Nathaniel O. Keohane

Cap and trade, rehabilitated: using tradable permits to control U.S. greenhouse gases.

This article presents the case for using a cap and trade program (i.e., tradable permits) to control U.S. greenhouse gas emissions. The analysis draws two basic distinctions between such an approach and a carbon tax (the alternative favored by many economists). The first concerns how the value of emissions is allocated. Under cap and trade, the government can capture the value of emissions by auctioning permits or by freely distributing allowances to emitters. A carbon tax would generally capture the entire value as revenue. While free distribution has efficiency costs, it gives policy-makers important flexibility to resolve distributional issues. The second distinction is that a tradable permit system sets the quantity of allowable emissions, while a tax sets the price. In the context of international policy, cap and trade promotes cost-effective abatement and broad participation. A quantity approach may also be preferred on efficiency grounds. Although the prevailing view among economists is that uncertainty about marginal costs favors taxes, that view ignores the possibility of allowance banking and borrowing, and overlooks growing scientific evidence that climate change will be highly nonlinear and characterized by “tipping points.” A simple thought experiment illustrates how a prices-versus-quantities argument might favour cap and trade.

Market Effects of Environmental Regulation: Coal, Railroads, and the 1990 Clean Air Act

Title IV of the 1990 Clean Air Act Amendments introduced a cap-and-trade system for sulfur dioxide emissions from electric power plants in the United States. This paper analyzes the effects of that regulatory change on the prices charged by the two railroads that hauled low-sulfur coal east from Wyoming. We estimate the effect of the tradeable permits regime by comparing prices at affected plants (called Table A plants) before and after the allowance market took effect, and by comparing prices at those plants to prices at unaffected plants. We show that after Title IV took effect, the delivered price of low-sulfur coal - controlling for the minemouth price of coal and the variable cost of transportation - rose at Table A plants within approximately 1000 miles of the Powder River Basin, and fell at Table A plants located further away. This shift in the delivered price schedule of PRB coal is consistent with a theoretical model of the effects of emissions regulation on demand for low-sulfur coal, and the corresponding optimal pricing strategy by a carrier with market power. Our results suggest that the railroads were able to price discriminate among power plants on the basis of the environmental regulations governing the plants.

The Influence of the Specification of Climate Change Damages on the Social Cost of Carbon

Drawing upon climate change damage functions previously proposed in the literature that we have calibrated to a common level of damages at 2.5 C, we examine the effect upon the social cost of carbon (SCC) of varying the specification of damages in a DICE-like integrated assessment model. In the absence of risk aversion, all of the SCC estimates but one agree within a factor of two. The effect of varying calibration damages is mildly sublinear. With a moderate level of risk aversion included, however, the differences among estimates grow greatly. By combining elements of different damage specifications and roughly taking into account uncertainty in calibration, we have constructed a composite damage function that attempts to approximate the range of uncertainty in climate change damages. In the absence of risk aversion, SCC values calculated with this function are in agreement with the standard quadratic DICE damage function; with a coefficient of relative risk aversion of 1.4, this damage function yields SCC values more than triple those of the standard function.

Unmask temporal trade-offs in climate policy debates

Both 20- and 100-year time scales should always be reported Global warming potentials (GWPs) have become an essential element of climate policy and are built into legal structures that regulate greenhouse gas emissions. This is in spite of a well-known shortcoming: GWP hides trade-offs between short- and long-term policy objectives inside a single time scale of 100 or 20 years (1). The most common form, GWP100, focuses on the climate impact of a pulse emission over 100 years, diluting near-term effects and misleadingly implying that short-lived climate pollutants exert forcings in the long-term, long after they are removed from the atmosphere (2). Meanwhile, GWP20 ignores climate effects after 20 years. We propose that these time scales be ubiquitously reported as an inseparable pair, much like systolic-diastolic blood pressure and city-highway vehicle fuel economy, to make the climate effect of using one or the other time scale explicit. Policy-makers often treat a GWP as a value-neutral measure, but the time-scale choice is central to achieving specific objectives (2–4).

Averting Enforcement: Strategic Response to the Threat of Environmental Regulation

This paper uses data from the U.S. electric power industry to explore the strategic responses of regulated firms to government enforcement. We focus on the enforcement of New Source Review, a provision of the Clean Air Act that imposes stringent emissions limitations on substantially modified older power plants. Starting in late 1999, the EPA sued the owners of 46 power plants for NSR violations. This paper explores how electric utilities responded to both the perceived threat of future action, and the action itself. We find that the threat of action did have a significant effect on emissions: plants that were likely to be named in the lawsuits (as determined by our discrete choice model of the lawsuit decision) reduced their emissions by about 17 percent on the eve of the lawsuits. After the lawsuits, we find no significant difference between those plants sued and other relatively dirty coal-fired power plants.

Environmental Policy Design and the Distribution of Pollution Control Techniques in a Regulated Industry

This paper analyzes the choice of pollution control techniques by regulated firms, under three policy instruments: emissions standards, emissions taxes, and tradeable permit systems. In this model, heterogeneous firms choose from a menu of abatement techniques, which may include some that have higher marginal costs (but lower capital costs) than a widely available benchmark technique. I show that the cost savings from any technique relative to the benchmark is larger under an emissions tax than under an emissions standard. An analogous result holds for tradeable permits. As a result, the distribution of techniques chosen by firms is more dispersed under market-based instruments than under an emissions standard. This offers a novel twist on the relationship between abatement cost heterogeneity and market-based instruments. I also compare a tax with tradeable permits, and show that the aggregate marginal abatement cost curve lies further from its benchmark value under a tax than under a tradeable permits. Thus the marginal cost curve is endogenous to the choice of policy instrument.

The Optimal Management of Environmental Quality with Stock and Flow Controls

We characterize environmental quality as a stock, and its rate of deterioration as a flow. We consider a class of problems, which we call “SFQ” problems, in which both stocks and flows can be controlled to promote the quality of a resource stock. Abatement (curbing the flow) and restoration (restoring the stock) are interdependent tools in such problems. Under the optimal policy, periodic restoration complements positive but variable abatement that partly stems the quality decline. The preferred balance between the two strategies depends on environmental and economic factors. If flows are low enough, or if abatement is sufficiently inexpensive relative to restoration, optimal abatement may be sufficiently intense to offset the expected deterioration and produce an equilibrium in expectation. When deterioration is more rapid or more variable, when abatement is more expensive, or when restoration is less costly, the optimal policy relies more on restoration. We apply the analysis to the restoration of an endangered species, and show how it could illuminate a range of other problems in the environmental arena. But the lessons are general, and we briefly discuss how they apply to the management of both physical and human capital stocks.