As recently as 2008, the prospects for cap-and-trade climate change legislation looked good. Both major-party presidential candidates in that year's election supported the concept, and there was bi-partisan support in both houses of the U.S. Congress. Now, as of July 2010, cap-and-trade is dead. The Senate will not bring the House-passed Waxman-Markey cap-and-trade bill to a vote, nor will it propose a substitute. What has this experience taught us about the politics of cap-and-trade?
Textbook analysis tells us there are two market-based approaches to controlling carbon emissions. One is a tax of a fixed amount per ton of carbon emitted. The other is to impose a cap on emissions and then issue tradeable permits. Under proper conditions, the equilibrium price of permits would settle down to the same value as the optimal tax, and the environmental effects of the two approaches would be equivalent. If the permits were auctioned off, the budgetary effects of cap-and-trade would also be equivalent to those of a tax.
More advanced economic analysis reveals second-order effects that may break the equivalence in favor of carbon taxes. For example, some economists argue that permit prices would vary greatly from year to year, introducing an element of uncertainty that could discourage pollution control investments. The volatility of EU carbon permit prices lends support to this concern. However, if cap-and-trade were more attainable politically, many economists would accept it as a second best.
Unfortunately for supporters of climate change action, the Waxman-Markey experience raises doubts about the politics of cap-and-trade. The old argument was that cap-and-trade made it easier to put together a climate action coalition. The main idea was that by giving away a limited number of permits for free, some polluters could be won over to the cause of limiting emissions. A secondary political benefit is that a cap-and-trade scheme would not, strictly speaking, be a tax. In the past, that was enough to garner the support of at least a few Republican legislators who would never dream of voting for a tax increase.
The lesson of Waxman-Markey is that the coalition-building powers of cap-and-trade were greatly overrated. In order to assemble a winning coalition in the House, not just a few, but nearly all permits were handed out for free. (Recall that Candidate Obama's 2008 campaign platform on cap-and-trade had called for all permits to be auctioned.) Worse than this, some permits were to be squandered on a bizarre scheme that would have protected consumers from higher energy prices, thus undermining a crucial incentive for energy conservation. Finally, the bill was loaded up with a grab-bag of command-and-control provisions, for example, renewable energy mandates for utilities. What was left was a weak measure that departed widely from the market-based efficiency of a textbook cap-and-trade plan.
When the debate moved over the the Senate, the cap-and-trade coalition collapsed entirely. So much had been given away to win a House majority that there was little room left for maneuver. When the Republican leadership decided to re-brand cap-and-trade as "cap-and-tax," the few remaining Republican supporters dropped away.
The bottom line: The demise of Waxman-Markey seems to be more than a tactical setback for the cap-and-trade approach to climate change. Right now, there seems to be no political appetite at all for climate change legislation. If demand for action emerges again in the future, the case for a straight-up carbon tax seems stronger than before, and the case for cap-and-trade weaker.
Follow this link to download a free set of classroom-ready slides that explains the basic economics of both carbon taxes and cap-and-trade, and discusses the specifics of the Waxman-Markey bill.