Why the Sierra Club is worried about 'cap and trade'

In a pinch of irony, the Sierra Club is upset about California's nascent Carbon Cap & Trade program. Has the Sierra Club joined the Tea Party? That would be Time-AOL merger! At the tender age of 45, I speak in cliches. "Every journey starts with a first step". California is the green guinea pig as we try to launch a credible carbon cap & trade program. The goal is to credibly commit to a slow ramp up in the price of carbon emissions. Right now the price = 0 and this is too low. The hope here is that by having a slow ramp up (i.e allowing the price of a ton of carbon to rise over time) that this incentivizes polluters such as fossil fuel power plants to green their game. They will have plenty of lead time to plan for such changes and can move on whatever margin they believe is most cost-effective for them. If polluters must change their ways (thanks to this regulation) then this will thicken markets for low carbon products and encourage specialization and human capital investment that will in total lower the cost of abatement. The lessons learned will be passed on around the world. In this sense, California is providing public goods.

Yet, the Sierra Club has deep concerns. Bill Magavern's letter to Gov. Jerry Brown lists several items related to the details of how California will launch its cap & trade program.

Mr. Magavern is concerned about;

1. reliance on offsets purchased by sellers from outside of California

2. local environmental justice

3. forest offsets

4. enforcement problems with offsets

5. handing out allowances to polluters

I will try to tackle these issues in this order;

1. As I understand it, California's AB32 allows firms who must comply with the cap to purchase carbon offsets from other entities who reside outside of California. So, if I must reduce my emissions by 10 tons --- I could pay some economists in Boston to walk more and drive their car less or pay a land owner in Brazil to not cut down his trees. These are offsets and I will search for the cheapest way to meet the regulatory requirement.

A couple of serious issues arise. Do such international credits actually take place or does the Brazilian land owner say that he has kept the forest a forest or did he cut it down anyway and cash my offset check? We need serious environmental accountants here to verify claims. There is also a counter-factual question; did my paying the Brazilian change his actions? If he would not have cut down his forest had I not sent him the check, then the California Cap & Trade has had no impact on global carbon emissions. It affects income transfers but not real activity.

Mr. Magavern wants carbon emissions reductions to be "home grown". He tries to be an economist with a Big Push argument claiming that the green economy will be stimulated if we do all of the reductions here in state. There is some truth to this but the costs of compliance will be higher and he intentionally avoids discussing this point.

2. Local environmental justice --- if local polluters can buy offsets, could they actually increase their carbon emissions and raise local air pollution problems in the poor neighborhoods where they are located? Again, there is valid concern here but in this age of the Internet and Twitter --- a public relations disaster would ensue for a firm that followed this strategy. As the cap is tightened over time, firms will have an incentive to take a close look at their production process and swap out old dirty capital and purchase cleaner capital. The net effect in the medium term will be lower ambient pollution near the polluting sources. New capital is cleaner than old capital (a 1960s power plant say) and this regulation will eventually nudge these firms to update their capital stock. Now, some scholars have documented that the Clean Air Act actually encouraged firms to slow down the replacement of old capital because of "grandfathering". New capital was regulated while existing production facilities (old capital) faced no regulation. But, the beauty of "cap and trade" is that such pricing regulation is not quantity regulation and it treats a ton of emissions the same regardless if it was produced by old or new capital.

3. forest offsets --- Mr. Magavern makes a nice point here and I am not qualified to discuss it. He is doing some good economics here by pointing out a potential unintended consequence of relying on forest offsets. There is also the broad accounting issue of how many trees equals a ton of carbon abated.

4. Enforcement problems -- there will be no enforcement problem if each polluter's total emissions can be verified. Once it is know how many tons I emit, then I owe the market price of a permit * the tons I emitted. Again, if I can buy offsets there is a key accounting here to determine whether my claimed offsets actually do offset the pollution I created. If there are nations who we do not trust to honestly comply with the contract then we could have the equivalent of "default risk". For example, if we don't believe Russian claims about their offsets then we don't have to have 1 to 1 exchange rate. Instead, 10 tons of Russian offset credits could equal 1 ton of California offsets. Facing this 10 to 1 exchange rate, California polluters would have an incentive to substitute to more trusted offset suppliers. Russia would have an incentive to bring in an arm's length certifier to confirm that they are achieving the offsets they are claiming. Why? If Russia took this action, its "exchange rate" would improve to 5 to 1 or at best 1 to 1.

5. Allocations --- The Sierra Club wants the "polluter to pay" --- I agree with this in terms of property rights. This is a classic initial Coasian issue of who has the right to pollute? But don't forget lobbying. The polluters must receive a side payment in order for them to not call in their lawyers. While I would prefer for the state to collect all of the revenue from the permit auctions, I am not surprised by the choice to hand out some allowances. The same thing happened in the case of Acid Rain SO2 markets. The coal fired power plants across the nation received huge initial allotments.

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