In my last post, I noted that I, personally, am a climate change sceptic. I also believe that we should not take any major action to mitigate the feared implications of climate change unless our major trading partner, the U.S, does likewise. However, I then went on to argue that if we must do something, then a carbon tax should not be rejected out of hand because it provides more opportunity for the market (businesses and consumers) to freely make economic choices than government regulation. For example, if the tax is high enough, businesses will seek alternative ways to produce. I also, mentioned in passing that a cap-and-trade system as instituted by Ontario and Quebec is, in principle, better than carbon taxes as a means to harness the ability of the market to fight carbon and other forms of pollution. While seeking the same objectives as a carbon tax, it achieves its goals at a lower overall cost for society. From a stewardship perspective that is important, since we don’t want to waste any of our God-given resources. I will expand on that in this post. However, I will first add a bit to what I said about regulation in the last post.
Some regulation will remain necessary.
In the past, I noted, regulation (command-and-control) was the main tool of environmental policy. Government bureaucrats specify what companies and consumers can and cannot do. Regulation, is costly and enforcement is frequently inadequate. Past regulation has frequently been too precise or with too short a compliance deadline, so that flexibility to implement the latest, best technology is reduced. I recognize, that, in practice, carbon taxes and cap-and-trade may also be implemented with a host of regulations and exemptions and, therefore, market choice and efficiency may be reduced. We should seek to reduce such over-regulation while exemptions might be better attained through other ways which do not affect the favourable incentives intended by these two policies.
Moreover, government regulation will have to remain a significant part of environmental policy. For the most toxic pollutants, for example, outright bans are the only possibility. Bans may also be required in particularly sensitive areas. The Chinese government, for example, banned all tree cutting in the flood-prone Yangtze basin because”trees standing are worth three times as much as trees cut” because of the flood control service provided by the forests. In other cases, such as mandatory minimum efficiency standards for cars or appliances or some pollutant emissions, simple regulation may prove most effective. As much as possible, such regulations should be restricted to specifying the result (the limits desired) rather than mandating how that result is to be achieved so that companies are left free to decide how best to meet these standards.
Regulation is also necessary to specify conditions for companies to operate in particularly environmentally sensitive areas e.g. drilling for oil and gas. Even then, however, the market can be used to supplement the regulations by requiring ‘environmental performance bonds’ (an insurance to be bought by companies who undertake environmentally sensitive actions such as building a pipeline through nature reserves). The market determined price of the bond will reflect the potential liability and force the companies to consider that cost. Moreover, in case of actual damage, the money can be used to rehabilitate the environment and compensate victims
Detailed government regulation is also required when the interests of parties in the marketplace conflict. For example, in 1990, European governments were concerned with the reduction of emission of volatile organic compounds (VOCs) which escaped when cars were being refuelled. The problem could be addressed either on the cars by installing a carbon cannister that would absorb the vapour or, alternatively, by installing a vapour balancing system on the pumps. Obviously, the oil companies and the automobile manufacturers could not agree on the choice. The German government finally made the decision in favour of the pump system.
In any case, the need for regulation continues. Continual review is, however, a necessity–if only to ensure the regulations do not become obsolete. Where regulation is deemed to be necessary, we must be prepared to devote adequate resources to establish and enforce them.
The Advantage of Cap-and-Trade
Cap-and- Trade (also referred to as a system transferable pollution permits) has the government set a cap for the total amount of carbon (or other pollution) emissions. Allowances or “rights to pollute” are then divided over all the companies either by auction or otherwise. The auctions generate revenue for the government.The key to the overall cost saving is that these allowances may be bought and sold. A simple example, will, hopefully make this clear. Consider the following companies who pollute different amounts (Column 1) and differ in how much it costs them to clean up their pollutants (Column 2):
Table 1 Cost of
Company 1 6,167 $100
Company 2 5,500 125
Company 3 25,000 150
Company 4 50,000 225
Company 5 30,000 300
Now consider the cost of cleanup if the government mandated a cut of 10% across the board. The cost to society of every company reducing their pollutants by 10% would be $2,530,000.
Table 2 Cost of
Cleanup 10 % Cost
Total per pollutants of
Pollutants pollutant Cleaned up Cleanup
(1) (2) (3) (4)
(2) x (3)
Company 1 6,167 $100 617 $ 61,670
Company 2 5,500 125 550 68,750
Company 3 25,000 150 2,500 375,000
Company 4 50,000 225 5,000 1,125,000
Company 5 30,000 300 3,000 900,000
116,667 11,667 $2,530,000
Now suppose we have a cap-and-trade scheme that would allow the rights to pollute to be traded. Let’s assume a market price for pollutants at $130. At that price, it would pay Companies 1 and 2 to clean up all their pollutants since they would be able to sell their right to pollute. On the other hand, it would pay the other three companies to buy these rights instead of cleaning up since their cost to clean-up are higher than this market price.
Table 3 Cost of
Cleanup amount Cost
Total per pollutants of
Pollutants pollutant Cleaned up Cleanup
(1) (2) (3) (4)
(2) x (3)
Company 1 6,167 $100 6,167 $ 616,700
Company 2 5,500 125 5,500 687,500
Company 3 25,000 150 0 0
Company 4 50,000 225 0 0
Company 5 30,000 300 . 0 0 .
116,667 11,667 $1,304,200
By having only those companies clean up that can do so at the lowest cost, 10% of pollutants can be cleaned up for $1,304,200 rather than $2,530,000. The same amount of pollution is cleaned up at a much lower cost under cap-an-trade than by government mandate a cut across the board. That’s the case for cap-and-trade!
Not only does every company have a financial incentive to reduce its pollution, with tradeable rights, the market will also ensure that the overall cost to society of pollution reduction will be as low as possible. Companies with more difficult problems can, in the first instance, buy up the available rights to pollute. As these rights become more expensive, the incentive to find technological solutions will increase. While the government enforces the overall permitted amounts, the market decides the most cost-effective way to reduce. In fact, the market price of the traded permits also serves as price signal. The higher the market price for the permit, the more incentive there is for innovators to devise new remedial technology or processes. A final benefit of the system is that environmentalists or governments can speed up the clean-up process by themselves getting together and purchasing--and not using--the pollution rights. In Cleveland, for example, a group called INHALE sprung up to buy and bid up the price of sulphur-dioxide credits so that U.S. utilities would be forced to clean up their own emissions. Such action reduces pollution immediately and, by raising the price of rights, increases the incentive for others to reduce pollution.
Of course, the effectiveness of tradeable quotas will depend on the extent of the permitted emission amounts—the cap. Any cap will be an arbitrary number but can be reduced over time to get the desired result while generating the least amount of disruption (e.g. in terms of employment). As such, this policy alternative (just like green taxes), is consistent with our conditional preference for the market. Since climate change is a global issue, it would seem reasonable that these allowances be traded over wide regions as has been done for carbon in a linked market by Ontario, Quebec and California. If you believe in the need to reduce carbon, it doesn’t matter where this reduction takes place. The problem is, however, to what extent these markets are actually harmonized e.g. are the caps equally burdensome etc? Only time will tell whether the implementation of this system will achieve the desired effect. In any case, cap-and-trade is, in principle, a useful policy tool in the fight against climate change—if you believe in the need to do something about it.
 That skepticism was reinforced by a recent post I read by Matt Ridley, “The Climate Wars’ Damage to Science”, https://quadrant.org.au/magazine/2015/06/climate-wars-done-science/
 Lester R. Brown, Plan B: Rescuing a Planet under Stress and a Civilization in Trouble, W.W. Norton & Co. Ltd., New York, 2003. p.209.
 Lévêque and Nadaï, in Henk Folmer, H. Landis Gable and Hans Opschoor, editors; Principles of Environmental and Resource Economics: A Guide for Students and Decision-Makers, Edward Elgar, Aldershot, UK & Brookfield, US., 1995,p.317
 And, admittedly, simplistic.
 This market would come to equilibrium at a price between $126 and $149
 Robert Sheppard, “How much am I bid for a pair of carbon-dioxide credits?” The Globe and Mail, Jan 17, 1998.