forces choose clean-up

technology?

Efficiency of Regulatory Approaches (Practice)

1980 1990 20000

20

40

60

80

100

120

140

117

41

0

LA County population (100,000s)LA City Stage 1 Smog Alert Days

Year

27% pop growth LA County (7.4 to 9.5 million)

Stage 1 days from 117 (in 1978) to 0 (late 1990s)

Data: SC AQMD and US Census

Market Based Regulatory Mechanisms• Price Controls (taxes)• Quantity Controls (mandated limits)– Cap and Trade – Variation on Quantity Control

• Emission Clean-Up (mandated technology)

• Incentive vs. outcome regulation• Advantages of market based regulations– Creates incentives for clean-up– “self regulating” – uses incentives and markets to

coordinate actions

Market based

Cap and Trade• Economy-wide cap on emissions (quantity regulation)– Similar to Clean Air Act concentration levels for traditional

pollutants• Firms get emission permits, which can:– Be used for emissions, or– Sold to firms that want extra permits

• Permits “depreciate” over time – cap binds more• Firms that can clean up inexpensively will do more

cleanup to sell permits to “dirty” firms• More emission reduction from firms that can reduce

emissions at lower cost

Exampledirty clean

Firm 1 Firm 2$300 $100 cost for reducing 1st ton of CO2e$500 $200 cost for reducing 2nd ton of CO2e$700 $300 cost for reducing 3rd ton of CO2e

$1000 $500 cost for reducing 4th ton of CO2e

both firms initially produce four tons CO2e

reduce four tons, two from each firm, cost = 1,100two permits per firm and can trade, cost = 900

Firm 2 will sell a permit to Firm 1 at any price higher than $300Firm 1 will buy a permit from Firm 2 at any price lower than $500

Does it work?• SO2 permit market, Clean Air Act Amendments

of 1990; RECLAIM SCAQMD• Conditions for Cap and Trade to be successful

and issues– No “hot spots” – location of emissions is no concern– Sufficient number of permit-holders for market to

work– Neither a shortage nor surplus of permits– Initial permit allocation issues

ARB Cap and Trade• Economy-wide cap: 1990 CO2e emissions by 2020• Price stability measures – reserve permits to offer

on market and effort to not be too slack• Distribute early permits by allocation, auction later

permits• Measures to reward prior energy efficiency with

permit allocation• Economic impacts mostly distributional– 2.3% state GSP growth per year 2007-2020 vs. 2.4%

“business as usual”

Use of Auctioned Permit Revenues

• Reduce distorting taxes• Dividends to consumers• Clean energy?• High speed rail?