An Introduction to Cap-and-Trade Climate Policy Holmes Hummel, PhD hummelhh@mindspring.com November 21, 2007 Using Musical Chairs: An Illustration of Managed Scarcity

Climate Science Climate change is driven by greenhouse gases accumulating in the atmosphere as a result of human activities . The U.S. is responsible for about 30% of the total accumulation since the Industrial Revolution – three times China and India combined. Climate change impacts are dangerous , and the Nobel Prize-winning IPCC scientists say 1/3 of all species are at risk . Burning fossil fuels – coal, oil, and gas – is the biggest driver of climate change, and it accounts for 85% of U.S. energy use. Most people in the U.S. believe something should be done to stop global warming – but what, and how? References: IPCC Fourth Assessment Report, Summary for Policy Makers, 2007. Navigating by the Numbers, World Resources Institute, 2005. National opinion poll by Krosnik, Kopp, and Aldhous, 2007.

Climate change is driven by greenhouse gases accumulating

in the atmosphere as a result of human activities .

The U.S. is responsible for about 30% of the total accumulation since the Industrial Revolution – three times China and India combined.

Climate change impacts are dangerous , and the Nobel Prize-winning

IPCC scientists say 1/3 of all species are at risk .

Burning fossil fuels – coal, oil, and gas – is the biggest driver of climate change, and it accounts for 85% of U.S. energy use.

Most people in the U.S. believe something should be done to stop global warming – but what, and how?

Climate Economics Today, consumers (and industries we support) dump an unlimited amount of greenhouse gases into the atmosphere for free. As a result, fossil fuel prices do not reflect their full cost . Life on Earth pays the ultimate price: more severe droughts, floods, fires and storms along with collapsing ecosystems and extinction . For this reason, some economists have called climate change “ the greatest market failure in history. ” References: IPCC Fourth Assessment Report, Summary for Policy Makers, 2007. The Economics of Climate Change, Stern Review Report, 2006.

Today, consumers (and industries we support) dump an unlimited amount of greenhouse gases into the atmosphere for free.

As a result, fossil fuel prices do not reflect their full cost .

Life on Earth pays the ultimate price: more severe droughts, floods,

fires and storms along with collapsing ecosystems and extinction .

For this reason, some economists have called climate change

“ the greatest market failure in history. ”

Climate Challenge “ If we’re not serious about this problem, then we’ve got much worse problems to start getting serious about…” Just enough for one big play Size of the entire industrial economy None U.S. carbon market worth more than $200 Billion Disruption of many life support systems on Earth Launch of a clean energy economy Eliminate 500 Million Tons of CO 2 Pollution Per Year

“ If we’re not serious about this problem,

then we’ve got much worse problems to start getting serious about…”

Climate Policy To curb emissions and avoid the worst climate change impacts, both national and international climate policies would encourage. . . consumers and investors to build a clean energy economy and reduce emissions by imposing a cost on greenhouse gases, and (b) policy-makers to commit money to 1) help those hit hardest by climate change damages, and 2) invest in jobs and infrastructure to support the transition. Mitigation & Adaptation

To curb emissions and avoid the worst climate change impacts,

both national and international climate policies would encourage. . .

consumers and investors to build a clean energy economy and reduce emissions by imposing a cost on greenhouse gases, and

(b) policy-makers to commit money to

1) help those hit hardest by climate change damages, and

2) invest in jobs and infrastructure to support the transition.

Climate Policy Policy makers have 2 main options for putting a cost on greenhouse gas pollution: (1) a carbon tax or “pollution fee” (2) creating a market for carbon emissions In order to stabilize global warming, fossil fuel prices would rise under either policy. Americans appear to have little appetite for a carbon tax. But there is also little understanding of the market-based alternative – a carbon cap-and-trade program . How would it work?

Policy makers have 2 main options for putting a cost

on greenhouse gas pollution:

(1) a carbon tax or “pollution fee”

(2) creating a market for carbon emissions

In order to stabilize global warming, fossil fuel prices would rise

under either policy.

Americans appear to have little appetite for a carbon tax.

But there is also little understanding of the market-based alternative –

a carbon cap-and-trade program .

How would it work?

Cap-and-Trade Climate Policy “ Cap-and-trade” means a government authority establishes a cap that limits the total amount of pollution allowed, and then distributes permits for a “right to pollute” the global atmosphere, which can be traded as private property. The amount of greenhouse gas emissions permitted declines each year , creating demand for a new commodity: carbon permits . When offered enough money (or faced with high enough costs), polluters who own permits (or need permits) will reduce their emissions. These trades establish a market price for greenhouse gas pollution. A familiar game can help illustrate the concepts… Got it?

“ Cap-and-trade” means a government authority establishes a cap that

limits the total amount of pollution allowed,

and then distributes permits for a “right to pollute” the global atmosphere,

which can be traded as private property.

The amount of greenhouse gas emissions permitted declines each year , creating demand for a new commodity: carbon permits .

When offered enough money (or faced with high enough costs), polluters who own permits (or need permits) will reduce their emissions.

These trades establish a market price for greenhouse gas pollution.

Musical Chairs: A Helpful Analogy This game of managed scarcity can help illustrate the following important concepts and issues: Banking Borrowing Equity Ethics Allocation Auction Trading Targets Leakage Offsets Safety Valve Spending

Banking

Borrowing

Equity

Ethics

Allocation

Auction

Trading

Targets

Leakage

Offsets

Safety Valve

Spending

Musical Chairs: A Helpful Analogy Each chair represents the “right to pollute”: one metric ton of carbon dioxide (1 mtCO 2 ) or an equivalent amount of any other greenhouse gas If you have a permit, you can have a chair.

Each chair represents the “right to pollute”:

one metric ton of carbon dioxide (1 mtCO 2 )

or an equivalent amount of any other greenhouse gas

If you have a permit, you can have a chair.

Musical chairs At the start of the game, everyone has a seat – because there are no limits on carbon emissions. 2008 All stick figures by Tormod Lund, GraffleTopia.com

At the start of the game, everyone has a seat –

because there are no limits on carbon emissions.

Musical chairs After the first year, a cap is imposed by limiting the amount of permits and making players compete for the permits available . In our analogy, one player doesn’t have a chair… 2009

After the first year, a cap is imposed by limiting the amount of permits and making players compete for the permits available .

In our analogy, one player doesn’t have a chair…

Would anyone be willing to trade their chair for $30 ?

Sure! For that price, I can finance an efficiency upgrade, eliminating my need for a pollution permit.

So, the market price for the “right to pollute” in the first year is $30 for one ton of carbon dioxide…

So, the market price for the “right to pollute” in the first year

is $30 for one ton of carbon dioxide…

Using Market Incentives At that price, some players may realize it would be more profitable to reduce their emissions and sell their permits. Profit opportunities are a main driver for innovation and investment in the global economy today, and the climate challenge needs both . 2009

At that price, some players may realize it would be more profitable to reduce their emissions and sell their permits.

Profit opportunities are a main driver for innovation and investment in the global economy today, and the climate challenge needs both .

Using Market Incentives If I could I build wind farms to replace my coal power plants, then I could sell permits… 2009

Using Market Incentives Hey, I made a profit by reducing my fossil fuel use and avoiding carbon emission costs! 2010

Achieving Reduction Targets The purpose of the game is to reduce greenhouse gas emissions. The game authority reduces the number of permits available each year until the ultimate target has been achieved. 2010

The purpose of the game is to reduce greenhouse gas emissions.

The game authority reduces the number of permits available

each year until the ultimate target has been achieved.

Achieving Reduction Targets In a market, players leave when they find better options as costs rise . Cap-and-trade lets players choose at what price they leave the game – and how they want to make that change . 2050 2040 2030 2020 Wind power Rail Transport Hybrid vehicle Solar power Green buildings Nuclear power 2010 $30 $150 $20 $100 $200 $50

In a market, players leave when they find better options as costs rise .

Cap-and-trade lets players choose at what price they leave the game

– and how they want to make that change .

Achieving Reduction Targets Who will be the last greenhouse gas polluters left in the game? 2050

Achieving Reduction Targets The last ones remaining in the game are those who: can afford to pay the most, or have the least flexibility to change games. The underlying assumption is that uses of fossil fuels for which people are willing to pay the most must be the most valuable . To stabilize global warming, most uses of coal, oil, and gas will have to move to a different game: the clean energy economy . 2050

The last ones remaining in the game are those who:

can afford to pay the most, or

have the least flexibility to change games.

The underlying assumption is that uses of fossil fuels for which people are willing to pay the most must be the most valuable .

To stabilize global warming, most uses of coal, oil, and gas will have to move to a different game: the clean energy economy .

Achieving Reduction Targets To avoid the worst climate impacts, the U.S. must eliminate at least 80% of its emissions by 2050. 2050 Comparison of Two Leading Climate Policy Proposals in the 110 th Congress (2007) Warner-Lieberman Chart modified for clarity Stabilize at 450-550ppm

To avoid the worst climate impacts, the U.S. must eliminate at least 80% of its emissions by 2050.

Achieving Reduction Targets There are no “time out” options between rounds. As the cap tightens in each new round, fewer permits are available . So, players with permits charge the buyers higher prices. $90 $90 $90 SELL PRICE: 2020

There are no “time out” options between rounds.

As the cap tightens in each new round, fewer permits are available .

So, players with permits charge the buyers higher prices.

Achieving Reduction Targets $90 $90 $90 How high can the price go? As high as it takes to motivate one of us to stand up. 2020 SELL PRICE:

The Carbon Market at Work So, is it cheaper for me to: buy a permit from another player, OR reduce my own emissions ? $90 $90 $90 SELL PRICE:

So, is it cheaper for me to:

buy a permit from another player, OR

reduce my own emissions ?

The Problem of “Leakage” Either choice may be difficult for some energy-intensive businesses (e.g. aluminum, cement) competing in the global economy. $90 $90 $90 2020 SELL PRICE:

Either choice may be difficult for some energy-intensive businesses (e.g. aluminum, cement) competing in the global economy.

The Problem of “Leakage” At higher carbon prices, I’ll need to close my cement plant – or move it to another country... $90 $90 $90 2050 SELL PRICE:

The Problem of “Leakage” $90 $90 $90 “ Leakage” occurs when polluters move to avoid regulation – which is why an international agreement is so important . SELL PRICE:

The Problem of “Leakage” “ Leakage” occurs when polluters move to avoid regulation – which is why an international agreement is so important . Otherwise, a national climate policy may drive jobs away and still not reduce global emissions. $90 $90 $90 SELL PRICE:

The Problem of “Offsets” $20 $20 $20 Opposite to leakage, a player may find a business sector that isn’t covered by the policy … but has a lower cost opportunity to reduce emissions. $15 Reducing methane from hog farms SELL PRICE:

The Problem of “Offsets” Because all tons of carbon emissions affect the atmosphere the same, this offset could be accepted as equivalent to a permit . $20 $20 $20 $20 No one would have used this chair unless I went out and bought it – and it’s just as good as any other! SELL PRICE:

The Problem of “Offsets” $20 $20 $20 However, it can be difficult to verify that the player’s investment was responsible for those reductions – and that they actually happened. Therefore, standards for offsets must be high to ensure the carbon reductions are real – and not “hot air.” $20 SELL PRICE:

The Problem of “Offsets” $20 $20 $20 China, India, and other countries have some very low cost opportunities to reduce emissions. However, the U.S. Congress did not ratify the Kyoto Protocol that makes use of the Clean Development Mechanism for offsets. $20 SELL PRICE:

The Problem of a “Safety Valve” $20 $20 $20 Some companies want market-based policies, but not market risk. SELL PRICE:

The Problem of a “Safety Valve” $20 $20 $20 Some companies want market-based policies, but not market risk. My business cannot cope with the possibility that carbon prices might exceed $20/mtCO 2 ! SELL PRICE:

The Problem of a “Safety Valve” $20 $20 $20 Some companies want market-based policies, but not market risk. A “safety valve” would put a cap on the carbon price rather than on the emissions, allowing firms to protect their investments by buying unlimited pollution permits at a guaranteed maximum price. SELL PRICE:

The Problem of a “Safety Valve” $20 $20 $20 Some companies want market-based policies, but not market risk. A “safety valve” would put a cap on the carbon price rather than on the emissions, allowing firms to protect their investments by buying unlimited pollution permits at a guaranteed maximum price. $20 $20 $20 SELL PRICE:

The Problem of a “Safety Valve” However, a “safety valve” would effectively violate the cap on emissions, and convert the policy to a stable tax . Anyone can burn as much coal as they’d like if they can pay the fee. $20 $20 $20 $20 $20 $20 $20 $20 SELL PRICE:

The Problem of a “Safety Valve” With a “safety valve” on the price of carbon, the market drivers are weaker, making command & control policies even more important. Building codes, fuel economy standards, renewable portfolio standards, tax laws, and other legal requirements are essential – as they are today. $20 $20 $20 $20 $20 $20 $20 $20 SELL PRICE:

Banking $90 $90 $90 $90 Players who receive more permits than they need would like to “bank” them. By saving a spare permit, the player can to pollute that amount in a future year or to sell that permission to someone else in the future. SELL PRICE: 2020 2015 2016 2017

Banking $90 $90 $90 $20 I’m glad I reduced emissions and saved permits in earlier years – because now they are worth much more! SELL PRICE: 2020 2015 2016 2017

Borrowing Similarly, some people who lack sufficient permits to cover their pollution would like to “borrow” them from the permits they expect to receive in the future. $90 $90 $90 $90 I can’t afford this market. I’d rather borrow from the future and hope that technology and business opportunities get better… SELL PRICE: 2020

Borrowing $90 $90 $90 $90 Didn’t Social Security and the national debt get into trouble that way?? SELL PRICE: 2020 on credit, due 2025

Coverage and Distribution Two critical aspects of cap-and-trade are determined by how each round begins : 1. Which polluters should be required to play? 2. Should polluters have to buy permits in an auction – or should they receive a free allocation of permits?

Two critical aspects of cap-and-trade are determined by how each round begins :

1. Which polluters should be required to play?

2. Should polluters have to buy permits in an auction –

or should they receive a free allocation of permits?

Coverage For practical reasons, most proposals only require fossil fuel suppliers and large polluters to play directly. As they pass on their costs, the rest of the economy is affected. Examples of “covered” pollution sources: Oil Refineries Coal companies Natural Gas companies Power Plants Mining plants Chemical companies Aluminum smelters

For practical reasons, most proposals only require fossil fuel suppliers and large polluters to play directly.

As they pass on their costs, the rest of the economy is affected.

Though sales of coal, oil, and gas should decline as carbon prices rise, economists say less than 20% of the permits should be given for free to compensate those firms for additional profits they might have had otherwise . Auctioning Permits vs Allocating for Free Permits auctioned to “covered” companies Free permits allocated to fossil fuel companies $20 $20 $20 $20 $20 $20 $0 BUY: Reference: Lawrence Goulder, Congressional Budget Office Conference on Climate Change, 2007.

Though sales of coal, oil, and gas should decline as carbon prices rise,

economists say less than 20% of the permits should be given for free to compensate those firms for additional profits they might have had otherwise .

By contrast, the Lieberman-Warner bill for U.S. climate policy proposes giving away more than half the permits.* Those companies start out each round “sitting down” at no cost. Auctioning Permits vs Allocating for Free $0 $0 $0 $0 $20 $20 $0 BUY: * Though portion would change over time, 1/4 are still free in 2050. Auctioned permits bought by corporations Free permits allocated to corporations 2012

By contrast, the Lieberman-Warner bill for U.S. climate policy proposes giving away more than half the permits.*

Those companies start out each round “sitting down” at no cost.

Why is this a cause for concern? 1. Unfair competition: New players entering the market with innovative ideas have difficulty competing against pre-existing polluters who get free permits as a subsidy to diminish their political opposition. Auctioning Permits vs Allocating for Free $0 $0 $0 $0 $20 $20 $0 BUY: Auctioned permits Free permits

Why is this a cause for concern?

1. Unfair competition: New players entering the market with innovative ideas have difficulty competing against pre-existing polluters who get free permits as a subsidy to diminish their political opposition.

Auctioning Permits vs Allocating for Free $0 $0 $0 $0 $20 $20 $0 BUY: Auctioned permits Free permits Why is this a cause for concern? 2. Unearned windfall profits: In a carbon market, firms that buy permits in an auction will try to pass costs to customers, and others receiving a permit for free can sell their permits at that same price.

Auctioning Permits vs Allocating for Free $0 $0 $0 $0 $20 $20 $0 BUY: SELL: $20 $20 $20 $20 $20 $20 $20 Unearned windfall profits Cost passed to consumers Why is this a cause for concern? 2. Unearned windfall profits: In a carbon market, firms that buy permits in an auction will try to pass costs to customers, and others receiving a permit for free can sell their permits at that same price.

A cap-and-trade policy with 100% auction avoids giving away unearned windfall profits and returns all proceeds to a public policy process for spending decisions. Auctioning Permits vs Allocating for Free BUY: All seats sold at auction to the highest bidders How auction revenue is spent affects the speed and cost of a clean energy revolution to avoid climate change catastrophes.

A cap-and-trade policy with 100% auction avoids giving away

unearned windfall profits and returns all proceeds to a

public policy process for spending decisions.

Spending Tax credits and Incentives – support for efficiency and zero carbon energy sources Research & Development – on the scale of a New Apollo Project or a Manhattan Project for zero carbon energy sources Low-income Households – committing at least 15% of all revenues to neutralizing impact of higher prices on fossil fuels and other goods Adaptation – helping vulnerable communities (1) avoid harm from climate change, and (2) recover from climate damages Green Collar Jobs – encouraging job development in the clean energy industry x With hundreds of billions of dollars being raised, expectations are high about who could benefit from climate policy – and how:

Tax credits and Incentives – support for efficiency and zero carbon energy sources

Research & Development – on the scale of a New Apollo Project or a Manhattan Project for zero carbon energy sources

Low-income Households – committing at least 15% of all revenues to neutralizing impact of higher prices on fossil fuels and other goods

Adaptation – helping vulnerable communities (1) avoid harm from climate change, and (2) recover from climate damages

Green Collar Jobs – encouraging job development in the clean energy industry

Concerns about Equity Most unearned windfall profits would go to shareholders who are members of the top 10% most wealthy households in the U.S. The top 10% of U.S. households already own 2/3 of the wealth , and the top 1% own half of that! References: State of Working America, 2006; data from U.S. government agencies (Census, IRS, BLS)

Most unearned windfall profits would go to shareholders who are members of the top 10% most wealthy households in the U.S.

The top 10% of U.S. households already own 2/3 of the wealth ,

and the top 1% own half of that!

A carbon tax and a cap-and-trade policy both would raise fossil fuel prices . Prices of products and services that use fossil fuels would also rise. This would impose hardship on low-income households unless the climate policy specifically includes “carbon cost rebate” measures funded with revenues raised from either a tax or a permit auction. Concerns about Equity

A carbon tax and a cap-and-trade policy

both would raise fossil fuel prices .

Prices of products and services that use fossil fuels would also rise.

This would impose hardship on low-income households unless the climate policy specifically includes “carbon cost rebate” measures funded with revenues raised from either a tax or a permit auction.

Under either a carbon tax or a carbon cap-and-trade policy, wealthy people would be able to take advantage of their class privilege to use more fossil fuels – both nationally and globally. In order to withstand popular opposition to higher fossil fuel prices, any climate policy must be widely regarded as fair by a broad base of beneficiaries . Concerns about Equity

Under either a carbon tax or a carbon cap-and-trade policy,

wealthy people would be able to take advantage of their class

privilege to use more fossil fuels – both nationally and globally.

In order to withstand popular opposition to higher fossil fuel prices,

any climate policy must be widely regarded as fair by a broad base

of beneficiaries .

Is it ethical to privatize the sky and treat pollution as a commodity traded like private property? Is it ethical to make a profit from carbon trading ? Will the complexity of a cap-and-trade system rival our tax system, opening similar opportunities for loopholes and favored treatment? Would our political institutions be reliable to manage this massive new market over decades under tremendous pressure? And if federal climate policy is not forthcoming from Congress fast enough… What local, state, corporate, and regional policies for energy, agriculture, science, taxes, and trade could be pursued to meet the challenge? Additional Questions to Consider

Is it ethical to privatize the sky and treat pollution as a commodity traded like private property?

Is it ethical to make a profit from carbon trading ?

Will the complexity of a cap-and-trade system rival our tax system, opening similar opportunities for loopholes and favored treatment?

Would our political institutions be reliable to manage this massive new market over decades under tremendous pressure?

And if federal climate policy is not forthcoming from Congress fast enough…

What local, state, corporate, and regional policies for energy, agriculture, science, taxes, and trade could be pursued to meet the challenge?

For Further Reference The following public interest organizations have a strong focus on climate policy design and development in the U.S.: World Resources Institute www.wri.org Pew Center on Global Climate Change www.pewclimate.org Resources For the Future www.rff.org Union of Concerned Scientists www.ucsusa.org Feedback on this illustrated introduction to cap-and-trade concepts is most welcome: [email_address] . x

The following public interest organizations have a strong focus on climate policy design and development in the U.S.:

World Resources Institute www.wri.org

Pew Center on Global Climate Change www.pewclimate.org

Resources For the Future www.rff.org

Union of Concerned Scientists www.ucsusa.org

Feedback on this illustrated introduction to cap-and-trade concepts is most welcome: [email_address] .

Yes, people will lose jobs – dislocation (tobacco), and opportunity – right now all the jobs are going to Europe and China b/c the U.S. isn’t in the game. Allocation vs Auction has no bearing on the Target – just on the cost; and on perception of fairness (points of “failure” for W-L); W-L target not what is scientifically indicated By the way, what are the little figures that appear in the upper left corner of some of the slides begining on Slide 9? 5. Slide 23: Leakage...it might also be worth mentioning that 'positive' leakage can occur as well if increasing carbon prices cause new innovations to emerge that are adopted by other polluters. meet my friend Nicole Cosmann who is fanatical about climate change issues and is working in DC as a CC analyst for Booz Allen… Many other instruments can be used to encourage greenhouse gas reductions – and we can do that today with codes, standards, and incentives integrated into our energy policy, farm policy, tax policy, building code policy, land-use policy, etc. Climate policy is focused specifically on the emissions themselves, and the U.S. does not yet have a climate policy. Mention reasons for opposition to 100% auctioning. SHORT VERSION; long version

Yes, people will lose jobs – dislocation (tobacco), and opportunity – right now all the jobs are going to Europe and China b/c the U.S. isn’t in the game.

Allocation vs Auction has no bearing on the Target – just on the cost; and on perception of fairness (points of “failure” for W-L); W-L target not what is scientifically indicated

By the way, what are the little figures that appear in the upper left corner of some of the slides begining on Slide 9?

5. Slide 23: Leakage...it might also be worth mentioning that 'positive' leakage can occur as well if increasing carbon prices cause new innovations to emerge that are adopted by other polluters.

meet my friend Nicole Cosmann who is fanatical about climate change issues and is working in DC as a CC analyst for Booz Allen…

Many other instruments can be used to encourage greenhouse gas reductions – and we can do that today with codes, standards, and incentives integrated into our energy policy, farm policy, tax policy, building code policy, land-use policy, etc.

Climate policy is focused specifically on the emissions themselves, and the U.S. does not yet have a climate policy.

Mention reasons for opposition to 100% auctioning.

SHORT VERSION; long version