Explaining Cap and Trade

On Friday, June 26, 2009 the US House of Representatives narrowly passed a “cap and trade” bill (219-212 votes). Cap and trade is a relatively simple concept that is both theoretically and practically sound, provided that (1) there is a need to reduce carbon emissions, (2) all major polluting nations (including China and India) will realistically act to reduce carbon emissions, and (3) the program is structured properly. I’m not sure any of those exist for this legislation, but my purpose today is to try to explain in relatively simple terms, how cap and trade works. I’ll do this by using what we economists call a “model,” in which we use simplifying assumptions to better understand how something works.

The Model

Assume that there are only two companies in the country, company A and company B. Company A generates coal powered electricity and company B is a gray iron foundry. That’s good because we need electricity and we also need metal parts, but we will also assume that we need to reduce carbon emissions.

Assume that each company produces 100 tons of carbon emissions per day, for total “societal” carbon emissions of 200 tons per day. Let’s assume that the government wants the total amount of emissions to be reduced from 200 tons to 150 tons per day. Let also assume that both companies have different costs of reducing carbon emissions. Utility company A can reduce emissions at a cost of $1,000 per ton, while it costs grey iron foundry B $2,000 per ton to reduce emissions.

Mandated Emissions Reductions. If the government simply mandated that each company reduce their emissions by 25 tons per day (to achieve the 50 ton desired reduction in emissions) it would cost company A $25,000 to reduce emissions by 25 tons and company B $50,000 per day to reduce emissions by 25 tons. The total “societal costs” of mandating that each company reduce emissions by 25 tons per day would be $75,000.

Under a Cap and Trade program
, the government would allow market forces to work, while at the same time achieving its “CAP” goal of reducing emissions to 150 tons per day. Because utility A can reduce emissions at a cost of $1,000 per ton, while it costs foundry B $2,000 per ton to reduce emissions, it makes sense for company A to reduce its emissions by 50 tons, while company B would not reduce emissions at all. The total cost of reducing emissions by 50 tons (if company A does all of the emissions reductions) would be 50 X $1,000 or $50,000. That is a “societal” savings of $25,000 over the mandated plan presented above, while still meeting the desired CAP of 150 tons of pollution per day.

But why would the electric company agree to spend another $25,000 to reduce emissions on behalf of the foundry, which doesn’t reduce emissions at all? Because the foundry will pay the electric company more than $25,000 to increase its abatement from 25 to 50 tons. In essence, the foundry buys from the electric company its tradable rights to pollute. If the foundry is willing to pay the electric company, say $1,500 per ton to reduce 25 tons of emissions on its behalf, the electric company will end up receiving $37,500 for reducing pollution that costs it only $25,000 to abate. This is a profit of $12,500 for the electric company.

On the other hand, the foundry, which would have paid $2,000 per ton ($50,000 total) to reduce 25 tons of pollution in a mandated plan, would spend only $37,500 to pay the electricity company to reduce pollution by the same 25 tons.

To summarize; if there was a mandated plan which demanded each polluter to reduce pollution by 25 tons, total pollution emissions would be reduced from 200 tons to 150 tons. The total societal cost of that pollution reduction would be $ 75,000. Under a cap and trade program the same goal of 150 tons of pollution would be achieved, but the total societal cost of the pollution reduction would be $50,000. There would be a private transfer cost of $12,500 from the foundry to the electric company, but this would not be a pollution abatement cost, but a trade profit for the electric company. Likewise, the foundry saves $12,500 that it would have spent under a mandated program, while at the same time satisfying the overall goal of reducing pollution from 200 tons to 150 tons.

Over time the government could reduce the CAP amount. This would raise the price of tradeable credits, but would still be more economical than a program that mandates pollution reduction from businesses in which it is extremely costly to abate emissions. The devil is in the details. We have yet to discuss the ramifications of the cap and trade program passed this week in the house. Of course, pollution abatement increases costs, and reduces output and employment in the economy. We’ll also address that in a later blog.

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