Carbon Credit Watch

Theory and practice of cap and trade

William Watson
Financial Post
March 1, 2007

Most economists love cap-and-trade systems for controlling different kinds of pollutants. The reason is that, at least in their ideal version, they’re beautifully simple. In practice, a new World Bank report suggests, the ideal isn’t attained. The practical implication of that is that a Kyoto cleanup will be more expensive than standard estimates suggest.

Start with the ideal. If you can figure out the “right” amount of carbon dioxide, say, to let into the atmosphere — and that’s a gigantic “if,” call it Big Assumption 1– you issue permits in that amount and then decree that no one can put carbon dioxide into the atmosphere without one of these permits. You also need Big Assumptions 2 (people don’t cheat) and 3 (all the world’s governments co-operate). But let’s run with the ideal for a minute.

Once you’ve issued your permits, you let people trade them and in theory your problems are solved. Individual economic agents compare the cost of buying a permit with the cost of reducing their emissions. If the permit costs more, they reduce their emissions. If the permit costs less, they buy a permit.

Who’s selling permits and cleaning up? People with low abatement costs. Who’s buying permits and not cleaning up? People with high abatement costs. Which is exactly what you want: the people for whom cleanup is easiest clean up.

If, as much evidence suggests, abatement is cheaper in poor countries that haven’t yet paid much attention to emissions and costlier in rich countries that have, then on balance rich countries buy permits and poor countries do the abatement. But that’s OK. As far as the atmosphere is concerned, emissions from any source are equally harmful. Efficiency means abating where the cost is lowest.

If you ever studied economics, you probably remember “marginal this equals marginal that.” Push an investment until the marginal benefit is just equal to the marginal cost and you will have maximized the return from investment. Balance work and home life so the last hour of each gives equal benefit and you will have arranged your time efficiently. Equating things “at the margin” is the economist’s standard recipe for efficiency.

In its ideal form, an efficient cap-and-trade system makes the marginal cost of abatement the same everywhere in the world (and, you sincerely hope, the same as the marginal benefit from reducing whatever is being abated).

But that happens only if, when purchasing permits, buyers focus solely on cost and benefit. This is yet another case (thank you, Adam Smith) where the pursuit of private profit brings about public good.

Will buyers focus solely on cost and benefit? The World Bank’s new study suggests they may not. But if they don’t, then cap and trade isn’t as beautifully efficient as we economists want to believe.

The two economists who did the study conclude that induced abatement investments in poor countries are not made solely with bang for the buck in mind. To learn more about how such investments might work, the people behind the Kyoto Protocol encouraged governments to try them out. Between 1992 and 2001, 22 investor countries (usually rich countries) and 42 host countries (usually poor ones) signed 147 letters of intent (Canada sponsored two). In all, 65 country pairs tried out projects.

What were the results? The most satisfying way of getting an answer would be to look at the projects involved, see how much abatement they produced, and compare them to the abatement other projects would have brought. Unfortunately, data like that simply doesn’t exist. So what the economists did instead was to see whether the pattern of investment was similar to the pattern of the rich countries’ development assistance. They found out that it was.

On the face of it, that’s peculiar. With more than 169 countries available to host abatement projects, rich countries typically danced with the same small numbers of countries they deal with frequently on the development side. Sweden, for instance, had a lot of deals with Estonia, even though Estonia probably doesn’t have the lowest CO2- abatement costs in the world.

In other ways, such a pattern does make sense. It’s easier for governments to deal with governments they already have contacts with. And it’s always possible that the countries with the best abatement opportunities also have the best development opportunities — though you’d think that a strange coincidence if it were true.

The two economists’ conclusion? It wasn’t true. Rather, “general national-policy objectives” influenced “project-investment outcomes,” and “quantitative evidence supporting this conclusion is robust and holds up under a series of alternative specifications.” In a model of understatement, they add that “often-used conceptual models of how markets might work under an implemented Kyoto Protocol are not fully consistent with this depiction of how investments were determined” in the pilot projects.

But if the investors don’t opt for the projects with the greatest abatement per dollar invested, which is the case if other objectives intrude, then the cap-and-trade system won’t bring about the beautifully efficient, minimum-cost reduction of emissions that economists and environmental lobbyists dream about. And Kyoto will cost more than current estimates allow.

Read the original story here. [PDFver here]

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