The Public Policy

Don’t Forget Cap and Trade

Lessons from the European "emissions trading" experience.

By and 8.14.09

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Amid the public outrage surrounding health care reform, another issue of equal importance for the average American has been nearly forgotten: the upcoming Senate debate on the Waxman-Markey "cap and trade" bill. This bill attempts to "cap" -- that is cut -- U.S. emissions of greenhouse gases by forcing all energy producers to pay for expensive emissions permits, which can be traded on the basis of need and cost. The idea is that making fossil fuel-based energy less affordable create incentives for investment in low-carbon energy supplies, or energy-efficient equipment, that otherwise would be prohibitively expensive.

Before the Senate vote, politicians and the public alike should consider the experience of the strikingly similar "emissions trading system" (ETS) in place in the European Union since 2005. The European version has succeeded only in raising energy costs to consumers, even as emissions continued to rise. Its entire approach is fundamentally flawed and even self-defeating for two main reasons. First, it is extremely difficult to judge how many permits should be created. Second, by initially allocating permits free of charge instead of by auction, both the European and the proposed American versions of ETS fail to impose the supposedly necessary costs on polluters, and thereby create perverse incentives for industry leaders and government bureaucrats alike.

To begin with, to judge how many permits should be created in order to achieve targeted cuts in carbon dioxide (CO2) emissions, regulators must make a series of projections about future economic growth and possible changes in technology. In Europe, they got their sums wrong. The number of permits created exceeded the amount of CO2 emissions, causing the price of carbon to collapse. Far from meeting target cuts, emissions within the EU actually rose during the first phase of ETS (2005-2007) by 0.8 percent. On the other hand, if too few permits are created, skyrocketing energy prices would bring the economy grinding to a halt, putting thousands out of work. Politicians are therefore more likely to err on the side of caution by speaking boldly but creating too many permits. This is what has happened in Europe.

The European ETS's biggest flaw is that individual governments were allowed to give away permits as they chose. The free allocation of permits essentially amounts to the distribution of subsidies to businesses, which gives bureaucrats the power to pick winners and losers. Those bureaucrats, in turn, become prone to "capture" by rent-seeking interest groups. In Europe, the companies that won the most permits were those with the best connections and lobbying teams, rather than those that needed them the most. Smaller distributors, such as hospital trusts, were forced to buy permits from bigger utilities. The price fluctuations inherent in such a politically-created market have also led to a great deal of uncertainty and a decrease in infrastructure investment, with the result that, as the Economist noted recently, for example, Britain is likely to experience blackouts in just a few years.

Moreover, the EU approach created a perverse incentive for businesses to lobby for more permits than they needed so that they could profit by reselling them to those that lost out in the wheeling and dealing of the allocation process. As long as permits are allocated free of charge instead of auctioned, the market logic of the ETS is fatally undermined. As the legislation now stands, under Waxman-Markey, 85 percent of the permits are to be given away for free. This is unlikely to change (for the better); for this bill would never have been passed in the first place if not for the myriad give-aways (e.g. free permits, subsidies) lavishly bestowed upon so-called "stakeholders."

To sum up, the failure of the European ETS should give pause to Senators considering a similar system for the U.S. Cap-and-trade will not result in emissions cuts. It will, however, greatly enhance the power of the government to regulate the economy. And it will lead to higher energy costs, as the costs of trading permits add to utilities' cost of doing business.

Given these facts, why the strong push for cap-and-trade? The sad fact is that both President Obama and the Democratic Congress are misleading the public. Alternative measures such as a carbon tax have not been considered precisely because their costs are transparent and obvious to the public. By contrast, cap-and-trade allows the President and Congress to claim credit for "taking action" on global warming without acknowledging the real costs that entails -- costs which the public, when informed of the facts, is rightly unwilling to accept.

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About the Author

Roger Abbott is a research associate at the Competitive Enterprise Institute in Washington, D.C.

About the Author

Iain Murray is Vice-President for Strategy at the Competitive Enterprise Institute.