Cap and Trade

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A critique of Cap and Trade from Robert J. Shapiro

Robert Shapiro:

"Cap-and-trade combines a regulatory cap on greenhouse gas emissions with a market-based scheme to trade as financial instruments the “permits” to produce those emissions. For all of cap-and-trade’s initial promise as an answer to climate change, the current financial crisis has made its vulnerabilities painfully clear. The strategy would have the government create trillions of dollars in new, asset-based financial instruments. These emissions-right-backed securities, like their cousins, mortgage-backed securities, also would throw off a host of new derivatives to be profitably traded by the “professionals.” Unsurprisingly, cap-and-trade’s fiercest promoters include Wall Street institutions that see emissions-permit trading as a lucrative new market that could earn them billions in new fees, commissions and, while it lasts, speculative gains. But after Wall Street’s meltdown, the proposition for another round of the financial merry-go-round that produced the worst economic crisis in our lifetimes seems either very naïve or very cynical.

That’s not the only tricky problem facing cap-and-trade. The other part of the policy’s design, the hard cap on emissions, ensures that the prices of the permits will be very volatile. Here’s why. The cap in cap-and-trade is set as a percentage reduction in annual emissions, figured from some baseline. The problem is that no one can forecast with precision how much energy American businesses and households will need from one year to the next, because no one knows how cold the winter will be, or how hot the summer, or how fast the economy will grow a year from now. When energy companies see that demand is going to outpace the forecast, so they will need more permits to keep on selling energy, the price of those permits will rise sharply. It’s not just theory: We use a small-scale cap-and-trade program to reduce the emissions that produce acid rain, and the price of those permits moves up and down an average of more than 40 percent per year. In the same vein, Europeans adopted their own cap-and-trade system for energy emissions a few years ago, and the price of their permits has moved up or down by an average of 17 percent per month.

For years, economists have worried that this basic feature of cap-and-trade would produce new volatility in energy prices. They’ve also cautioned that the result would likely be less investment in climate-friendly fuels, since no one would know what the price of their carbon content would be. Now there’s another, equally serious problem: The unavoidable volatility of the prices of emission permits also would attract furious financial speculation, since speculators live off of volatile prices. And we now know the risks that we all run when rampant speculation occurs in financial instruments tied to our economic foundations, such as housing -- or energy.

Like the excesses that helped create our current crisis, the financial markets for emissions permits also could well produce serious insider trading and manipulation. That’s because the final purchasers of the permits, large energy companies and utilities, would see shifts in demand for the underlying energy coming before anyone else. This information would create golden opportunities for insider profits and market manipulation, and erecting a “Chinese wall” inside the companies to segregate the production division from the trading division would work no better than it has on Wall Street. That may explain why until its own collapse, Enron was a prominent advocate of cap-and-trade.

The only reason to play another round of Russian roulette with the economy would be if cap-and-trade were the only way to address climate change. Happily, it isn’t: Many economists and some politicians support the major alternative, carbon-based taxes with rebates. This approach would create no new financial instruments to trade and abuse, and produce no additional price volatility, because the price of carbon would be set. It also would be relatively simple to administer and enforce. And it can be designed to recycle its revenues in payroll tax reductions or rebates. In this way, the carbon tax would change the relative price of different forms of energy, based on how much damage they do to the climate, while protecting people from the additional, direct costs of the tax itself. The revenues could also be recycled as a flat payment to each American household, providing relatively more help to low and middle-income families. The policy’s only real weakness is that it has no cap. But the tax rate could be adjusted periodically if actual emissions exceed its goal." (

Why we need a carbon tax instead

Charles Eisenstein, in chapter 10 from Sacred Economics:

"Considerable controversy surrounds present-day cap-and-trade proposals, and by and large, I agree with their critics. A truly effective emissions allowance program would be an auction system with no offsets, no free credits, no grandfather clauses, and strict sanctions on noncomplying countries. Even so, problems remain: price volatility, speculative derivatives trading, and corruption. Enforcement is an especially critical problem because cap-and-trade gives a big advantage to manufacturers in places with lax enforcement, which could result in more total pollution than the present regulatory regime.5 Another problem is that in a cap-and-trade system, individual restraint frees up resources or allowances to be used by someone else, leading to a feeling of personal powerlessness.

The problems with cap-and-trade suggest a different approach: direct taxes on pollution, such as Paul Hawken's carbon tax. Fossil fuels could be taxed on import, and the proceeds rebated to the public. This is another way to force the internalization of costs, and would be especially appropriate in situations where the social and environmental costs are easy to quantify and remedy. As with cap-and-trade, international enforcement is a big problem, as manufacturing would become more profitable in countries that refused to levy the tax or collected it inefficiently. It might also require frequent rate adjustment in order to attain the desired ceiling.

For those readers who recoil at the suggestion of another tax, consider that the two mechanisms I have described, cap-and-trade systems and green taxes, are not actually new levies upon society. Someone is going to be paying the costs of environmental destruction regardless. In the present system, this "someone" is either innocent bystanders or future generations. These proposals merely shift these costs onto those who create them and profit from them.

However it is accomplished, when the costs of pollution are internalized, the best business decision comes into alignment with the best environmental decision. Suppose you are an inventor and you come up with a great idea for a factory to cut pollution by 90 percent with no loss of productivity. Today, that factory has no incentive to implement your idea because it doesn't pay the costs of that pollution. If, however, the cost of pollution were internalized, your invention would be a hot item. A whole new set of economic incentives emerges from the internalization of costs. The goodness of our hearts, which want to cut pollution even if it isn't economic, would no longer have to do battle with the pressures of money.

While both cap-and-trade programs and pollution taxes have a role to play in the internalization of social and ecological costs, we could also integrate them into the structure of money itself, an intentional kind of money that embodies our reverence for the planet and our emerging sense of the role and purpose of humanity on earth. It unites the internalization of costs with the rectification of the great injustice of property described in Chapter 4, returning the commons to the people while nonetheless giving free rein to the spirit of entrepreneurship. It implements the principle of Chapter 9: to make money sacred by backing it with the things that have become sacred to us. Among them are precisely the same things that green taxes and the like aim to preserve. While the details of cap-and-trade, currency issue, and so forth may have a technocratic feel to them, the underlying impulse, which the next chapter will flesh out, is to align money with the things we hold sacred.

Whether it is accomplished through traditional taxation or cap-and-trade, or by integrating it into money itself, we are embarking on a profoundly different relationship to Earth. In the days of the Ascent, the story of the growth of the human realm and the conquest of the wild, in the time of humanity's childhood, when the world seemed to have infinite room to accommodate our growth, there was no need for collective agreements on how many fish to catch, how many trees to cut, how much ore to dig, or how much of the atmosphere's capacity to absorb waste to use. Today, our relationship to the rest of nature is changing on a fundamental level, as it is impossible to ignore the limits of the environment. The fisheries, the forests, the clean water, and the clean air are all obviously close to depletion. We have the power to destroy the earth, or at least to cause her grievous harm. She is vulnerable to us, as a lover is to a lover. In that sense, it is no longer appropriate to think of her only as Mother Earth. A child, in his wanting, does not take his mother's limits into account. Between lovers it is different. That is why I foresee a future in which we maintain local, regional, and global ceilings on the use of various resources. Fishery catches, groundwater use, carbon emissions, timber harvests, topsoil depletion, and many more will be carefully monitored and held to sustainable levels. These resources -- clean water, clean air, minerals, biota, and more -- will be sacred to us, so sacred that I doubt we will refer to them as "resources," any more than we refer to our own vital organs as resources, or dream of depleting them." (