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Real World Problems with Cap & Trade

One of the more interesting misunderstandings about cap and trade is the idea that cap and trade systems provide certainty about the quantity of emissions. This is true in the world of supply and demand diagrams, but it doesn’t translate to the real world without a lot of additional conditions. These conditions are pretty hard to satisfy.

Start with the wonderful supply and demand diagram we economists use for almost everything. It has two dimensions. Value goes on the vertical axis with price. On the horizontal axis we put quantity. Quantity actually stands for the amounts that people buy and sell, so the horizontal direction is really about behaviour. A cap on any product appears as a vertical line and a statement about how people are allowed to behave: no one is allowed to buy or sell beyond that line. If you can enforce this rule perfectly you can limit emissions precisely.

Of course at this stage your cap is all theory. In the real world you have to set the caps, then monitor actual behaviour, and then enforce the rules. The nice neat vertical line on the graph turns out to a blurry, thick collection of rules, behaviours, arguments, forms that have to be filled out, forms that have to be read, filed and stored, interviews with people who seem to be breaking the rules, discussion with lawyers, and then going back to revise the rules.

The cap and trade system only works if you set the caps correctly (hard to do politically when every company and every industry is in the Minister’s office begging for exceptions), if every one who should be capped is capped (nearly impossible technically), if surveillance is intensive enough to catch people who exceed their caps (definitely expensive and unpopular), and if the caps are enforced (this is surprisingly difficult especially in countries that have already cut back on environmental and heath inspections).

In practice the largest trading system to date has failed on every one of these conditions. The European system has improved, but it is still costly and full of holes. The holes are there because politicians were convinced to leave those holes. Maybe a cap and trade system will work with no politicians, but that hasn’t been tried yet.

So short-run certainly under a cap and trade system requires setting, monitoring and enforcing caps, avoiding offsets, and comprehensive caps. Long-run certainty is even harder to provide unless there is
1) a mechanism for laying out the path of of the aggregate cap for 20 years,
2) a demonstration of willingness to be tough, and
3) a way of committing future governments.

Without those there is no certainty, just an abstract principle derived from a graph.

In fact it is far cheaper to satisfy all the requirements with a Fee and Dividend system. The tax system is cheap to run. Cutting the population in on the revenues with a dividend locks the government in because it is hard to take back a transfer to the public. A dividend therefore serves as a commitment mechanism. It allows the government to make a credible commitment to raising the tax over time, reducing uncertainty about whether the government will follow through tighter controls. Overall a tax and dividend approach provides more real certainty about reducing emissions than a cap and trade system can.

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