Why a Cap-and-Trade System Needs a Regulatory Backstop

by Alice Kaswan

August 26, 2009

As fellow environmental law professors David Schoenbrod and Richard Stewart take their advocacy for market mechanisms and skepticism about regulation public, with an op-ed in the Wall Street Journal on Monday, I thought it was time to speak out in favor of a role for regulation. They claim that the climate change bill that passed the House in July, the American Clean Energy and Security Act of 2009 (the Waxman-Markey bill), relies too much on “top-down” regulation and not enough on pure market mechanisms. Regulations, in their view, are bureaucratic, inefficient, and politically motivated to favor key industrial constituencies. Market mechanisms would be more efficient and effective, they say, because once an emissions cap is set, industry and consumers would make their own rational emissions reduction decisions.

Ideological claims that “markets work” and “regulations don’t work” miss the point. Schoenbrod and Stewart identify failed regulations and successful markets. I can identify failed markets and successful regulations. For example, the European Union’s European Trading System, its initial foray into greenhouse gas controls, failed to reduce emissions or generate innovation incentives, while many U.S. regulatory initiatives have successfully reduced traditional pollutant emissions. We can all point to examples of success or failure for a given policy instrument. While markets and regulations have differing intrinsic strengths and weaknesses, the most critical factor is how well or poorly they are designed, not the choice between them. In a fraught regulatory environment presenting plenty of opportunities for either method to fail, Congress should provide the Environmental Protection Agency with the flexibility to adopt regulatory requirements to complement -- or rescue, if necessary -- its predominant market strategy.

Professors Schoenbrod and Stewart rue the instances in which Waxman-Markey calls for regulation. What they do not emphasize is that the bill’s predominant approach for directly addressing emissions sources is cap-and-trade. The bill strips EPA’s authority to impose regulations on most stationary emissions sources by exempting all sources covered by the cap-and-trade program from the Clean Air Act’s regulatory provisions. (EPA can set “new source performance standards” only for the uncapped sources that are too small to be included in the trading program.) While some Clean Air Act provisions are indeed ill-suited for addressing greenhouse gases, Waxman-Markey fails to provide a better-tailored regulatory alternative.

One of the most important reasons to give EPA the authority to establish regulatory requirements is that the cap-and-trade program could fail. Schoenbrod and Stewart themselves state that the current bill “purports to set a cap on greenhouse gases, but the cap is so loose in the early years that through the use of cheap offsets the U.S. need not significantly reduce its fossil-fuel emissions until about 2025.” Of course, the best solution would be for Congress to tighten the cap and restrain offset use to create more robust reduction incentives. But what if it doesn’t -- what if both chambers agree on a bill with a weak cap and generous offsets? What stronger statement could be made for why EPA needs to retain the authority to require reductions when the market fails to incentivize them?

Nor do markets seamlessly motivate industry or consumer behavior. Even if the cap-and-trade system were robust enough to generate price signals that would, in economists’ models, motivate emission-reducing behavior, the required investment decisions are complicated. For example, both industry and consumers could resist the capital investments necessary to reduce emissions significantly, and prefer purchasing allowances or paying electricity bills, even if they’re higher. While the cap must be met one way or another, markets could fail to generate the technological transformations that would meet the cap most efficiently and best prepare the nation for a long-term transition away from fossil fuels. Targeted regulatory measures may be necessary to induce technological change in areas resistant to market signals.

Schoenbrod and Stewart fear, with some reason, that politics could poison the regulatory process. They view government with suspicion, and do not trust the wisdom of its regulatory choices. But government regulation also has great potential. Our civil servants, led by democratically elected officials, have the capacity to take the long view of the public interest (unlike the short-term profit horizons that industry faces). In addition to making up for market failures, targeted regulatory approaches could serve a variety of important public purposes.

First, regulation could provide greater economic and energy security. If the market does not induce less reliance on fossil fuels, and if major emissions sources choose to buy allowances rather than reduce emissions or switch to less-emitting fuels, then our energy sector would remain highly vulnerable to future allowance shortages. Allowance shortages could arise from a variety of sources, including the decreasing cap itself, economic growth that increases greenhouse-gas emitting production activity, or international limits on developing country emissions which could constrain or eliminate the supply of cheap international offsets. With allowance shortages could come significant price spikes. If EPA is given a regulatory option, it could adopt policies to facilitate deeper technological transformations and greater actual emission reductions that would leave the nation less vulnerable to variable allowance supplies.

Another public purpose served by regulation is maximizing co-pollutant reductions. As Schoenbrod and Stewart state, “key greenhouse gases and many conventional pollutants come from the same fuel-burning processes. Systems for regulating both kinds of pollutants should work together rather than at cross purposes ….” Conventional pollutants are concentrated in certain areas of the country, imposing significant public health consequences for the impacted populations. While greenhouse gas emissions themselves do not cause localized impacts, reducing greenhouse gases will almost always reduce the associated co-pollutants. Encouraging greenhouse gas reductions in polluted areas would maximize the climate program’s co-pollutant benefits. Since the government cannot control the location of reductions in a trading program, regulations could provide a more effective mechanism for integrating co-pollutant and greenhouse gas reduction goals.

More broadly, while Schoenbrod and Stewart decry the potential role of politics in distorting regulatory programs, what about the politics of market design? Cap-and-trade programs are rife with opportunities for influence that could undermine a program’s effectiveness. Not surprisingly, “politics” are an inevitable part of the democratic process. Politics will influence the cap-setting process, the extent to which offsets are allowed, the types of permissible offsets, the content of and control over offset integrity rules, the choice between freely distributing allowances versus auctioning them and numerous other critical parameters. It is not clear that one or the other policy instrument is more or less subject to potentially abusive political influence.

The Waxman-Markey bill relies on cap-and-trade as its primary mechanism for directly controlling emissions from most major sources. That approach could offer important advantages over a pure regulatory approach. But that does not mean that regulation does not have its place. The Senate, in its climate change legislation deliberations, should ensure that EPA retains or obtains sufficient regulatory authority to impose targeted emission reduction requirements where a cap-and-trade program proves insufficient.

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