Cap and Trade 101
Marlon G. Boarnet
Professor of Public Policy
Director of Graduate Programs in Urban
Planning and Development
University of Southern California
July 10, 2010
Externalities
• An externality occurs
when a market
transaction affects a
party who neither
pays not gets paid
Private Markets
$
MPC
MPC = marginal private cost
MPB = marginal private benefit
Q = quantity consumed (purchased)
D = MPB
Qp
Q (Televisions)
Externalities
• An externality occurs
when a market
transaction affects a
party who neither
pays not gets paid
Private Markets
$
MPC = MSC
MPC = marginal private cost
MPB = marginal private benefit
Q = quantity consumed (purchased)
MSC = marginal social cost
MSB = marginal social benefit
D = MPB = MSB
Qp
Q (Televisions)
Externalities
Markets with Externalities
• An externality occurs
when a market
transaction affects a
party who neither
pays not gets paid
MSC
$
MPC
Social cost
exceeds social
benefit for
these trades
MPC = marginal private cost
MPB = marginal private benefit
Q = quantity consumed (purchased)
MSC = marginal social cost
MSB = marginal social benefit
D = MPB
Q* Q
p
Q (Driving)
Photos: SQ AQMD
and Los Angeles
Times
Regulatory Approaches
Tax = (MSC – MPC)
• Price Controls (taxes)
MSC
$
– Example: Value Pricing on
SR-91
MPC
• Quantity Controls
(mandated limits)
– Example: Clean Air Act
compliance
Social cost
exceeds social
benefit for
these trades
• Emission Clean-Up
(mandated technology)
– Examples: Catalytic
Converters; Unleaded Fuel
D = MPB
Q* Q
p
Mandated emissions limit
Q (Driving)
Efficiency of Regulatory Approaches
(Theory)
• Price Controls (taxes) and Quantity Controls
(mandated limits)
– Both lead to efficient externality reduction (to point
where social costs of activity = social benefits)
– Difference is in information available to regulator
• Emission Clean-Up (mandated technology)
– Can regulator “pick” the right technology?
– Why not let market forces choose clean-up
technology?
Efficiency of Regulatory Approaches
(Practice)
140
120
117
100
80
LA County population (100,000s)
60
LA City Stage 1 Smog Alert Days
41
40
20
0
1980
1990
0
2000
Year
Data: SC AQMD and
US Census
27% pop growth LA County (7.4 to 9.5 million)
Stage 1 days from 117 (in 1978) to 0 (late 1990s)
Market Based Regulatory Mechanisms
Market based
• Price Controls (taxes)
• Quantity Controls (mandated limits)
– Cap and Trade – Variation on Quantity Control
• Emission Clean-Up (mandated technology)
• Incentive vs. outcome regulation
• Advantages of market based regulations
– Creates incentives for clean-up
– “self regulating” – uses incentives and markets to
coordinate actions
Cap and Trade
• Economy-wide cap on emissions (quantity
regulation)
– Similar to Clean Air Act concentration levels for
traditional pollutants
• Firms get emission permits, which can:
– Be used for emissions, or
– Sold to firms that want extra permits
• Permits “depreciate” over time – cap binds more
• Firms that can clean up inexpensively will do
more cleanup to sell permits to “dirty” firms
• More emission reduction from firms that can
reduce emissions at lower cost
Example
dirty
Firm 1
$300
$500
$700
$1000
clean
Firm 2
$100
$200
$300
$500
cost for reducing 1st ton of CO2e
cost for reducing 2nd ton of CO2e
cost for reducing 3rd ton of CO2e
cost for reducing 4th ton of CO2e
both firms initially produce four tons CO2e
reduce four tons, two from each firm, cost = 1,100
two permits per firm and can trade, cost = 900
Firm 2 will sell a permit to Firm 1 at any price higher than $300
Firm 1 will buy a permit from Firm 2 at any price lower than $500
Does it work?
• SO2 permit market, Clean Air Act
Amendments of 1990; RECLAIM SCAQMD
• Conditions for Cap and Trade to be successful
and issues
– No “hot spots” – location of emissions is no
concern
– Sufficient number of permit-holders for market to
work
– Neither a shortage nor surplus of permits
– Initial permit allocation issues
ARB Cap and Trade
• Economy-wide cap: 1990 CO2e emissions by
2020
• Price stability measures – reserve permits to offer
on market and effort to not be too slack
• Distribute early permits by allocation, auction
later permits
• Measures to reward prior energy efficiency with
permit allocation
• Economic impacts mostly distributional
– 2.3% state GSP growth per year 2007-2020 vs. 2.4%
“business as usual”
Use of Auctioned Permit Revenues
•
•
•
•
Reduce distorting taxes
Dividends to consumers
Clean energy?
High speed rail?