An increasingly popular measure in environmental regulation is the creation of trading markets that allow polluters to buy and sell emissions credits between themselves. While this arguably has some benefits, such as allocating emission penalties more efficiently, or decreasing the costs of public administration, there are several very important objections to be aware of.
First, with apologies to a number of starry eyed politicians, environmentalists, business people, and journalists who wax romantically about them, these are not free markets, and referring to them as such is just so much hogwash. Free markets arise from the complex and voluntary interactions of numerous heterogenous agents, whose individual actions create a feedback loop between changes in the prices of scarce resources and the total quantities desired and brought to market. This is a bottom-up process, one whose success can be enhanced by sensible top-down regulation and enforcement. Emission markets, on the other hand, are created entirely from the top down, being imposed and incentivized via government legislation and regulation. The typical emission trading market starts with output quotas (the cap in "cap and trade") and a fixed initial starting price (penalty, really) for the pollutant being regulated. Participants can then exchange pollution credits for money, depending upon whether they are above or below their output quota. Through the use of futures contracts, they can also hedge against future output liabilities, based upon their current expectations for both output and the regulatory stance of government (as an aside, anyone with capital markets expertise should recognize the potential incentives for malfeasance, as governments and regulation-favored participants may be incentivized to impose higher degrees of uncertainty on the market in order to reap the benefits of higher price volatility and derivative pricing). Because the political process is a key element in these markets, and because most of the economic costs and benefits will accrue outside of the trading markets themselves, we should expect feedback loops to be more distorted and mispricings to be corrected less efficiently than would be the case in a true free market.
Second, those who favor these markets imply that a top-down approach will be as optimal and efficient as a bottom-up one. The starting point for any emission trading process is the initial cap limits, future reductions, and pricing imposed by regulators. Thus, the argument for trading markets is based on a rather dubious assumption that regulators can get the price of the externality right, and avoid the economic costs associated with arbitrariness and inefficiency. It’s especially important to recognize that while cap and trade markets are intended to address the real cost of a specific externality, the price signal in these markets does not contain information about the cost of the externality itself–it only contains information about the costs imposed on participants by regulators, costs that might not be in line with reality. And as noted above, there’s no intrinsic mechanism in these markets to correct significant mispricings.
Third, while these markets may improve upon the administrative efficiency of government and lower the public cost of climate change policy, they will also create new classes of rent-seekers. Although Sen. Boxer scolded some participants and committee members for mentioning Enron at a recent hearing, it is worth noting that it was one of the primary rent seekers in the cap and trade area until its demise a few years ago. Is mentioning Enron in conjunction with the current push for climate legislation a taint on the character and intentions of, for example, the corporate members of USCAP? Of course not. But it does get people’s attention, and helps illustrate the intimate ties between rent-seeking, business competition, and politics. In the final analysis, concerns about rent seeking depend on the degree of material benefits that accrue to society relative to those who benefit from pollution trading markets. In other words, if this rent seeking activity does indeed produce economic value, then technically it’s not rent seeking. So if stabilizing CO2 emissions does prevent significant economic harm in the future, then the trading rents might be an acceptable tradeoff. However, if the CO2 hypothesis is disproven by real events–for better or worse–while new rent seekers have benefitted at the expense of competitors, taxpayers, and consumers, then the tradeoff and the political machinations that made it possible will prove to be a disaster in hindsight.
In response to concerns like rent-seeking, analysts of various political stripes have called for carbon taxes instead of trading markets (e.g., here and here). Comparing the net costs and benefits of taxes-versus-trading is a complicated and imprecise exercise, but like cap and trade, if the CO2 hypothesis holds true, and carbon taxes help us to avoid significant economic harm in the future, then higher consumer prices they cause might be an acceptable tradeoff; if the CO2 hypothesis is disproven, then the opportunity costs incurred by taxpayers will be a disaster. But whether through tax or trade, political measures aimed at reducing CO2 emissions will still create winners, losers, and rent seekers in the short run. For example, if we assume that carbon taxes are used to finance climate technology R&D, it’s clear that one group of people will benefit at the expense of the rest. We would hope that their research produces technologies that have real economic value to society, but as with any investment, there’s plenty of uncertainty involved, and sunk costs are sunk costs; there’s also a high degree of agency risk involved when politicians and experts decide how to invest everyone else’s wealth.
All told, it’s clear that the essential political risk at hand relates to decision making, to which we would point out that the more brains involved, the better. In a field as novel and complex as climate science, and indeed, in any pursuit involving estimation under uncertainty, the least bad method is to aggregate as many competing opinions as possible–in this case via a political analogue to free markets, referendum. Despite the growing body of evidence for such an approach, it’s likely to meet with resistance, as such measures might threaten to: marginalize the hard earned expertise of climate scientists; diminish politicians’ power and sense of self-importance; devalue the compelling business opportunities perceived by some firms; and force true believers on all sides to give some control to those they disagree with.
We encourage people to think openly and critically about the climate debate, but we suggest being especially critical of "free market" allegations. Public action to remedy a perceived externality of the free market is n
ot "free" in any sense of the word. Wise, perhaps, but never free.