Once we are free from the illusion that free-market environmentalism will protect the environment, we are free to explore the pros and cons of different policies that can. This chapter seeks to provide environmentalists and progressives who are not economists with the necessary information to correct common misunderstandings about what different policies do, and do not do. Hopefully this knowledge will render environmentalists and progressives immune from intimidation at the hands of technocratic economists who often do not share their values and priorities.
While mainstream economists argue that the choice of environmental policy should be based on technical merits and guided by traditional cost-benefit analysis (CBA), environmentalists and progressives sense that often CBA is not the appropriate methodology and that policy choices both are and should be based on other concerns as well. This chapter validates common concerns of progressives and environmentalists by exploring complications and real-world issues regarding environmental policies that mainstream economists do not like to talk about.
First we explore the basic logic of regulation, taxes, and tradable permit programs; dispel common myths about monitoring and enforcement; and explain how to analyze the distributive effects of policy options. Next we explore property rights, zoning, and how a little-known policy called transfer development rights can help overcome political resistance to anti-sprawl initiatives. Then we discuss community management as an alternative to both privatization and government regulation of common pool resources (CPR) to prevent the tragedy of the commons. Finally, we evaluate fears about permit markets and Wall Street machinations and discuss the practical implications of tax-phobia.
We begin by exploring the logic and implications of three different ways to reduce carbon dioxide emissions in a market economy. Suppose the U.S. government decides it wants to reduce national emissions by 10 percent next year. This could be done in three ways: (1) a regulation approach mandating a 10 percent reduction in emissions from every source; (2) a carbon tax set at a level that achieves a 10 percent overall reduction in emissions; (3) or a cap-and-trade program where the number of permits printed allows for only 90 percent of last year’s total emissions. Since all three policies reduce emissions by the same amount they are called equivalent, but as we will discover this does not mean their consequences are the same in other regards.1
Regulation: The regulatory approach would be to order every source inside the United States emitting carbon dioxide to reduce its own emissions by 10 percent. Many economists object to this approach for two sensible reasons: (1) This policy fails to minimize the cost to society of achieving a 10 percent reduction in overall emissions if there are differences in abatement costs among sources.2 For example, suppose one source emitting carbon dioxide can reduce emissions for half what it costs another source to reduce its emissions. It is inefficient to require the second source, for whom abatement costs are higher, to reduce emissions by the same percentage as the first source, for whom abatement costs are lower. Because there are significant differences in abatement costs among different sources, this criticism of the regulatory approach to reducing carbon dioxide emissions is well taken. (2) Ordering all sources to reduce emissions by 10 percent provides no incentive for any source to search for new technologies that could reduce its emissions by more than 10 percent—no matter how cheap it might be.
There is an additional problem with the regulatory approach that mainstream economists seldom point out, but that should be of concern to anyone concerned with equity. The regulatory approach does not require sources who, in our example, continue to emit 90 percent of the carbon dioxide they emitted the previous year to pay for the costs their emissions continue to impose on the rest of us. In other words, the regulatory approach does not implement the “polluter pays” principle, which many environmentalists and progressives champion with good reason. In effect, the regulatory approach draws an arbitrary line. It says that the last 10 percent of emissions from each source is so damaging that it must be outlawed completely, whereas the first 90 percent of emissions costs society nothing, and therefore sources should be free to emit 90 percent of their previous levels without payment or apology. But this is not consistent with the facts. The fact is that as long as sources wish to emit more carbon dioxide in the aggregate than is consistent with climate stability, whenever anyone emits any carbon dioxide it imposes a cost on society. In effect, the regulatory policy excuses 90 percent of socially costly emissions.
Another way to look at the issue is that the regulatory approach implicitly grants sources a legal property right to emit 90 percent of what they were emitting previously, but cancels what had been their de facto property right to emit the last 10 percent. In other words, regulation creates a valuable new legal property right, gives 90 percent of this property right to those emitting carbon dioxide, reserves only 10 percent of the new property right for the rest of us, and bars everyone—both emitters and the public—from selling their new property right, no matter how beneficial a deal they might be able to find.
A second kind of regulation mandates use of particular technologies and outlaws use of other technologies. For example, all new coal-burning power plants could be required to include a new process that captures and stores carbon emissions, and existing plants might be given a specified time to acquire this new technology. Or buildings could be required to include more insulation or sealants for energy conservation. When the best response takes a particular form that the government can easily determine or when businesses fail to make changes that reduce emissions even though these changes will prove profitable over time, this kind of regulation can be very effective. As a matter of fact, many of the most successful environmental policies to date, like the Clean Water Act and Clean Air Act, have been of this kind.
However, the fact that those who claim technological expertise with regard to alternative technologies for producing and consuming energy often disagree on what they recommend—or at least disagree on which changes should be prioritized and mandated first—suggests that technological regulation with regard to energy production and consumption may not be as obvious as its supporters often assume. Since there are many different ways to produce and conserve energy, since least-cost means are often different for different sources, since least-cost means are particularly difficult for outsiders to identify, and since businesses often do respond more or less sensibly to price signals, using a price mechanism to induce businesses to find their own least-cost means of compliance has obvious advantages.
Tax: An alternative way to achieve a 10 percent reduction is to impose a tax on carbon dioxide emissions. The government would have to use trial and error to find the level to set a carbon tax in order to achieve an overall reduction in emissions of 10 percent. However, there is a carbon tax—some number of dollars per ton of carbon dioxide emitted—that would achieve a 10 percent overall reduction in carbon dioxide emissions in the United States.
The logic of a carbon tax is to force producers to take into account the cost to society of their carbon dioxide emissions, just as they have to take into account the cost of using labor and scarce raw materials. Labor and resource markets make producers pay for the labor and raw materials they use, but unless the government levies a carbon tax nobody has to pay for the damage their emissions cause. Consequently, in the absence of a carbon tax, producers ignore the social cost of their emissions in order to maximize their profits, and households have no incentive to consider the damage their emissions cause. A carbon tax seeks to “internalize” this otherwise neglected, negative “external” effect so businesses and households will take it into account.3
When all who emit carbon dioxide pay the same tax per unit of emission, those with lower abatement costs will find it in their interest to reduce emissions by more than those with higher abatement costs. Sources will find it in their interest to reduce their emissions as long as their reduction costs are less than the tax they must pay if they fail to reduce emissions. Sources with high reduction costs will reduce their emissions by less, while sources with low reduction costs will reduce their emissions by more. This means a carbon tax distributes reductions among emitters in a way that minimizes the cost of achieving the overall 10 percent reduction—sources with low abatement costs will do more of the total reduction and sources with high abatement costs will do less. It also means all sources have an incentive to develop new technologies to further reductions no matter how much they have already abated.
So a carbon tax minimizes the overall cost of achieving a 10 percent reduction in aggregate emissions. A carbon tax also explicitly makes polluters pay. It forces those who wish to emit greenhouse gases to pay the rest of us (in the form of a carbon tax) for using a scarce, valuable resource—space in the upper atmosphere where too much carbon is already stored. At least in theory, each citizen of the United States has an equal claim on the tax revenues of the federal government. So implicitly a carbon tax awards 100 percent of what was formerly an ambiguous property right that was habitually appropriated by polluters without asking permission—the right to release carbon dioxide into the atmosphere—to all citizens on an equal basis.
Tradable emission permits: While commonly misunderstood, each part of this policy is quite simple. Emission permits: Anyone emitting carbon dioxide is required by law to own permits to do so. If I am emitting 246 tons, and if a permit allows me to emit one ton, then I must acquire 246 permits. If I have 246 permits but emit more than 246 tons, I am in violation of the law—just as I would be if I caught six trout when my fishing permit only allowed me to catch five trout—and I am subject to whatever punishment for violation is established as part of the carbon permit law. Tradable: Anyone who owns a permit is free to sell it to anyone she chooses, and anyone who wants to buy a permit is free to buy it from anyone who is willing to sell it. In other words, there is a free market for the permits to emit carbon where everyone is free to strike any mutually agreeable deals they wish.
So if the U.S. government wants to reduce carbon emissions by 10 percent, all it has to do is print up 10 percent fewer permits than the number of tons of carbon emitted in the United States last year. However, declaring these permits to be tradable in a free market is not the same as deciding how to distribute the permits in the first place. Many assume that when the government says there will be a market for emission permits, it means the government will sell the permits at an auction where all are free to come to buy. But this is not the only possibility and unfortunately has seldom been the case. Prior to 2008 the bulk of pollution permits were given away free of charge to firms emitting the pollutant.4 The procedure usually used is called the “grandfather system,” which awards permits for free to polluters based on their share of past emissions. Under the grandfather system, for example, if a company was responsible for 28 percent of all carbon emissions last year, it would receive without charge 28 percent of all the permits printed this year. Another way to think about the grandfather system is that every source of carbon emissions would receive, without charge, permits sufficient to cover 90 percent of whatever amount it had emitted the previous year. That would be its windfall wealth gain, which it is free to use as it pleases. Companies, for example, could use all their permits themselves, or sell some of them on the permit market if they decide to reduce emissions by more than 10 percent, or add to the permits they received free of charge in the initial grandfather distribution through purchases in the permit market if they decide to emit more than 90 percent of what they emitted last year.
In many respects, tradable carbon permits will lead sources to behave in the same way a carbon tax does. If I want to emit more carbon dioxide, I need to have more permits. If I do not own enough permits, I have to buy more in the permit market—which is costly. But even if I own enough permits to pollute as much as I want, it is still costly for me to emit carbon dioxide because the more I emit, the fewer carbon permits I can sell for a profit to others in the permit market. Under both a carbon tax and a cap-and-trade permit program, there is an opportunity cost when sources emit carbon dioxide. And if the price of a permit to emit one ton of carbon dioxide is the same as the tax on a ton of carbon dioxide, as it will be if the programs are equivalent, the opportunity cost of emitting a ton of carbon dioxide is the same in both cases and therefore induces the same behavioral response. In other words, at least in theory, tradable carbon permits yield the same efficiency advantages as carbon taxes—they minimize the overall cost of achieving a 10 percent reduction in carbon dioxide emissions-because they induce sources with lower reduction costs to reduce their emissions by more than sources with higher reduction costs.5 Like a carbon tax, a tradable carbon permit program also provides incentives to develop cleaner technologies to reduce a company’s carbon footprint since lower emissions leave fewer carbon permits to buy or more permits to sell.6
Like a carbon tax, cap-and-trade permit programs where all permits are auctioned also implements the “polluter pays” principle and distributes new property rights on an equal basis to all citizens. Anyone who wants to emit carbon dioxide must pay for that privilege by purchasing a permit to do so at a government auction. A carbon cap-and-trade program takes an ambiguous property right—the right to release carbon dioxide into the atmosphere—and explicitly transforms it into a legal property right. Whereas this “right” was formerly appropriated by any who wished because nobody (who mattered) objected, under a cap-and-trade program the property right is encapsulated in carbon permits. If 100 percent of the permits are sold at auction, the property right is explicitly awarded to all citizens on an equal basis since all citizens, at least in theory, have an equal claim on the revenues of the federal government.
However, if permits are given away free of charge—as they always have been with the single exception of the recent North East Regional Greenhouse Gas Initiative—the new, legal property right is awarded to whoever receives them. Under the grandfather system, the new property rights are awarded to those who are emitting carbon in proportion to their share of past emissions. The fact that those who receive the permits under the grandfather system may choose to sell them or buy more of them on the permit market simply means that those who have been explicitly awarded this new wealth are legally free to do with it as they please.
Monitoring and enforcement: Critics sometimes argue that if monitoring and enforcement are inadequate, permit programs will fail to deliver expected reductions. This is true. However, this is equally true for regulatory and tax policies. If sources can get away with underreporting emissions so they do not have to purchase as many permits as they should, we obviously have a problem. But if they can get away with it, sources will underreport emissions to avoid fines under a regulatory program, and sources will underreport emissions to reduce tax liability in the case of a carbon tax. In other words, all three policies require authorities to know how much sources have emitted and establish effective penalties for violations. All three policies face the same practical problems with regard to devising an effective system for measuring, monitoring, and enforcing compliance. And contrary to the claims of some free-market environmentalists, none of these policies, including cap-and-trade, is “self-monitoring.” With regard to monitoring and enforcing, we could say all three policies are “created equal.”
Incidence: Any policy that reduces carbon emissions will raise the price of carbon emissions and thereby change the price structure in the economy, which will in turn change income distribution as well. This is true if we regulate carbon emissions by ordering an across-the-board cutback of 10 percent for all sources, if we impose a tax, or if we “put a price on carbon” through a cap-and-trade program. The distributive impact of raising the price of anything has long been studied by economists with regard to sales taxes imposed on particular commodities under the label “tax incidence.” It turns out that in a market economy it is far from obvious who will end up paying how much of a sales tax. For example, whether the tax is collected from sellers or from buyers turns out not to affect who ends up paying the tax. Instead, the relative elasticities7 of market demand and supply for a commodity determine how much sellers and buyers end up paying. If the tax is imposed on an intermediate good—a commodity that enters into the production of other commodities, as fossil fuels and the energy they are used to produce do—the tax will affect the relative prices of goods it is used to produce, raising the prices of goods whose production is more fossil-fuel-and-energy-intensive relative to the prices of goods that are less fossil-fuel-and-energy-intensive. Since people in different income categories spend different percentages of their income on different goods, this means that any policy that raises the price of energy reduces the purchasing power and therefore the real income of poor and rich to different extents. Fortunately, many empirical studies of tax incidence largely agree on the distributive effects of putting a price on carbon regardless of how we do it. Unfortunately, it turns out that the poorer you are, the larger will be the drop in your real income if the price of carbon emissions is raised through regulation, taxes, or a permit program.
Progressive versus regressive taxes: When a tax is progressive, the higher your income is, the higher percentage of your income is spent on the tax. For example, before deductions the federal income tax is progressive since the tax rate for people in high-income brackets is higher than for people in lower income brackets. When a tax is regressive, the higher your income is, the lower percentage of your income is spent on the tax. For example, sales taxes on cigarettes are regressive because (1) low-income people consume more (and save less) of their income in general, and because (2) out of their consumption expenditures, low-income people spend a higher percentage on cigarettes than wealthier people—even when a low-income person buys the same number of packs per week as a higher-income person. When a tax is proportional, everyone pays the same percentage of their income on the tax, regardless of whether they are rich or poor. Few existing taxes are exactly proportional, although not long ago some economists called for replacing all existing federal taxes with what they called a flat tax of 19 percent on all income, which they calculated would be revenue-neutral—that is, it would raise the same amount of revenue as the taxes it replaced. In sum, a progressive tax makes after-tax income distribution more equal than the pre-tax distribution, a regressive tax makes after-tax income distribution more unequal than the pre-tax distribution, and a proportional tax keeps after-tax income distribution the same as the pre-tax distribution.
What kind of tax is more or less fair? Support for making the tax system more progressive on grounds that this would make it fairer has long been a hallmark of “progressive” politics. The most common reason given is that the rich are more able to pay taxes than the poor—in effect, that the rich can afford to be more charitable. A less common reason given is that government programs and services, which include protecting property rights, benefit the rich more than the poor, so those who benefit more should pay more. Strangely, the best reason why progressive taxes are fair is the least articulated: A higher percentage of the income of the rich, as compared to the poor, is undeserved, making a progressive tax necessary to reduce economic injustice.
Those who argue for progressive taxes as a means to reduce economic injustice could stipulate that in every income bracket there are some who deserve what they get as well as some who do not. All one has to believe is that a smaller percentage of poor people do not deserve even the smaller amounts they receive than the percentage of rich people who do not deserve the far larger amounts they receive. Not only does this strike most people as plausible, but also it is virtually a statistical certainty! If we break income down into a “deserved” and an “undeserved” component, then in groups with a higher-than-average observed income we should expect to find a disproportionately large number of people with higher-than-average “undeserved” income.8 Whereas the noblesse oblige argument for progressive taxation implicitly sanctions pre-tax income distribution as fair but requires the wealthy to be more charitable, this argument for progressive taxation forces people to confront how labor and capital markets distribute income unfairly in the first place.
Unfortunately, it is a well-known fact that carbon taxes are regressive. Since the poor save a lower percentage and consume a higher percentage of their income, carbon taxes, like most consumption taxes, are regressive. And while wealthy households have a higher carbon footprint because they consume so much more in absolute terms, per dollar of expenditure poorer households have a higher carbon footprint, which also makes carbon taxes regressive.9 One remedy for the unfortunate fact that carbon taxes are regressive is to substitute revenues from the carbon tax for revenues from an even more regressive tax, such as the employee share of the FICA (social security) tax. However, while such substituting on a dollar-for-dollar basis would be revenue-neutral and make the overall tax system less regressive, it does not change the fact that in and of itself the carbon tax is regressive. Raising the price of carbon emissions through mandatory reductions or a carbon cap-and-trade policy also has a regressive effect on income distribution for the same reasons.
Rebates: Since neither regulation nor grandfather cap-and-trade programs collect any revenues, they provide no direct means to redress the regressive effects of putting a price on carbon. However, taxing carbon and a cap-and-trade program where permits are auctioned both generate new revenues that can be used to offset the regressive effects of raising the price of carbon emissions. “Tax and dividend” has been discussed in policy circles for some time, and Senators Cantwell and Collins introduced a cap-and-dividend bill during the 111th session of Congress that unfortunately was never even brought to the floor for discussion. Their Carbon Limits and Energy for America’s Renewal (CLEAR) Act would have auctioned 100 percent of carbon permits and used 75 percent of the revenues to give every legal resident of the United States an equal rebate, or what the bill called a “dividend.” Due to the high inequality of income in the United States, rebating an equal amount to every resident is so progressive that it more than overcomes the regressive effect of raising the price of carbon. Studies estimated that under the Cantwell-Collins bill the rebate would have paid all households up through the 70th income percentile more than what they would have lost because the cap on fossil fuels entering the economy raised energy prices; the higher prices would have cost only the top 30 percent of households more than their rebate. Of course, in theory, the revenues from a carbon tax could be rebated in exactly the same way.
It has been a long time since owning a piece of property in the United States meant you could do absolutely anything you wanted with it. Special laws and regulations about land use have been with us for centuries. In 1860 a New York State statute prohibited all commercial activities along Eastern Parkway in Brooklyn. Today this statute would be considered a necessary “downzoning” for urban planning by city officials, but criticized as a “taking” by property rights activists since it reduced the market value of property along the parkway. In response to public displeasure with construction of the Equitable Building on Broadway, which blocked views and sunlight from reaching adjacent residents, the City of New York adopted citywide zoning regulations in 1916. The author of these regulations, Edward Bassett, went on to write the Standard State Zone Enabling Act, which became the blueprint for zoning in most states and empowered local governments to establish their own zoning laws.
In the 1920s a landlord in Ohio challenged the Village of Euclid zoning ordinance on grounds that by restricting use of his property it violated his rights under the Fourteenth Amendment to the U.S. Constitution. While lower courts ruled in favor of the landlord and declared the zoning ordinance unconstitutional, the U.S. Supreme Court overruled the lower courts and upheld the ordinance in 1926 in the case of Village of Euclid, Ohio v. Ambler Realty Co. The Supreme Court based its decision on two arguments: (1) that zoning extended and improved on nuisance law by providing advance warning of what would be considered a nuisance; and (2) that zoning was a necessary instrument for municipal planning. To this day “Euclidean zoning,” named after the Village of Euclid, which segregates land uses into districts where the type and degree of development is specified, is by far the most prevalent zoning in U.S. cities and municipalities. Typical categories of land use are single family residential, multifamily residential, commercial, and industrial; and typical “dimensional standards” include minimum lot sizes, maximum densities, maximum heights for buildings, and minimum setbacks from public roadways and sidewalks.
One of the most politically contentious environmental issues in the United States is urban sprawl. A great deal of local politics revolves around this issue. The flip side of abandoning poor, inner-city neighborhoods is environmentally destructive growth, or “sprawl,” in outlying areas. But while it may be profitable for developers to spread new homes for upper- and middle-class families indiscriminately over farmland, this is not what is best for either people or the environment. It is an environmental disaster because it needlessly replaces green space with concrete and asphalt. It is a fiscal disaster because, since new residents are spread over a large area lacking in existing services, for every new dollar in local taxes collected from new residents, it costs local governments roughly a dollar and a half to provide them with the streets, schools, libraries, and utilities they are entitled to. And it has a disastrous effect on people’s lifestyles as the “rural character of life” in outlying areas is destroyed for longtime residents, and those moving into bedroom communities spend more and more of their time on gridlocked roads commuting to work and driving to schools and strip malls at considerable distances from their homes.10 Nor does sprawl even address the nation’s most pressing housing need—a scandalous shortfall of “affordable” housing.
Typically rural land is initially zoned in a way that allows for subdividing farms into many lots for new houses—which is how sprawl happens. The way to prevent this is to downzone land outside cities and town centers. For example, whereas a 100-acre farm might have been zoned to allow for 100 houses, it could be downzoned to allow for only two dwellings. This prevents houses from sprouting in farm fields where they are not wanted and forces new residential construction inside growth boundaries, where “upzoning” to permit greater density can absorb residential growth where it is more desirable. But environmentalists and urban planners are sadly mistaken if they think their jobs are done once they demonstrate that zoning changes like these to prevent sprawl produce large positive net benefits. While changes in zoning to promote smart growth often yield a large efficiency gain in the form of better protection for the environment and a reduction in the cost of providing public services, changes in zoning also change the market value of land, which means there will be losers as well as winners. Ignoring these distributive effects has prevented environmentalists from winning many local battles against sprawl.
Farmers usually strongly oppose downzoning because it dramatically decreases the price they can sell their land for if they decide to give up on farming. In some ways this is ironic because farmers can wax poetic over how much they personally enjoy rural life and how much they hate to see subdivisions sprouting up where their neighbors’ farms used to be. As former chair of a special task force appointed by the Commissioners of St. Mary’s County, Maryland, to recommend ways to protect the county’s rural preservation district, I can assert that farmers there seldom took kindly to urban refugees moving in—particularly when their kids drove all-terrain-vehicle toys across fields that looked unused to them and when their parents threatened lawsuits over noxious smells and allergies caused by fertilizers and pesticides, leading to retaliatory “right to farm” ordinances. But the psychic pain of seeing neighbors’ farms turn into housing developments apparently does not compare to seeing the market value of your own farm drop to a fraction of what it had been before downzoning because developers no longer knock on your door. In effect, farmers want all their neighbors’ land downzoned but not their own. The conflict over who will sell out first to the despised developers, combined with a great deal of self-rationalization, makes for very confusing testimony at public hearings but a solid block of votes against downzoning land in “agricultural preserves” by those who claim to love living there. In any case, the downzoning is clearly a “taking” because it creates a significant financial loss for rural property owners. Developers traditionally oppose downzoning farmland as well because it is cheaper than buying land inside growth boundaries to build on, and also because profit margins on larger homes with larger lots are higher on average than on smaller houses on smaller lots.
A policy called transfer development rights, or TDRs, can change the calculus of self-interest for landowners near urban growth areas by compensating the traditional losers from zoning changes necessary to promote smart growth. One reason to do this might be because it is unfair to expect farmers who are often not particularly wealthy to bear the burden of preventing sprawl. But even if landowners are better off than others, it might be wise to support TDR programs that provide financial compensation for landowners because otherwise their political opposition to smart growth may prove strong enough to stall smart growth initiatives.
The problem is that the farmer owns two assets that are unfortunately tied together into a single commodity. The actual land has a certain value when used for agricultural purposes, which may be higher or lower depending on soil quality, rainfall, demand for crops the land is suitable for, and so on. Because farming near growing metropolitan areas has become less and less profitable for a variety of reasons, the value of the land for this purpose has generally been falling. But the farmer also owns the development rights that the current zoning of the land permits. And as metropolitan populations grow, the demand for residential development rights increases and the development rights the farmer owns become more valuable as a result. As a matter of fact, unless taxing authorities tax land in agricultural use at a lower rate, the growth in the value of the development rights inflates farmers’ property taxes and is part of the reason farmers near urban areas have a hard time making ends meet. TDRs allow farmers to break their commodity into two parts and sell them separately from each other and, most importantly, sell them at different times.11
How does a well-designed TDR program work? First, farmland in an agricultural or rural preservation district must be downzoned. This prevents sprawl. In exchange for taking away the development rights on his own land, the farmer is given development rights that can be used only to build new living units elsewhere, inside growth boundaries: hence the name TDR. Finally, what gives the TDRs a market value is that developers are required to buy TDRs to build additional units inside growth boundaries or development zones. This is why developers will continue to knock on farmers’ doors. But now, instead of offering to buy the farm to secure its development rights, developers will only be interested in buying farmers’ TDRs. Because it cannot be built on, developers no longer want the farmland itself. But developers need farmers’ TDRs or else they cannot build additional units inside development districts where upzoning has increased permissible densities—provided a developer has TDRs.
Environmentalists and urban planners anxious to replace inefficient sprawl with more efficient smart growth get what they want. Farmers not only get to cash in on their development rights, they can do it whenever they wish and continue to farm as long as they want, secure in the knowledge that they will remain surrounded by farming neighbors. Developers now have to pay for TDRs to build more units inside growth boundaries, but they were paying for the same development rights before when they purchased farmland along with its development rights to build in rural areas. Ignoring differences on profit margins for different kinds of housing, developers are no worse or better off than before. And finally, once development rights are stripped from farmland, it becomes cheaper for a new generation of organic farmers to buy land near urban areas when older farmers growing traditional crops go out of business. Young, idealistic organic farmers no longer have to outbid developers for land to use. Just as the developers really only wanted the farmers’ development rights and not the land, new farmers really only want the land, not the development rights, which are a financial barrier to entry for them. The TDR program means that nobody has to pay for more than what they want to use, just as it means that landowners can sell their development rights separately from their land.12
As with any policy, there are devils in details that require careful attention. And as with most policies, it is possible to tilt the policy to the advantage of different constituencies. For example, if developers are required to purchase more than one TDR to build an additional residential unit inside growth boundaries, this will increase the demand for TDRs and therefore their price, to the advantage of farmers and the disadvantage of developers and new home buyers to the extent that developers can pass on their increased cost. And while TDRs are designed primarily to make the pattern of development more concentrated and efficient, they can also be used to change the overall rate of development by creating more or fewer TDRs than the number of development rights that are lost when rural areas are downzoned. Finally, TDRs are no guarantee to untie all Gordian political knots that prevent communities from engaging in smart growth. At least for now, the efforts I participated in to create an effective rural preservation district in St. Mary’s County by fixing a dysfunctional TDR program there have failed, and as a result not only agricultural land but also forest and wetlands crucial to restoring water quality in the Chesapeake Bay, which surrounds the county on three sides, remain at risk.
Until recently, the only answers considered worthy of discussion to the problem Garrett Hardin made famous as “the tragedy of the commons” were government regulation and privatization. In 1990 Elinor Ostrom introduced a third policy response into the public debate with publication of Governing the Commons: The Evolution of Institutions for Collective Action.
In Governing the Commons Ostrom demonstrates that a review of the literature covering many historical case studies where CPRs were managed by communities of users revealed that while overexploitation was sometimes the result, in many cases overexploitation did not occur. In chapter 3, “Analyzing Long-Enduring, Self-Organized, and Self-Governing CPRs,” she presents case studies of communities that proved successful in avoiding the tragedy of the commons so widely predicted. In chapter 5, “Analyzing Institutional Failures and Fragilities,” she examines other cases where communities failed to prevent overexploitation. Ever since, Ostrom and many others working in what is now known as the institutional analysis and development (IAD) framework have continued to add more case studies to their database and refine theoretical tools helpful in the search for key factors that determine success or failure when communities self-manage access to CPRs without resort to privatization or government involvement. Ostrom was awarded the Nobel Prize in Economics in 2009 for her pathbreaking work.13
We return to our example from Chapter 4 of a salmon fishery on San Juan Island to illustrate the logic of regulation, privatization, and community self-management of a CPR. Under free access, we discovered that as many as nine fishing boats would go out each day even though nine boats would catch no more fish than eight while adding $100 to the cost of fishing. We also discovered that CBA reveals the optimal number of boats to be five since a sixth boat would raise revenues (social benefits) by only $75 while adding $100 to both private and social costs.
Privatization: Free-market environmentalists recommend privatizing CPR to prevent the tragedy of the commons. How would this work in the San Juan salmon fishery? If one of the fishing boat captains bought out the other eleven, he would only send out five of what are now his boats each day because sending out more or fewer would only lower his profits. In the view of free-market environmentalists, the problem lies in the ambiguous property rights inherent in CPRs, and the solution lies in eliminating any ambiguity by converting CPRs into privately owned resources to realign the profit criterion with the efficiency criterion. In this case, the benefit from using the fishery will go to its private owner, who presumably can be better trusted to manage it efficiently and will receive $250 in profits per day for doing so.14 In sum, the tragedy of the commons has been solved by turning a CPR into private property and awarding the benefit from its use to a single fishing company.
It is important to note that to implement this policy the State of Washington would have to back up the legal right of the owner to deny all others access to the fishery, which is now his private property. Otherwise, even if he has purchased the boats of the other eleven fishermen, there is nothing to prevent any of them from buying new boats and fishing again, or to prevent others from fishing in the owner’s private property, for that matter. Moreover, by restricting his own use to five boats per day, he has created an incentive for all others to poach because any sixth boat that manages to fish in his private property can expect to earn a profit of $37.50 per day. So he will need the State of Washington to protect his property rights, which, of course, is not a problem for free-market environmentalists, who are only too happy to restrict the role of government precisely to this and only this.
Regulation: Opponents like to label regulation “command and control” and treat it as a “taking” by “clumsy Big Brother.” If we go beyond sound bites, what does regulation actually look like? Suppose the State of Washington eliminated any ambiguity about ownership of the CPR by declaring it to be public property that nobody can access without permission from the Washington State Department of Fisheries. The Department of Fisheries could solve the problem of overexploitation by limiting fishing to only five boats per day. The Department of Fisheries would have to decide which five of the twelve captains were allowed to fish on any given day. This could be done in a variety of ways, including drawing five names out of a hat with all twelve names in it every evening or following a fixed rotation.
While the CPR has been converted into public property, in this case the fishing captains are still the ones who benefit from its use. It is now all twelve captains who benefit rather than only a single fishing company who receives the benefit under privatization, but it is only fishermen who are beneficiaries nonetheless. As a matter of fact, the State of Washington has just done the fishermen a big favor! Under free access, expected profits from fishing are zero when nine boats fish. If the Department of Fisheries restricts access to five boats, average profits are $50 for each of the five boats fishing on any day.15 If each captain can expect to fish five out of every twelve days, this means average expected daily profits are now 5/12 times $50 or $20.83 rather than zero. As a CPR the fishery was overexploited, and the users barely broke even. Now the resource is public property, but the benefits from its use go entirely to the twelve captains as profits—five boats times $50 profit per boat, or $250 per day. Citizens of the State of Washington might want to ask why they should not also benefit from a resource if it is now explicitly owned by the public at large. The answer, of course, is that they can.
Suppose the Department of Fisheries required fishermen to buy a license to fish in what is now public property, charging $50 per day for a commercial salmon fishing license. This would raise the daily cost of fishing from $100 (for gas and wages) to $150 (for gas, wages, and license). Now if there were already five boats out fishing, no captain who arrived later at the dock would go out to fish that day because he would expect to earn only $137.50—or even less, if others arriving after him foolishly went out as well. In this case, regulation has converted a CPR into public property, but the benefit from its use will go to the general public. What was before $250 in fishing profits per day has now become $250 a day of revenue for the State of Washington and all its citizens as five captains pay $50 each for a daily fishing license. James Boyce (2002) might suggest at this point that in the real world, if regulation is chosen as the answer to the tragedy of the commons for fisheries, whether regulation takes the form of fishing licenses or limits on the size of catch will be determined largely by who has more power—the fishing industry or ordinary citizens. But as Mancur Olson taught us, it would be naive to assume that just because there are more citizens than there are fishing captains, the citizens will prevail. As Olson famously explained, precisely because they are greater in number, each citizen individually has little to gain from lobbying legislators on state fishing policy, while each fishing captain has a great deal at stake (Olson 1965).
Community self-management: Elinor Ostrom and now many others ask why communities cannot restrict their use of CPRs themselves without resort to privatization or government intervention. After all, our twelve fishing captains are killing themselves when nine of them go out to fish every day. Why don’t they wake up, smell the coffee burning, and do themselves a favor by agreeing to send out only five boats a day? If they can manage to agree to a certain amount of self-restraint, their expected profit will increase from zero to $20.83 per day, and they will have 44 percent more leisure time as well!16
In this case, the CPR has become what some call community property to distinguish it from private property and public property. It would be more accurate to call it “user common property,” although users frequently coincide, or at least strongly overlap, with those who live in communities adjacent to CPRs. As we have seen, if traditional users restrict their own exploitation of user common property, they will generate the same efficiency gain we observed under privatization and regulation, and they will be able to appropriate these benefits all for themselves. While progressives criticize privatization of CPRs on equity grounds with good reason, many progressives fail to consider the possibility that community self-management may also be objectionable on equity grounds. If user communities are poor, then allowing them to appropriate the benefits from restricting access through self-management increases equity. On the other hand, if our twelve salmon captains are wealthy compared to other residents, their fellow Washingtonians may find the distributive effect of this policy that converts a CPR into user common property objectionable on equity grounds.
But why would users ever fail to do what is clearly in their self-interest? The problem is that it may not be easy for users to come to an agreement on how to restrict their own use, particularly if they will find it difficult to deny access to outsiders. If traditional users can get over the first hurdle and mutually agree to restrict their own use, they increase incentives for others to crash their party if they cannot successfully deny outsiders access to their user common property. And unlike private property and public property, where property rights are clear-cut and legal enforcement is generally reliable, user common property is often more tacit than legal and requires self-enforcement against poachers besides self-restraint among traditional users.
We can begin to think about problems that prevent users from successfully managing to restrict their use of CPRs by asking why our twelve captains might fail to organize themselves into a fishing cooperative to decide how many boats to send out each day. Any actual or perceived inequalities between the captains in equipment, skill, experience, and so on make it more likely that some would refuse to join an organization that restricts access because they believe they can do better than average under free access. Also, if there are variations in catches, negotiating a deal where some captains get one-tenth the profits and others get one-fifteenth, for example, makes the bargaining more prone to hassle and therefore less likely to result in a successful agreement to form a cooperative than if it is obvious why cooperative profits should be split equally among all twelve members. But most importantly, stability among potential users is crucial to achieve and maintain restricted access. If, after the twelve captains from Friday Harbor have formed a cooperative that maximizes cooperative profits they have agreed to share by sending out five boats per day, a new, thirteenth fishing boat can come over from an adjacent island—or worse still, a larger fishing boat can easily reach San Juan waters from harbors on the mainland—there is little incentive for the twelve Friday Harbor captains to restrain themselves. If other boats can fish every day and ride for free on the self-restraint of the Friday Harbor captains, it is hard to imagine they would be able to organize and keep a cooperative intact.
Of course, discovering what real-world conditions are likely to make CPR users more or less successful at organizing either a formal or what amounts to an informal producers’ cooperative is what Ostrom began to tease out by comparing the successful historical cases with the unsuccessful ones in Governing the Commons. Based on a great deal of further empirical and theoretical investigation since then, IAD researchers now feel confident about a list of factors Ostrom identified on a provisional basis back in 1990 as critical for successful community self-management of CPRs. Whenever one or more of these conditions is not present, the tragedy of the commons becomes more likely.
1. Who has rights to withdraw resources from the common pool must be identified, and the boundary of the resource itself must be clearly defined.
2. Rules regarding appropriation must be well suited to local conditions.
3. Users must be able to participate in elaborating and modifying the rules of use.
4. Those who monitor use must come from the ranks of the appropriators and/or be clearly accountable to them.
5. There must be effective but graduated sanctions against those who violate rules of appropriation.
6. There must be quick, easy, and cheap mechanisms available to appropriators and officials to resolve conflicts.
7. The right of the community to self-manage the CPR must be acknowledged by higher authorities.
In sum, community self-management is now widely recognized as one possible solution to overexploitation of at least some CPRs. When there is good reason to believe that most of the above conditions hold, there may be no reason to resort to privatization or government regulation to prevent the tragedy of a commons. While neither Ostrom herself nor most IAD researchers argue that community self-management is always the best policy, they do recommend exploring the possibility of creating the missing conditions before jumping to the conclusion that privatization and outside regulation are the only alternatives to the tragedy of the commons. One issue many who jump on the community self-management bandwagon would do well to think more about is the equity implications of allowing traditional users to appropriate the benefits of user common property. As always, progressives need to ask if the distributive effects of a policy ameliorate or aggravate existing inequities, which means that careful attention should be paid to whether traditional users are better or worse off than the public at large.
Before the financial crisis of 2008, many people reacted positively to the idea of creating a new market for carbon. Mainstream economists, politicians, and the mass media—particularly in the United States—were inclined to assume that markets were the best solution to any and all economic problems and could be relied on to behave in a predictable and desirable way. In Part II we discovered that because of perverse incentives resulting from externalities and free riders, markets are often the root source of environmental problems and that private enterprise market economies are, indeed, plagued by an unhealthy growth imperative. And in Chapter 6 we discovered that free-market environmentalism was based on a gross misinterpretation of the Coase theorem and that there was every reason to believe that, if matters were left to voluntary negotiations between polluters and pollution victims, grossly inefficient levels of pollution would be the result. But before 2008, not only were well-established theories about “market failure” widely ignored, but a literature documenting inefficiencies that result from disequilibrium dynamics in markets went ignored as well, as did concerns about pernicious effects of marketization on preference formation raised by economists outside the mainstream of the profession.17 In sum, until recently only a few people worried that a market for carbon emission permits might prove problematic.
However, the havoc unleashed by the crash of financial markets in 2008 and the “great recession” that swept around the world in its aftermath has dramatically altered popular attitudes about markets. Now when people hear that a policy requires creating a new commodity that can be traded in a new market, many react with trepidation, fearing that the new market may not behave like the ideal markets in economic textbooks or may even “go postal” on us. Complacency about serious problems with markets prior to 2008 was, to put it mildly, naive. Hopefully a greater awareness of potential problems triggered by the collapse of financial markets in 2008 will facilitate a more judicious examination of (1) how a carbon market might malfunction, (2) what, if anything, can reduce the likelihood of this happening, and (3) what would and what would not be affected if a carbon market did behave badly.
The first point that cannot be over-emphasized is that in the real world there are both efficiency and equity reasons to prefer a carbon tax, which does not create a new commodity and market, over an equivalent cap-and-trade carbon permit program, which does. A carbon cap-and-trade program can yield the same efficiency gains as an equivalent carbon tax only if the carbon permit market achieves its equilibrium price instantaneously—that is, only if the permit market behaves perfectly. A carbon tax does not require a market for carbon emission permits to behave more perfectly than any real market ever has or will in order to deliver the maximum efficiency gain possible, whereas a cap-and-trade policy does. A carbon tax also has an important practical advantage over a cap-and-trade policy with regard to equity. As explained above, a tax automatically awards the property right to emit carbon to “we, the people.” For a cap-and-trade policy to do the same, we must first win the political fight to auction all carbon emission permits rather than give any away for free.
However, sometimes circumstances may favor a cap-and-trade program over a tax, so it is important to be neither naive nor paranoid about what kind of problems real permit markets can create.18 In the short run, the problems with permit markets derive from what economists call “false trading.” However, there are larger potential problems in the long run if speculators become involved in the permit market. Because price volatility magnifies uncertainty with adverse effects on investment decisions, any bubbles or crashes in the market for carbon allowances would be counterproductive. And if a poorly regulated financial sector allows speculators in the carbon market to profit from bubbles and crashes at the expense of the rest of us, as they were permitted to profit from the recent bubble and crash in real estate markets, the economy would become even more unfair than it already is.
We need to put a price on carbon. The price should be as close as possible to the magnitude of the negative consequences that a ton of carbon emission generates. And this price signal needs to be steady and predictable in order for it to affect behavior in desirable ways. If the price of carbon permits is way below or above what it should be, if the price fluctuates wildly, or if the permit market experiences bubbles and crashes, both efficiency and equity will be adversely affected.
False trading: In a cap-and-auction program that is equivalent to a particular carbon tax, the price of a permit sold at the auction should, in theory, turn out to be the same as the tax. But what if some sources underestimate their need for emission permits and either do not attend the auction or buy too few permits? This means that those who do buy at the auction will pay a lower price for permits than had everyone demanded as many as they should have. In other words, the price that clears the auction market will be too low because not all of what we might call “fully informed demand” showed up. One of two things will happen: If no postauction trading of permits is allowed among sources, those who bought lots of cheap permits will fail to reduce their emissions as much as is efficient given their emission reduction costs compared to others, and those who failed to buy as many permits as they should have will have to reduce their emissions more than is efficient given their relative emission reduction costs. On the other hand, if postauction trading of permits among sources is allowed, presumably the wise, early birds will be able to sell some of their permits at a higher price than they paid for them at the auction to those who were caught sleeping, and the postauction price will rise toward the price that would have cleared the auction had everyone correctly estimated their situations in the first place. By allowing the wise (or lucky) to benefit at the expense of the dimwitted (or unlucky), postauction trading reduces the inefficiency that occurs when early birds who could have reduced emissions more cheaply than sleepyheads fail to do so. But here is the important point: Any behavior committed to and carried out while the price signal is wrong—which includes the auction price that was too low by hypothesis, and any of the prices that are climbing, but still below the eventual postauction equilibrium price if postauction trading is permitted—will be inefficient to some degree. In the language of theoretical economics, behavior induced by trading at “false prices” is inefficient.
In this example, the question reduces to how much false trading will take place, how much inefficiency this false trading will generate, and how unfair we think it is for the wise and lucky to profit at the expense of those who are less so. In the real world there will always be some false trading, and whatever inefficiency and inequity results is a measure of how much more inefficient a cap-and-trade program will be as compared to an equivalent tax program where nothing is ever traded. If permits are good only for the year they are printed the time frame for false trading will be limited to one year. However, if permits can be “banked” and used at any time over a number of years, as is often the case, the time frame for false trading will be longer and the inefficiency caused by false trading can be much greater as well.
Speculation: Much of the behavioral change we want to induce requires major investments in energy production, storage, and distribution from renewable sources, as well as massive investments in energy conservation. Decision-makers will weigh benefits that stretch decades into the future against very large sunk costs in the present. What if the price signal from the carbon permit market that tells them how large those benefits will be is not loud and clear? What if there is a great deal of volatility in the price signal, or what if investors have reason to believe there may be a carbon permit bubble followed by a crash, so the price of emitting carbon will yo-yo out of control? This, of course, is exactly the wrong kind of price signal to send investors. What are the chances that a cap-and-trade program will send a much less effective price signal to investors than a carbon tax that can be set for as many years into the future as we wish?
If speculation enters into the auction or postauction trading, the problem of false trading can expand into a much bigger problem. Despite hundreds of years of empirical evidence to the contrary, mainstream economists prefer to believe that equilibrating forces can be relied on to push nonequilibrium prices toward their equilibrium, and therefore false trading occurs only because these adjustments may take time during which transactions will be inefficient to some degree. Most economists regard market bubbles and crashes—where prices “inexplicably” diverge farther and farther from their equilibria—as rare exceptions, blaming these aberrations on those they call “speculators” whose “herd behavior” they characterize as “irrational.” However, standard treatments of market bubbles and crashes are badly misinformed and misleading. Not only are bubbles and crashes far more common and serious problems than market enthusiasts want to admit, but they are the result of very rational behavior on the part of market participants who cannot be nicely partitioned into “good” buyers and sellers whose only interest is how useful the commodity is to them, and “evil” speculators who have no use for the commodity themselves but seek only to profit from trading.
The famous “laws” of supply and demand, which predict that when market price rises, quantity supplied will increase and quantity demanded will decrease, leading markets toward their equilibria, are based on a questionable, implicit assumption about how market participants interpret price changes. Standard analysis implicitly assumes that sellers and buyers believe that when the market price rises, the new higher price is the new stable price. Or, more precisely, standard reasoning assumes that when a market price rises, buyers and sellers assume that price is just as likely to fall from this new higher price as it is to rise further. If this is truly the case, then it is sensible when market price rises for sellers to offer to sell more than before and for buyers to offer to buy less than before—as the “laws” of supply and demand say they will.
However, sometimes buyers and sellers quite sensibly interpret price changes as indications of further price movements in the same direction. In this case, it is rational for buyers to respond to an increase in price by increasing the quantity they demand before the price rises even higher, and for sellers to reduce the quantity they offer to sell while waiting for even higher prices to come. When buyers and sellers behave in this way, they create greater excess demand and drive the price even higher, leading to a market bubble. When buyers and sellers interpret a decrease in price as an indication that the price is headed down, it is rational for buyers to decrease the quantity they demand, waiting for even lower prices, and for sellers to increase the quantity they offer to sell before the price goes even lower. In this case, their behavior creates even greater excess supply and drives the price even lower, leading to a market crash. This means that if market participants interpret changes in price as signals about the likely direction of further price changes, and if they behave rationally, they will not only fail to behave in the way the “laws” of supply and demand would lead us to expect, but rather behave in exactly the opposite way from what these “laws” predict.19
We have had more than enough reminders recently that market bubbles and crashes are alive and well. The U.S. housing bubble was the largest bubble in history, and the Great Financial Crisis that began in 2008 is only the most recent and serious financial crisis to occur over the past few decades. The Mexican “tequila” crisis of 1995 was followed by the far bigger East Asian financial crisis of 1997, which was followed by smaller financial crises in Russia, Turkey, and Brazil, and finally by the disastrous Argentine financial crisis of 2001. It is therefore sensible to ask if creating a market for carbon emission allowances may lay the groundwork for the next big financial bubble and crash. A domestic cap-and-trade program could create a hundred billion dollar annual carbon market in the United States alone. A post-Kyoto cap-and-trade climate treaty could generate half a trillion dollars of carbon trading a year.
There are only two ways to prevent the financial industry from ripping off sizable chunks of economic output while creating conditions that give rise to financial crises. The best way is to declare the entire financial industry too important to be allowed to fail—repeatedly—and so replace private with public finance. Accepting deposits and making loans to creditworthy consumers and businesses with sound investment plans is not terribly complicated. Only if one is trying to turn a simple industry into one that will make obscene fortunes for its investors and executives are complicated financial instruments and esoteric ways to increase leverage necessary. Where did the wizards of Wall Street steer investment resources over the past few decades? Did they wisely steer investment into renewable energy and energy conservation technologies and projects? Have they deftly orchestrated a massive conversion program to transform our fossil-fuel-based economy into a carbon-neutral system in time to avert climate change? Or did the private financial sector steer savings into a stock market bubble followed by a housing bubble and into the production of more energy-guzzling, big-ticket items such as SUVs and McMansions? A very high percentage of all the global savings that were sucked into the U.S. financial system over the past two decades was funneled into counterproductive activities that took us farther down an unsustainable dead-end road. In the words of Herman Daly, much of the investment chosen by the private financial sector went into promoting uneconomic growth. A public financial sector not only would be much more immune from crisis, but could do a much better job of channeling savings into the kinds of productive investments we really need rather than asset bubbles—investments that lead to better products and technologies, investments that increase our physical, human, and natural capital.
The only other way to protect the rest of us from Wall Street excesses is to restructure the financial industry and subject its various parts to regulations that are appropriate and competent. This is a second-best policy because, as history has just demonstrated once again, (1) the financial industry is very adept at figuring out ways around existing regulations—regulating finance is like hunting a moving target that has every incentive and means to stay one step ahead of its pursuers; (2) the financial sector will relentlessly lobby politicians to remove and relax regulations, and even if the industry’s profits were less bloated it would still have sizable financial resources to devote to such efforts; and (3) there is little reason to believe that in private hands the financial sector, even if competently regulated, would steer investments as aggressively as a public credit system could into the kinds of projects desperately needed at this critical juncture in history when we must mobilize to avert climate change.
In any case, if we replace private with public finance or if we subject private finance to competent regulation, we need not fear that carbon allowances will become part of the next toxic financial cocktail. Moreover, if we fail to reform finance in one of these two ways, it is almost certain there will be more financial cocktail crises, whether or not carbon allowances are one of its ingredients. In other words, we cannot prevent future financial crises by refusing to create certified carbon emission reduction credits. Future financial crises can only be prevented by successful financial reform.
However, consider a worst-case scenario. Suppose we create a global market for carbon allowances and offsets that climbs above half a trillion dollars a year. Suppose financial regulatory reform never happens. Suppose Wall Street does create a horrible cocktail of subsidiary markets around the carbon market—including carbon futures markets, markets for carbon swaps, derivatives based on fluctuations in the price of carbon, and whatever financial “innovation” Wall Street comes up with next. Suppose all these carbon futures, swaps, derivatives, and so on are packaged together with other opaque securitized financial instruments, based on other commodities, which nobody understands but eventually everyone comes to mistrust. In other words, suppose Wall Street mixes carbon allowances into a terrible, toxic, financial potion, and suppose this new asset bubble does burst with a vengeance.
This would be dreadful indeed. And if the financial crash were worse than the one that just occurred, it would lead to even more awful consequences for all of us who live on Main Street. But this is the important point: The financial collapse would not diminish the reduction in global carbon emissions one iota. Fluctuations in the price of carbon allowances and any derivatives based on those prices would redistribute income and wealth in mostly undesirable ways. And the price volatility for allowances that results would fail to send the steady, reliable price signal desired. But as long as laws and treaties requiring those who emit carbon to have the appropriate number of permits were enforced, the effort to reduce emissions and avert climate change would not be undermined.
In this worst-case scenario, what would happen is Wall Street would siphon off a big chunk of world product—first by trading in toxic assets that include carbon allowances as a bubble built, and then by shifting the cost of the financial cleanup onto the rest of us when the bubble burst. But this has nothing to do with the number of carbon permits in existence, and therefore nothing to do with how much carbon can be emitted. Moreover, such a financial crisis would not be the fault of the carbon market. This tragedy would be due entirely to the failure to either nationalize or subject the financial sector to competent regulation. It is highly implausible that denying Wall Street access to one new commodity, carbon allowances, would prevent future financial crises if the financial industry remains free from competent regulation.
There are strong reasons for progressives to prefer a carbon tax over a domestic cap-and-trade program. As explained above, a tax is simpler and easier to administer. With a tax there is no carbon market to go haywire. With a tax the government collects the revenue automatically, whereas in a cap-and-trade program progressives always have to fight for 100 percent of the permits to be sold at auction so the government gets the revenue instead of giving away the new wealth the cap creates for free to polluters. For all these reasons, most progressive economists, including me, generally prefer a domestic carbon tax over an equivalent cap-and-trade program—that is, one that achieves the same overall emission reduction. However, there are some very compelling reasons to favor cap-and-trade over a carbon tax in the United States right now.
Unfortunately, in the United States a great deal of the electorate suffers from acute tax-phobia. While it is often irrational for low- and middle-income people to fear taxes, the fact is that raising taxes is extremely difficult in the United States. Apparently it is much easier to remind people of the pain taxes cause them, and how much they dislike how their taxes are often spent, than to remind them that sometimes they like the programs their taxes go to pay for. In any case, the bottom line is that even if we could get a carbon tax passed in the United States, there is no way it would be high enough to generate nearly as large a reduction in emissions as the reductions we can achieve through a cap-and-trade policy.
Of course, there are better and worse versions of domestic cap-and-trade programs, and as every day passed during the spring and summer of 2010 the chances of the U.S. Congress passing an effective, fair, and efficient cap-and-trade domestic climate bill diminished to the point where no climate legislation was ever voted on, much less passed. Due to successful industry lobbying, the Waxman-Markey bill, which was passed by the House of Representatives but left to die by the Senate, was a cap-and-trade disaster. It was ineffective because it allowed generous offsets in agriculture where emissions were not capped without adequate provisions to ensure that agricultural offsets would be “additional” and therefore not puncture large holes in the bill’s emission cap.20 It was unfair because it gave 85 percent of permits away free of charge to large sellers of carbon fuels and utilities and failed to compensate working- and middle-class households for higher energy bills. It was inefficient because it compensated very low-income households for higher energy prices by subsidizing their utility bills rather than giving them a rebate they could spend as they wished, thereby failing to provide them with any incentive to reduce their energy consumption.
The Cantwell-Collins CLEAR Act was a much better bill. This bill, which was introduced in the Senate would have auctioned 100 percent of the permits and rebated 75 percent of the revenues on a per household basis. As mentioned above, it is estimated that the bottom 70 percent of households would have been more than compensated for higher energy prices, and only the top 30 percent would have paid more in higher energy prices than their rebate. By compensating for higher energy prices through rebates, which could be spent however people wished, the incentive provided by higher energy prices for all consumers to reduce their energy consumption would have been preserved. The Cantwell-Collins bill would have required the other 25 percent of revenues to be used to stimulate investment in renewable energy and energy conservation programs, which are desperately needed if we are to jump-start conversion to a carbon-neutral economy before it is too late. The bill permitted no offsets, which meant that the bill’s emission cap was firm. Because fossil fuels would have been capped as they entered the economy at mine sites, oil and gas heads, and ports of entry, only a few thousand businesses would have had to be monitored. Finally, Cantwell-Collins contained provisions designed to reduce the dangers of speculative activity in the market for carbon permits.
Unfortunately, under pressure from industry lobbyists and the Obama administration, the Democratic Party Senate leadership opted to champion a far worse bill, the American Power Act, sponsored by Senators Kerry and Lieberman, not the Cantwell-Collins bill. Some environmental organizations denounced the Kerry-Lieberman American Power Act, pointing out its many deficiencies that would have taken us backward, not forward. Other environmental groups, fearing that prospects for passing a better bill after the November 2010 elections would have been even worse, reluctantly endorsed the bill, arguing that it was better than no climate bill at all. In the end none of the debates over pros and cons in any proposed bills mattered. Decades of lobbying for legislation to address climate change and hundreds of millions of dollars environmental organizations poured into these efforts all went for naught as the U.S. Senate adjourned for the summer with its two-decade record of never passing a single piece of legislation to address the climate change crisis still intact.
1. In theory it is the harmful activity that the government would want to regulate, tax, or limit through permit—which in this case is the act of releasing carbon dioxide into the atmosphere. For this reason we analyze different ways to reduce carbon emissions as applied to sources of emission. However, the number of emission sources for carbon dioxide in the United States is very large and includes homeowners, operators of automobiles, most farmers, and virtually all businesses and industries, which would make monitoring and enforcing any carbon reduction policy applied to all emitters exceedingly burdensome. Instead, what is usually recommended is applying any of these policies as far “upstream” as possible in order to reduce the number of actors one must monitor. Since a very high percentage of all carbon emissions derives from burning fossil fuels, which enter the economy from a relatively small number of sources—domestic oil and gas heads and coal mines, and imports of fossil fuels at ports of entry—it is more practical to apply any of the above policies to these sources only. Companies that extract or import oil, gas, and coal are referred to as “first sellers,” and most legislation currently under discussion in the U.S. Congress proposes regulating, taxing, or permitting only the roughly 2,000 first sellers based on the amount of carbon dioxide that will be released by a barrel of oil, a cubic foot of natural gas, or a ton of coal when it is burned.
2. The cost of reducing emissions is commonly referred to as the abatement cost, and abatement is the common way to refer to the activity of reducing emissions.
3. As already explained, A.C. Pigou was the first to propose taxes to correct for negative external effects in market economies, and economists traditionally refer to these kinds of corrective taxes as Pigovian taxes, although they are more commonly called pollution taxes, emission taxes, effluent taxes, or green taxes. Unlike sales taxes on goods where no externalities are involved, which cause what economists call “dead weight efficiency losses,” Pigovian taxes correct for an existing inefficiency in the market system and therefore yield an efficiency gain.
4. The first exception was the North East Regional Greenhouse Gas Initiative, under which virtually all permits were sold at auction. But selling permits at auction is, unfortunately, not the new norm. In its current draft the Western Climate Initiative still calls for giving a large percentage of permits away free of charge to major carbon users. Europe still gives away most carbon permits free of charge to sources. And even though presidential candidate Barack Obama called for a 100 percent auction, the Waxman-Markey bill passed by the House of Representatives would have given away 85 percent of permits for free, and the Kerry-Lieberman Senate bill would also have given away a significant number of permits free of charge in the early years of the program. Clearly we are far from winning the political battle to stop giving permits away free of charge.
5. Only if the actual permit market functioned like the ideal market in mainstream economic textbooks would a cap-and-trade policy be as efficient as an equivalent pollution tax. We discuss the implications of possible problems in real-world permit markets later in this chapter.
6. There is one version of tradable carbon permits that in theory yields exactly the same results as an equivalent carbon tax. If the government auctioned off 100 percent of the carbon permits and if the permit market reached its equilibrium price instantaneously, the results of the two policies would be not only equivalent but also identical in every way. In both cases every source would reduce its emissions by exactly the same amount because the opportunity cost of failing to reduce emissions would be the same—pay a tax or buy a permit for the same amount as the tax. In both cases every source would pay the government exactly the same amount—in one case in taxes and in the other case by purchasing permits at the government auction. And in both cases the government would collect the same amount of total revenue—in one case as tax revenue and in the other case as proceeds from a permit auction.
7. Elasticity is a useful concept that measures how sensitive demand or supply is to a change in price. If, for whatever reason, demand is more sensitive than supply to a change in price, sellers will pay more of any tax imposed on the good than buyers. If supply is more sensitive than demand to changes in price, buyers will pay more of the tax than sellers.
8. A delightful irony that should not escape economists is that the above argument is analogous to the one made by Milton Friedman half a century ago in support of his famous theory of “permanent” consumption based on the concepts of “permanent” versus “transitory” income and consumption.
9. A host of empirical studies of the incidence of carbon taxes confirm this finding. The explanation lies in the fact that low-income families tend to spend a high percentage of their income on transportation, utility bills, and energy-intensive manufactured products. The only exception may be for the very poor who do not own cars.
10. An excellent documentary film on the harmful effects of sprawl and what can be done about it is Save Our Land, Save Our Towns, produced by Thomas Hylton and available from Bullfrog Films.
11. The idea of breaking land titles into separable commodities when convenient is not original to TDRs. Long before TDRs were invented in the 1970s, coal and oil companies purchased mineral rights and oil and natural gas rights to what lies underneath land while leaving farmers and ranchers free to continue to own and use the land surface.
12. In my new home state of Oregon, long famous for land use planning and growth boundaries, rural landowners and developers have battled environmentalists and urban planners repeatedly over the past few years. In 2004, ballot measure 37 gave property owners the right to claim compensation from state or local governments if their property values were adversely affected by land use or environmental regulations. In 2007, ballot measure 49 reversed many of the provisions of ballot measure 37. If either “49ers” or “37ers” wanted to negotiate an end to their civil war, they might consider offering TDRs as a peace initiative.
13. Elinor Ostrom, whose PhD is in political science, not economics, was the first woman to win a Nobel Prize in economics.
14. When five boats fish, total revenues are $750 while total costs are only $500, leaving $250 in profits. Note that here we are concerned only with the perverse incentive that arises from free access to a CPR. Other perverse incentives might still lead the private owner of the fishery to exploit it inefficiently. As discussed in Chapter 4, if the owner’s rate of profit were higher than the social rate of time discount, as is quite likely, he would still overexploit the resource, but for a different reason than the one examined here.
15. When five boats are fishing, average revenue is $150 while average cost is only $100, which leaves $50 per boat per day as profit.
16. Under free access, each captain goes out nine out of every twelve days on average. If they agree to restrict access, each goes out only five days out of twelve. Cutting back from nine to five days saves four workdays out of nine, which means 44 percent less fishing time and 44 percent more leisure time.
17. For a full treatment of a long list of problems that markets create and reasons to search for alternatives to market economies, see Hahnel (2007a).
18. In Part IV we explore why an international treaty that places caps on national emissions and allows trading is a better approach than chasing the illusion of an international carbon tax, and later in this chapter we discuss why cap-and-trade domestic policies can achieve much greater emission reductions in countries plagued by tax-phobia.
19. Standard textbook treatments try to salvage the “laws” of supply and demand in face of these seemingly anomalous outcomes by interpreting them as the result of changes in the “expectations” of buyers and sellers that shift the supply and demand curves. In the standard explanation, both before and after the shift, the supply curve slopes upward and the demand curve slopes downward—that is, at all times the curves obey the “laws” of supply and demand. It is the shift that causes the seemingly anomalous result that the quantity actually demanded responds positively to changes in price while the quantity actually supplied responds negatively to changes in price. It is certainly true that the anomalous behavior results from changes in expectations, but what textbooks invariably fail to point out is that the standard interpretation renders the “laws” of supply and demand unfalsifiable. In any case, however we choose to interpret the phenomenon, it is clear that market bubbles and crashes can result from behavior on the part of individual buyers and sellers that is perfectly rational when they interpret a change in price as an indication of the direction the price is headed, and that this behavior leads to movement away from, rather than toward the market equilibrium.
20. In Part IV, problems caused by offsets from sectors (or countries) without caps are discussed at great length.