Increased concentrations of greenhouse gases have heightened concern throughout the world about climate change and global warming. One manifestation of this concern in the United States is reflected in a market-based approach termed "cap and trade" to regulate carbon dioxide emissions; this is contained in the proposed American Clean Energy and Security Act of 2009. Various regulatory approaches exist for controlling pollution. A common one is "command and control." One example in the context of carbon emissions is the Corporate Average Fuel Efficiency (CAFE) standards, which mandate minimum fleet mileage standards for motor vehicles sold in the United States. Generally speaking, economists tend to prefer market-based approaches, such as a cap-and-trade program, to other regulatory approaches for reducing carbon emissions. Various economic reasons exist for preferring market-based approaches. First, all polluters face the same marginal cost of reducing pollution, which is a necessary condition for reducing pollution in the most cost-effective way. The cap-and-trade legislation illustrates the interplay between economics and politics.
c l i m a t e c h a n g e Regulating Carbon Emissions: The Cap-and-Trade Program By Cletus C. Coughlin and Lesli S. Ott © Michael Prince /cOrBiS I ncreased concentrations of greenhouse gases have heightened concern through- out the world about climate change and As long as the firm’s incremental costs stay less than or equal to $15, then it will reduce its emissions; if not, assuming it is profitable Meanwhile, the marginal cost (MC) curve is sloped positively to reflect the assumption of increasing marginal abatement costs. In global warming. One manifestation of this to do so, then the firm will pay the tax or buy other words, as a firm attempts to abate more concern in the United States is reflected in the permit. (Note that part of a firm’s adjust- and more carbon emissions, incremental costs a market-based approach termed “cap and ment to the higher price to pollute might to the firm of additional abatement increase. trade” to regulate carbon dioxide emissions; entail a cut in its production of goods.) this is contained in the proposed American Second, incentives are provided so that figure 1 Clean Energy and Security Act of 2009.1 This pollution is reduced relatively more by firms Cap-and-Trade legislation requires a 17 percent reduction in with relatively lower costs of doing so. In emissions of carbon dioxide by 2020 from other words, if firms must pay $15 per ton P MC 2005 levels.2 While there are numerous con- of carbon emissions, then firms that can troversial provisions in this legislation, this reduce pollution at relatively lower cost will article focuses on the economic principles undertake relatively more abatement than P* underlying the cap-and-trade proposal.3 will higher-cost firms. Third, market-based approaches provide Reducing Carbon Emissions Efficiently incentives for innovative activity that can MB Various regulatory approaches exist for lower the cost of reducing pollution. Sim- controlling pollution. A common one is ply put, firms can increase their profits by O Q* Q (emissions abated) “command and control.” One example in the finding ways to lower the cost of reducing context of carbon emissions is the Corporate pollution. Given the curves in Figure 1, the ideal Average Fuel Efficiency (CAFE) standards, Under a cap-and-trade program, the quantity of abatement is indicated by Q*. which mandate minimum fleet mileage stan- quantity of carbon emissions is capped. Given This quantity of abatement will result in a dards for motor vehicles sold in the United an upper limit on the quantity of carbon price of carbon emissions of P* per unit. This States. Generally speaking, economists tend emissions, market participants will determine efficient outcome reflects the fact that emis- to prefer market-based approaches, such as a the price of these emissions. The supply and sions abatement should continue until the cap-and-trade program, to other regulatory demand diagram in Figure 1 can be used point at which the marginal benefits equal approaches for reducing carbon emissions. to illustrate the basics of a cap-and-trade the marginal costs. Additional abatement Various economic reasons exist for prefer- program. The horizontal axis measures the beyond Q* is inefficient because the marginal ring market-based approaches. First, all pol- quantity (Q) of carbon dioxide emissions costs exceed the marginal benefits. luters face the same marginal cost of reducing abated, while the vertical axis measures In the preceding example, the marginal pollution, which is a necessary condition for the value (benefits or costs) per unit (P) of benefit and cost curves were assumed to be reducing pollution in the most cost-effective carbon abated. Note that by cappi
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