Why is Cap-and-trade considered a solution to Global Warming?

Question

I'm sure we've heard it all: Global-level mass-extinction, famine, war, disease, natural disasters, basically an apocalypse waiting for us if we don't reduce carbon emissions to halt global warming (climate change), and it's coming sooner rather than later.

However, it appears the political leaders of the world (the whole world) believe that global warming is a problem that the first-world countries can simply throw money at and it will go away. Cap and Trade is one such philosophy. From Wikipedia:

A central authority (usually a governmental body) allocates or sells a limited number of permits to discharge specific quantities of a specific pollutant per time period. Polluters are required to hold permits in amount equal to their emissions. Polluters that want to increase their emissions must buy permits from others willing to sell them. Financial derivatives of permits can also be traded on secondary markets.

The "cap" part of "cap and trade" makes sense: if we want to reduce emissions, then we should limit how much emissions we can tolerate to reduce global warming. It's the "trade" part that bothers me. My particular concern is as such:

Firstly, let us assume that countries pollute at vastly different levels. This could be caused by any number of things, including but not restricted to:

Land mass: A larger country can hold more factories, and therefore produce more emissions.

Economy size: A country with a larger/more prosperous economy has more people employed (in raw numbers) and some of those people are involved in professions which increase pollution.

Stage of development: Poorer countries may not have the technology required to build greener technologies, or the expertise to use green technologies which already exist.

Economy type: Economies built based on e.g. manufacturing will pollute more than economies built on e.g. tourism.

And so on. However, my understanding is that carbon credits are distributed to countries irrespective of these factors. To apply a bit of game theory, there appears to be two solutions to this conundrum (in which this is a sliding scale, not a dichotomy):

1. Pollute less. This could include things such as increasing education/R&D to develop greener technologies, or simply shutting down businesses which pollute too much.

2. Buy carbon credits from other countries who pollute less.

Since option 1 might be very politically inexpedient (telling a large manufacturer to shut down 20 plants is probably not going to fare well next election cycle), option 2 is the most expedient. In which case, it seems to me, the result of cap and trade is simply a money-funneling operation from countries which rely highly on high-emission industries to countries which do not, without meaningfully impacting actual greenhouse gas emissions.

Now, my questions are as follows:

1. If we believe global warming to be a global extinction level event, why do we allow the "trade" part at all? Why not simply "cap"? If you are a country who misses your targets, you get sanctioned, e.g. by international tariffs of countries refusing to buy products produced by inefficient manufacturing, etc., until you get your emissions down.

2. If we allow the "trade" part of "cap and trade", why do we not simply allocate emissions targets using a method more realistic to the states of various economies? E.g. If the USA gets 50 carbon credits and uses 70, and Norway gets 50 credits and uses 20, why not instead allocate 75 credits to the USA (allowing them to use their 70 credits with 5 left over) and Norway gets 25 (allowing them their 20 credits with 5 left over)? Why is a transfer of money necessary for this scheme to be effective?

Answer 1

More realistic numbers

If we allow the "trade" part of "cap and trade", why do we not simply allocate emissions targets using a method more realistic to the states of various economies? E.g. If the USA gets 50 carbon credits and uses 70, and Norway gets 50 credits and uses 20, why not instead allocate 75 credits to the USA (allowing them to use their 70 credits with 5 left over) and Norway gets 25 (allowing them their 20 credits with 5 left over)?

This is unrealistic. The actual situation is likely to be that the United States would get 325 credits and Norway would get 5, as the US has more than sixty times the population of Norway. Norway probably currently uses something like 9 credits and the US uses 1000. Source: World Bank; adjusted based on 325 million population in the US and 5 million in Norway.

Now, how is Norway, which has fought hard to get down to 9 credits of usage going to feel when it is allocated 6 credits (two thirds of what it is using) and the US is allocated 667 (two thirds of its usage). Norway has to seriously reduce its usage, even though proportionally it is only using 50% more than its share by population while the US overuses more than 233% of its proportional usage. But both have to cut usage by the same amount. The US would be overusing by more than 100% even after the reductions. Meanwhile, Norway would be overusing by 33%.

Since emission targets are essentially dependent on the countries themselves enforcing them, chances are that Norway would simply refuse. They'd insist on a more even split.

Without trade, emissions increase

Without the trade portion, emissions would move physically. A plant would close in the US and an equivalent plant would open in a country that is not using all of its cap. Along with that, manufacturing would move. For example, aluminum production is heavily dependent on electricity. So it will move where the electricity is available.

The emissions used to build the new plant are a dead weight loss. That increase is entirely unnecessary. We could save them simply by allowing the existing plant to continue operating. This is what trade allows. Existing plants can buy credits from countries that don't currently use all the emissions that they could.

Building renewables

It is much easier to produce renewable energy in some places. For example, the Sahara desert gets more sunlight per square foot per year than New York City does. Trade allows the Sahara to get 100% of its electricity from solar and batteries while New York City continues to be reliant on other sources. The countries in the Sahara can use the profits from selling their carbon credits to buy the solar and batteries.

Central planning

Trying to figure out all these numbers at one central location and then assign carbon credits appropriately is not going to work. It requires a full understanding of the preferences of the entire world population. Meanwhile, a market does this naturally. People communicate their preferences via the prices that they are willing to accept. The best case solution would be for the central planner to match what the market does. But the truth is that the central planner does not match the market. Central planners do noticeably worse, creating shortages (we only planned for 1 GWh of electricity; we used that in the first 25 days of the month; for the last 5, no electricity) or waste (albeit this is easier to handle).

Answer 2

If the pollution credit is worth $1 and I can cut my own pollution at a low cost of say $0.80 then I will spend $0.80 to cut pollution and sell the credit. I will then be $0.20 wealthier. Presumably the buyer of the credit can cut pollution at a cost higher than $1 so perhaps it is $1.20 to operate a little more cleanly. If the buyer pays $1.00 for the pollution credit then she avoids spending $1.20, so she is $0.20 wealthier. Both sides of the trade experience a benefit.

Different activities, businesses, and countries have different costs. For example if my country has inexpensive labor perhaps I can do more tourism and less steel exporting so I have an inexpensive way to cut pollution. Note it is not without cost because if my economy is already heavily tourist oriented, there must be a (costly) reason why it is not already even more heavily tourist oriented.

If the trade is illegal then the seller of the credit owns something valuable that it cannot sell which means a loss of sovereignty and the buyer has something valuable (money) and it cannot exchange it and that is a loss of sovereignty.

Answer 3

If you want my opinion, the answers here so far either over complicate or slightly miss the mark. Aside from the question here’s a dirty little secret environmentalists like myself don’t want you to know, a cap and trade system and a carbon tax function the exact same and will acquire the exact same results in theory. We use cap and trade because it is more likely to win over fee market voters.

Anyways back to the question. There are two basic reasons for a trade system.

1. It allows for the resources (pollution) to go to its highest valued use. This is a very fundamental principle of a free market, which this is trying to take advantage of. If someone produce x amount of gdp with 1 unit of a pollution, while someone else needs 2x to create it, the 2x will buy up more pollution and will result in more GDP. If someone is given 1 unit of pollution to use but the can use .75 unit of pollution and have close to the same gdp, this is good and we should not let that spare pollution go to waste.

2. Trade breeds innovation. Simply put, if you find a way to cut your pollution in half and make the same amount, we should be glad you can trade it.

Answer 4

If we believe global warming to be a global extinction level event, why do we allow the "trade" part at all? Why not simply "cap"? If you are a country who misses your targets, you get sanctioned, e.g. by international tariffs of countries refusing to buy products produced by inefficient manufacturing, etc., until you get your emissions down.

Ignoring the question if the cap and trade is on an international or country level, it makes sense to leave flexibility in the system which will mean that pollution is caused where most 'essential' I.e. where there is enough incentive to pay for it. To make arbitrary sector by sector limits would 'waste' pollution on less important things.

e'g. If the USA gets 50 carbon credits and uses 70, and Norway gets 50 credits and uses 20, why not instead allocate 75 credits to the USA (allowing them to use their 70 credits with 5 left over) and Norway gets 25 (allowing them their 20 credits with 5 left over)? Why is a transfer of money necessary for this scheme to be effective?

Your assumption that credits will not be maxed out without financial incentives out is flawed, especially as the point is to reduce overall emissions. A second false assumption is that initial quotas would not take circumstances into account.

Answer 5

If we believe global warming to be a global extinction level event, why do we allow the "trade" part at all? Why not simply "cap"? If you are a country who misses your targets, you get sanctioned, e.g. by international tariffs of countries refusing to buy products produced by inefficient manufacturing, etc., until you get your emissions down.

We allow trade because:
1) It increases efficiency
and
2) Not allowing trade isn't an option

1) If you want people to accept your proposed solution to climate change, you should have the highest effect for the lowest cost as possible. There is something in economics called "the efficient frontier". Imagine a two dimensional graph of all possible policies, with the x-axis being how effective it is, and the y-axis being how expensive it is. There would be some regions in that graph that represent some possible policy. For instance, the "reduce carbon emissions by one ton by spending one trillion dollars" point would probably be in the region. "Reduce carbon emissions by one million tons by spending one dollar" probably would not be. The boundary between those regions is called "the efficient frontier".

This will be some curve that will probably have positive slope: as the amount of desired effect increases, the needed expense will also increase. Different people will have different ideas about where on that curve we should be: some people might say that we should spend a little bit of money to have some effect, while others will say that we should be willing to spend a massive amount of money if it will have a large effect. But we should all agree that we should be somewhere on the efficient frontier. Getting below the efficient frontier is, by definition impossible. And getting above it is "leaving money on the table: if we're above the frontier, we can either move down (spend less money for the same effect) or move to the right (get more effect for the same money).

Any just-cap-don't-trade system is pretty much guaranteed to be above the frontier: if no one wants to trade, then the question of whether it's allowed is moot. If people do want to trade, then that means that there is some profit to be had by trading. More profit means the cost of the system is going down. And since emissions are capped, the effect is staying the same. So: less cost, same effect.

2) Even if we wanted to prohibit trade, we couldn't. Suppose, without credit trade, Country A would have more factories than its credits supports, while Country B has fewer. What will happen? The the companies in Country A will close down their factories there, then build new factories in Country B, then export the stuff the factories make back to Country A. Result: a bunch of carbon emissions from tearing down the factories in Country A, more from building the new ones in Country B, and even more shipping the products back to Country A. So unless we have an extremely protectionist trade system, prohibiting credit trade will result in the same effect, but at much higher cost.

Calculating the carbon footprint from a particular country's manufacturing is a pointless exercise. The world's economy is interconnected. There are things that are made in other countries that America consumes, there are things that are made in the US that other countries consume, and there are things that are made in other countries that the US uses to build products that are shipped to a third country. Are you going to try to pull apart the entire supply chain of the entire world, or are you just going to assign credits and let the economy sort it out?

If we allow the "trade" part of "cap and trade", why do we not simply allocate emissions targets using a method more realistic to the states of various economies? E.g. If the USA gets 50 carbon credits and uses 70, and Norway gets 50 credits and uses 20, why not instead allocate 75 credits to the USA (allowing them to use their 70 credits with 5 left over) and Norway gets 25 (allowing them their 20 credits with 5 left over)?

From a Coasian point of view, it doesn't matter. From a political point of view, you're basically rewarding countries for ramping up carbon emissions as high as possible right before credits are assigned. The primary criterion for assigning credits is going to be what's "fair". Different people are going to have different ideas about what is "fair", but whatever it is, it probably won't be the same as "however much the country is currently emitting".

Suppose Alice and Bob are on a ship the shipwrecks on a deserted island, and the first day they're there, Alice eats a bunch of coconuts. The next day, Bob says to Alice "There are only a limited number of coconuts on this island. We should split them evenly." Alice says "You don't even like coconuts! I should get all of them." Bob says "Just because I don't like them, doesn't mean it's fair for you to take my share. If you want my share of coconuts, you should offer me something in exchange." That's basically what the cap and trade system is: even if a country isn't using their credits, they're going to want something in exchange for another country using them.

Why is a transfer of money necessary for this scheme to be effective?

Because this isn't a command economy. Money is the means by which different participants in a market economy share information about the value of assets. By trading carbon credits, the market establishes a market price for carbon credits, which tell market participants whether their carbon emissions are efficient: if you can sell a product for more than the cost of the carbon credits that you have to buy to make the product, then your company is providing value to the economy greater than the damage of its carbon emissions, and so should continue. If you can't sell the product for more than the cost, then you are producing less value than the damage, and so you should stop. The market price of carbon credits provides a quantitative, object metric of what activity is a net positive, and what is not.

Answer 6

Question 1: If we believe global warming to be a global extinction level event, why do we allow the "trade" part at all? Why not simply "cap"?

As the global emissions are simply defined by the cap component, one could say that there is no reason to trade or not to trade. Trade is irrelevant to the emission level which is exclusively defined by the cap (as long as the cap is low enough to have a restrictive effect).

Therefore, you might also ask "Why do we want to forbid trading, if it doesn't do any environmental harm?" As H2ONaCl perfectly explains both seller and buyer benefit from trade. Why should anybody be stopped from doing more in exchange for an adequate compensation?

Costs may vary significantly from country to country and industry to industry. In one industry the introduction of some cheap technology might reduce emissions by half, in another a reduction by three or four per cent would either be extremely expensive or even physically impossible.

Trade lowers the total cost to achieve a given emission level. This means that the citizens of the trading countries are wealthier than they would be in a non-trade environment.

Of course, it is possible to use some of these expected gains to set a more ambitious cap level.

Question 2: If we allow the "trade" part of "cap and trade", why do we not simply allocate emissions targets using a method more realistic to the states of various economies? E.g. If the USA gets 50 carbon credits and uses 70, and Norway gets 50 credits and uses 20, why not instead allocate 75 credits to the USA (allowing them to use their 70 credits with 5 left over) and Norway gets 25 (allowing them their 20 credits with 5 left over)? Why is a transfer of money necessary for this scheme to be effective?

Here you are touching another question: the allocation of the carbon credits. You seem to assume that every country gets the same number of credits: the USA, China or Saudi-Arabia receive the same number of credits as the Bahamas, Vanuatu or the Vatican.

The allocation was/is indeed a contentious issue. Two seemingly fair positions:

1. "Every country has to reduce its emissions by the same percentage of its current level."

2. "Every human has the same right to pollute earth. The carbon credits have to be distributed to the countries based on their population size (or directly to each human)."

The first position is opposed by poorer, less-developed countries who fail to understand why they should forever be obliged to pollute less - and live poorer - than those who have created the problem in the first place.

The second position is perceived as a lazy excuse by developing countries as they wouldn't be obliged to do anything (and gain from trading).

Answer 7

Great question! It does seem counter-intuitive that we could trade units of emissions, believing that all the emissions are bad. Why should any country with money be allowed to pay to benefit from another country's unused units?

The missing premise is the carbon cost of economic growth. Countries that aren't as well-developed as the US and Europe are increasing their carbon consumption each year, because that is the most cost-effective way to build a new hospital, schoolhouse, road, factory, office building, military, or large-scale farm.

Compared with selling emissions units, it seems just as unfair that a country with inadequate healthcare would not benefit from the same affordable growth that the US and Europe already completed, and so people don't want to appear heartless by preventing developing countries from using cost-effective forms of energy.