The quandary for capping and trading is straight out of Econ 101: As long as some countries restrict emissions and some don't, many firms will simply move their emissions rather than eliminate them, seriously compromising CO2 reduction targets.
Written by Zach Arnold, Breakthrough Generation Fellow
Imagine it's 2010. The environmental lobby and its governmental allies have finally managed to implement a carbon cap-and-trade system. Under this plan, CO2 emissions are limited to those allowed by a set number of permits; companies who emit more than their allotment have to buy permits from those who don't, and as caps tighten over time, most everyone is required to lower their emissions.
Sounds good, right? An elegant scheme to be sure, and one that has borne fruit in the past - cap-and-trade policies are widely credited with America's drastic reductions in the pollutants that form acid rain. But can a rigorous American cap-and-trade system work similar wonders for CO2? I don't think so.
What Econ 101 has to say about cap-and-trade
When it comes to reducing emissions, an America-only cap-and-trade system will have little effect. To explain why, we need only resort to that most familiar of adages - "follow the money." CO2-emitting businesses will naturally "follow the money" around the world, migrating to wherever they can save the most - that is, wherever the cost of emitting is lowest.
This, of course, is not a peculiar trait of polluting businesses; the accelerating pace of economic globalization over the past few decades has been driven by this behavior. Manufacturers flit from American factories to Mexican maquiladoras to Chinese sweatshops in pursuit of cheap labor, and call-center operators transfer jobs from well-paid Americans to job-hungry (and English-speaking) Indians. You basically do the same thing when you drive an extra few blocks to a cheaper gas station, rather than pay a few extra pennies per gallon closer by.
Carbon emitters like factories, refineries, and power plants will follow the same logic. As cap-and-trade raises the price of emitting (by forcing companies to retool or to buy permits), they'll be increasingly tempted to move to countries where their emissions aren't taxed. In turn, carbon emissions may simply move, rather than disappear. Interestingly, as carbon caps become more rigorous, thus raising the price of emissions, the costs of staying stateside will increasingly outpace the hassle (financial and otherwise) of picking up shop. In this way, stronger climate policy might end up shooting itself in the foot.
Who pays the price?Of course, fleeing cap-and-trade is more of a possibility in some industries than in others. It's hard to see, for example, how a CO2-spewing coal plant in Ohio can just move overseas, considering that its transmission lines and customers are stuck in Cleveland and Akron. (This helps explain why SO2 cap-and-trade was so effective - most SO2 comes from power plants, which can't move.)
Yet the alternative might not be any better for our atmosphere. For example, those electricity providers that can't skip town will face a higher cost of generation, which will then be passed on (at least partially) to their customers. Those industries and firms that purchase electricity will face the same dilemma as those who emit directly, and might just head over to China as a result - especially if this price pressure is piled on to the economic woes such firms are already facing - high labor costs, lagging demand, etc.
It's easy to see how this dynamic could create both an economic headache and a political catastrophe for American climate activists. Assume a cap-and-trade system passes in 2009. As the first few factories and server farms start moving, and the first few Southern utilities start building their new plants in Mexico rather than Texas, critics will (correctly) point the finger at environmentalists. The resulting spat could dwarf previous scuffles like the call center outsourcing crisis of a few years ago. And since the incentive to migrate is directly tied to the carbon price, it's unlikely that environmentalists and their backers, in the midst of a political firestorm, would be able to raise it incrementally (as many cap-and-trade plans entail).
Patching up the problemThe quandary is straight out of Econ 101: As long as some countries restrict emissions and some don't,
many firms will simply move their emissions rather than eliminate them, seriously compromising CO2 reduction targets.How to address this quandary? We might try to "patch up" our unilateral cap-and-trade system with measures aimed at preventing migration. One add-on might be a carbon import tariff, in which carbon-intensive imports are taxed for the emissions they "embody," so to speak. This would theoretically attach the price disincentive to emissions no matter where they happen (as long as the products are coming into the US, that is). But such a system would be nightmarishly complicated to administer - how do you audit the carbon content of every item you import? Moreover, a new tariff regime administered unilaterally would be seen as a flagrant violation of WTO laws and a slap in the face to our trade partners.
Another patch could be simply to throw cash at those businesses affected by carbon caps. This was the strategy of the ill-fated Lieberman-Warner bill, which provided hundreds of billions of dollars for industry "transition assistance" and the like. Indeed, recycling the proceeds of carbon taxation back to industry might well keep firms in the country - but only by offsetting the financial pain of emitting carbon, thereby eliminating the disincentive to emit and rendering the price for carbon toothless. If the money businesses pay for emitting carbon will just come back to them a bit down the road, why bother reducing emissions at all?
Looking forward
Patches like these won't solve the structural problem inherent in a single-state cap-and-trade regime. Really, there's only one good solution: a
truly global carbon regime. A single, worldwide carbon price would level the international playing field, leaving no opportunity for firms to avoid the cost of carbon and spurring CO2 reductions rather than evasion.
It's perhaps with this in mind that many environmentalists have boosted cap-and-trade not so much for its actual effect on climate change as much as for its potential to enable America to broker a global carbon regime. Joe Romm exemplifies the trend: "If China won't alter its coal policy to make its environment livable today even with the Olympics coming, it will require very strong international leadership (led by an America with a moral climate policy of our own) to have any chance at making them alter it to preserve a livable climate in the future."
But the developing world has already signaled its unwillingness to restrict emissions, no matter how hypocritically the U.S. may or may not be behaving. Besides, if we act first, then quite a few developing countries may find themselves with new industries, creating new interests against restrictions. For example: will Mexico be more or less likely to adopt cap-and-trade once they've begun to attract new factories and power plants, drawn in precisely by their lack of a carbon regime?
In any case, with limited time on our hands, we should be wary of devoting our primary energies to the laborious implementation of an efficient carbon regime both in the U.S. and then globally. Put more simply, we may not have time to get cap-and-trade right first. What we need, fast, is a clean energy technology portfolio that's cheap worldwide - a set of technologies that make financial sense both to American utilities and Indian entrepreneurs, regardless of the policies in place in one country or another.
An American commitment to developing these cheap, clean energy sources will not only ensure America's success in cutting emissions, but will also enable developing nations to follow with their own emissions reductions as their economies expand. The marginal renewable energy sources of today - wind, solar, geothermal and the like - could well come to fulfill this role, but only if policymakers focus their attention on tech deployment and development, rather than obsessively pursuing America's emissions alone. Will cap-and-trade's proponents wake up in time?
Zach, the problem of leakage is a concern but is not as intractable as you make it out to be. Consider Lieberman-Warner, because it actually dealt with this quite well (though it had plenty of other faults). The sectors covered are transportation, electric power, and industry. Transportation is covered by upstream allowance requirements on petroleum importers (or 'first seller' for domestic reserves I believe), so moving abroad does no good. Electric power is similarly not vulnerable because you can't ship kilowatts from China or India. Might a few power plants spring up on Canada/Mexico side of the borders? Sure, maybe, but its really minor considering the limited area they could serve compared to the vast rest of the country. So right off the bat you know this leakage issue applies to a particular corner of the economy - industry.
You mention Lieberman-Warner gave away credits to keep those plants in the US. Those credits were given away more as a bribe for political support than to achieve anything - since they're not tied to production levels a plant could seriously ramp down production (shifting new production overseas) and still keep collecting. But L-W did have quite a clever method of dealing with the risk of leakage. In short it was a carbon tariff designed to be WTO compliant.
Title VI (and Title XIII in Boxer substitute) creates an "International Reserve" of allowances. This reserve would be unlimited, but the price would be pegged to the price of a domestic allowance (by day to day closing price on the spot market). Foreign importers would have to purchase carbon allowances from this reserve just like domestic producers have to. Since its a different pot, there's no competition for limited permits driving up the price. And since it's pegged to the price of domestic permits, there's the equality of treatment between domestic and imported goods crucial for WTO compliance. They had lawyers working on this, and apparently pretty good ones.
So how do you decide how many allowances need to be submitted for which goods? The EPA has to create a list of emissions intensive (covered) goods from importing countries whose national emissions are above a de minimis threshold. It sounds like it would be a bureaucratic nightmare, but really it wouldn't. A lot of emissions are from chemical processes where amounts are known and pretty standard. A lot can be traced to the heat or electricity used in production, and in combination with the power or fuel portfolio of a country/region you can get a pretty good estimate. And they'd have until 2015 (it was 2020 in the original) before the International Reserve requirement goes into effect to put this together. Perfect or not it clearly is more than enough to eliminate the incentive to ship factories overseas, especially considering (though it wasn't specified in the bill, but could be in administrative rulemaking) an extra Carbon premium could be assessed for international shipping as well.
Remember everyone wants access to the American market, because we make a lot of money and we don't save much of it (i.e. we like to spend). So if moving abroad doesn't improve the ability to cater to the American market at lower costs, it won't happen. Would it be better to have a global system? Of course. But this inertia of US saying we want a global system and developing countries insisting the US lead first must be broken. Since there's no way China/India will be convinced to adopt hard targets without our leading (nor should they), that means the ball is in our court.
Posted by: Max Epstein at June 21, 2008 8:45 PM