The EU Parliament recently considered, and apparently abandoned, a proposal that would have destroyed the economic credibility its Emission Trading System for greenhouse gases. The proposal would have withheld from the market permits for 2013-14 permits for 900 millions metric tons of carbon. Contrary to popular reporting, this does not leave the ETS “in tatters” (Wall Street Journal) or “crumbling” (Click Green). Rather, it means that, at least for now, the credibility of the ETS as an economic incentive has survived another crisis.
Incentives such as marketable permits and pollution taxes have been popular policy tools among economists for decades. They are founded on the premise that private markets do not produce socially optimal results unless the private and social costs of an activity are equal. Externalities prevent private and social costs from being equal. They can be internalized by imposing Pigouvian taxes on negative externalities (or Pigouvian subsidies for positive externalities), or by establishing a regime of fully marketable permits that create property rights in the production of the good or service responsible for the externality. (A third economics-based approach consists of clearly assigning property rights, for many negative externalities would not exist but for the absence of clear property rights.)
In the economist’s classroom, these incentives are indistinguishable because they achieve the same result. The choice of a Pigouvian tax or subsidy on the one hand, or a fully marketable permit on the other, thus depends on two practical considerations related to technical uncertainty and administrative simplicity. For example, if there is less technical uncertainty about the optimal quantity, then economists usually recommend establishing a marketable permit system. Governments can specify the quantity of a good that will be supplied (or the quantity of a “bad” that will be allowed), and let price be set by the marketplace. Similarly, marketable permits also would be preferred if it is substantially easier to administer a permit system than a tax regime.
The test of a properly functioning Pigouvian tax is whether it succeeds in equalizing private and social costs or benefits. If it does, then the government need do nothing to achieve the socially optimal quantity; it will happen automatically. Similarly, the test of a properly functioning marketable permit system is whether it succeeds in achieving the socially optimal quantity. If it does, then the government need do nothing to achieve the socially optimal price; it will be obtained automatically.
In practice, however, governments and market actors alike may display a predictable pattern of refusing to leave well enough alone. When governments grow enamored of or dependent on the revenue produced by Pigouvian taxes, they raise these taxes to generate additional revenue without regard for equating private and social costs. When the beneficiaries of Pigouvian subsidies grow comfortable with or dependent on them, they lobby governments for more. A similar story can be told about marketable permits, in which public and private sector entities strive to squeeze more from the permit system than it was intended to deliver. Firms that have to buy marketable permits want the government to flood the market with them, driving the permit price down. Advocates of stricter regulation want the government to supply less than the optimal quantity so as to restrict the supply even further.
The absence of economic growth, and for some EU countries, persistent recession, has resulted in greenhouse gas emissions that are well below expectations when the ETS was established. For that reason, the market demand for permits has been weak and is expected to remain so for some time. That, in turn, has caused the market price of ETS allowances to fall, as shown by the adjacent New York Times graph.
If the purpose of the ETS is to reduce greenhouse gas emissions to the designated quantity target, then there is nothing that the EU Parliament needs to do. The ETS is a success, not a failure. Falling permit prices are evidence that that low economic growth has reduced the magnitude of the problem that the ETS was supposed to solve. The ETS is not “in trouble,” as Brad Plumer writes in the Washington Post:
Europe’s emissions are well under the cap and permit prices had been hovering below $9 per ton since 2011. Companies have little incentive to make any drastic changes. Polluting is cheap…
Plumer correctly describes the nature of the conflict within the EU. There are countries such as Poland that say the ETS is working fine because the EU’s greenhouse gas emission goals are being achieved.
This is, essentially, how cap-and-trade is supposed to work. When meeting the targets is easy (and it’s much easier when the economy is in the toilet), then the price of carbon goes down. If the euro zone ever recovered from its pit of endless despair, then the price of polluting would presumably rise again.
But as Plumer notes, “many people in Europe want a high price on carbon.”
Many politicians and analysts weren’t satisfied with simply staying under the cap. They wanted a high price on carbon that would drive big changes to the continent’s energy supply. And, it’s true, the ETS wasn’t providing that.
Of course, it wasn’t intended to do that if it was supposed to overcome an externality. And this is the real-world problem that seems to afflict economic incentives. Governments and some stakeholders appreciate the political appeal economic incentives offer but are unwilling to be subject to incentives’ internal logic.
Intellectual confusion about economic incentives is not limited to the left side of the political spectrum. After the EU Parliament voted against expropriating permits,and thereby refused to destroy the ETS’ economic logic, the Wall Street Journal editorial page claimed that this action spelled the end of “[o]ne of the great policy bubbles of our times.” If preserving the ETS as a bona fide economic incentive matters, then the EU’s rejection of the proposed expropriation was crucial to saving it, or at least allowing it to survive another day. A properly functioning ETS ignores the market price of permits; it does not act to “prop them up.” That “anticarbon crusaders” failed to persuade the EU to abandon the economic rationale of the ETS may well reveal that they do not genuinely support economic incentives to solve environmental problems. It does not, however, “give the lie to the claim that cap and trade is a ‘market solution’ to climate change.” As long efforts to undermine the ETS’ economic logic continue to fail, the ETS remains a plausible market solution.
Still, the proposed permit expropriation and the EU’s refusal to adopt it illustrate a fundamental problem with the ETS and similar cap-and=trade proposals. Under a well designed marketable permit scheme, permit ownership must be accompanied by an inviolable property right. Governments must not be able to expropriate permits for any purpose, and permit owners must be able to trade them without restriction or interference. ETS permit prices are lower than they should be in part because inviolable property rights are missing. Prospective buyers will not pay full price because they cannot be certain that they will be able to emit the greenhouse gases presumptively allowed by permit.
The EU Parliament resisted the temptation to expropriate permits this time, but the vote was close and there are no guarantees it will withstand the pressure next time. Prices will continue to be depressed unless and until the EU proves that its transferable permits are enforceable property rights.