Cap and trade could be double-edged sword

April 20, 2009

"Cap and trade" is shorthand for what economists call emissions trading. It is a method of regulating pollution, primarily from power plants.

We've been successfully using emissions trading to control pollutants—specifically sulfur dioxide—for almost two decades. It is pretty important to understand the cap-and-trade debate because the Obama administration proposes using the practice to reduce carbon dioxide emissions. The effect on energy costs and, hence, our economy could range from negligible to breathtakingly extreme.

Under cap and trade, each power producer would be given permits to pollute, probably based on the amount of power produced. These permits would allow producers to release into the air some quantity of carbon dioxide, but the permit "caps" the total level of pollutants.

Power producers are polluting already, but different power sources (for example, coal, natural gas or nuclear) release different levels of pollutants for each kilowatt hour of energy they produce. As a consequence, some of the power plants will have too many permits, others too few. Here's where the trade part comes in.

The government establishes a secondary market for these permits. Companies that have excess permits can sell them, while those with too few can buy them. The price of these permits is then established by their scarcity. This gives incentives to firms to choose technologies and fuels that reduce pollution, but also allows them to phase in the costs. Anyone can purchase these permits and simply remove them from the market (this is called retiring them, in the trade lingo). Sulfur dioxide is currently selling at about 75 cents a pound.

Trading emissions works very well for pollutants that are widely dispersed, affecting us all. Sulfur dioxide trading has reversed the acid rain catastrophe that loomed in the 1970s and 1980s. Emissions trading does not work well for highly localized pollutants such as mercury or lead. Obviously, in this case, a single plant could discharge huge amounts of pollutants in a single area, making it unlivable. Markets are the single most successful human invention for organizing resources, but they don't solve all our problems.

Not everyone likes cap-and-trade policies. Opponents come in two flavors. First, there is a strong subcurrent of environmentalists who don't like anything that smacks of market-based solutions. Given the success of emissions trading thus far, we should let them dwell on the fringe of the debate.

The other group of folks are those worried about geographic equity. Some regions could be economically devastated by cap-and-trade policies. This depends on the level of the cap. Any region that relies upon coal (the Midwest or Southeast) is at risk of much higher energy costs, which could cripple manufacturing in our state.

Cap and trade could lead us to a much cleaner, more prosperous future or it could devastate our economy. We all need to pay close attention to the details of the debate.

Hicks is director of the Center for Business and Economic Research at Ball State University. His column appears weekly. He can be reached at cber@bsu.edu.

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