In my last post, I suggested that it might be possible to create a ‘no cost’ (or ‘low cost’ anyway) solution to CO2 Growth. In this post I will start to explain the principles behind my own conservative proposal for how to curb CO2 growth without hurting the economy.
My idea on this dates back to, of all things, a conversation I once had with my extreme libertarian friend. This is that friend I mentioned before that believed that the freeway system hurt the economy because it put the trains out of business and didn’t let a natural market solution grow. Being an extreme libertarian, he naturally believed that the market was all good. If you just let the market alone it would, in his view, always find an optimal solution through the famous invisible hand of the market.
To prove his point to me, he started to explain to me how emission trading worked. Now mind you, this is a real thing that really has been tried out successfully by local governments for various types of pollution. He used the example of air pollution. This is how he described it.
Bruce, the market solves all problems. It can even solve air pollution. The only good thing to ever come out of the EPA was emissions trading. It’s brilliant because it’s a market solution to pollution. What they did was they sold emission rights to companies. This created a market for pollution rights. They could then sell to each other or to anyone. The Sierra Club got together and pooled their money and actually bought up pollution rights from companies. Because the pollutions rights now had a market value companies wanted to sell them if they could, so it was good for everyone. See, Bruce, the market really can solve all ills.
This really was very close to what he actually told me. I was, I admit, intrigued.
After thinking about this for a few days I went back to him. And here was my ‘counter’ argument.
Jeff, there is one thing you’ve missed. Until the government legislated an emissions market, the markets did not naturally put a correct price on pollution. So this ‘market solution’ is, at it’s core, still a government regulation and markets do not solve all ills on their own. So some government regulation is necessary to produce a good market after all.
Still, Jeff’s point stuck with me. I do not doubt that once you did use government regulation as a way to force pollution to be ‘visible’ to the market, that the market would then promptly start to fix the pollution problem far more elegantly and efficiently than any direct government regulation could ever hope to.
Not long later, I took a class as part of my MBA program and actually studied how emissions trading really worked. It turns out it’s a bit more complicated than my libertarian friend had made it sound.
Externalities
Markets are notorious for failing to respond to certain types of ‘externalities.’ Pollution is a type of externality.
The traditional analysis of externalities assumes that market failures arise because people ignore the external effects of their actions. (Economics: A Contemporary Introduction, p. 676.)
Often externalities are solved by the market without government intervention. According to The Caose Theorem:
As long as bargaining costs are small, an efficient solution to the problem of externalities will be achieved [merely] by assigning property rights. (p. 677)
The example used in the text I’m quoting from is of a lab that tests delicate equipment that happens to be located next to a heavy machinery manufacturer. The vibrations from the machinery manufacturer throw off the delicate lab equipment next door. That vibrations produced by the machinery manufacturer are the externality that the market needs to find a solution for. In this case, let’s say it would cost $2 million for the manufacturer to reduce their vibrations and $1 million for the lab to move location.
Without a doubt, the efficient market solution is for the lab to move. As it turns out, all the government needs to do to cause the market to find it’s efficient solution is assign ‘property rights.’ It doesn’t even matter how they assign them. If the government decides that the testing lab has the ‘right to operate free of vibrations’, then the machinery shop will offer $1 million for the testing lab to move rather than pay $2 million for the necessary vibration proofing. If, on the other hand, the government decides that the machinery shop has the ‘right to operate there,’ then the lab will pay $1 million to move rather than $2 million to get their neighbor to vibration proof themselves. The outcome only effects who has to pay, not whether or not the efficient solution is found. (p. 677)
However, a natural logical corollary of The Caose Theorem is that if negotiation costs are high, then the market will fail to find the efficient solution.
Inefficient outcomes do occur, however, when the transaction costs of arriving at a solution are high. For example… a power plant emitting sulfur dioxide would have trouble negotiating with the millions of people scattered across the downwind states. (p. 677)
This is why pollution is an externality that usually the market can’t solve on it’s own. Unfortunately markets are ‘blind’ to such externalities. So additional government intervention is needed to make the market ‘aware’ of the problem so that the correct cost of the externality gets built into the market price.
This is a known failing of the free market system. The Invisible Hand cannot efficiently solve an externality problem if transaction costs are high. Thus we have a case for regulation to assist markets with finding an efficient solution. But this is also why I favor Emissions Trading, because it uses the markets to find its own solution with minimal government interference.
Emissions Trading / Selling Pollution Rights
For example, suppose that a firm dumps it’s pollutants into a river as an “inexpensive outlet for pollutants that otherwise would have to be disposed of at greater cost.” (p. 678). Economic theory predicts that the daily discharge rate will continue to occur until the private marginal value of discharging wastes falls to zero. Since it’s free, that’s a lot of pollutants. The market, being blind to the externality, fails to price it into the cost of firms sales like it should have.
Now imagine that the government mandates that the river must have no more pollutants than is still safe to allow swimming and fishing. Also assume that monitoring pollutants is possible. How can we reach our goal?
Consider first the problems of either slapping the firm with fines or taxing them for pollutants. Both of these require that government be smart enough to figure out exactly what the cost of the fines or taxes should be to reach an efficient market solution. Make the fines/taxes too low and the river will be too dirty to swim in because the firm has incentive to go over the required amount and just pay the extra fines/taxes. Make the amount too high and the river is cleaner that it needs to be and the market isn’t being efficient.
Worse yet, what do you do when a new firm wants to start up and also pollute the river? Now you have to adjust the fines and taxes all over again.
Instead, we could use an Emissions Trading approach by giving pollutions rights, at the desired level, to the first firm at no cost. This will force them to immediately cut their pollutants, but they probably won’t care because they were just given something valuable for free. This is one of the best things about a Emissions Trading system. Existing companies often favor them because they are “receiving something of value, [so they] are less inclined to fight the… program.” (p. 680)
Even better, now when the new firm wishes to open up, they have to buy pollution rights from the market and the market itself sets the price for the right to pollute. (p. 679)
Conclusions
This is why I favor an Emissions Trading approach to CO2. I believe this constitutes a true market solution to the CO2 growth problem. It does not represent any sort of carbon tax because the money goes to the market and the market gets to set the appropriate costs for emission rights. And even the tree huggers can pool their resources and buy up CO2 emission rights if they really wish to save the world from imminent doom.
Oh, by the way, another name for emissions trading is “Cap-and-Trade.” However, I admit I do not know whether or not my proposal is the same sort of cap-and-trade that the liberals favor, so this may be two things that happen to use the same name.