Early next year, one of the major bills that the Senate will take up will be a comprehensive clean energy bill. According to Sen. Reid, this bill will be taken up after financial reform and prior to the summer, which serves as a natural cutoff point, after which the elections will rule all. At present, a notional clean energy bill has bipartisan backing (thanks to the courageous work of Lindsey Graham) and will have to go through many, many revisions before being passed by the Senate.
The Importance of the Climate
I and many other Kossacks consider this to be an absolutely critical issue, perhaps even more critical than health care, given that climate change can have unpredictable and massive “nonlinear” effects. In short, if we don’t pass this bill, we could be sentencing millions to death and subjecting our entire planet to massive and damaging temperature rises, ocean acidities, population displacements, extreme weather, and other dangerous eventualities.
In this DK GreenRoots diary, I wanted to talk a little bit about the economic theory that underlies the economic regulation of carbon dioxide emissions. These systems can take the form of “command and control” (CAC) regulations or optimal taxation methods, which include volumetric per-unit taxes or emissions trading systems (like the one contained in the Waxman-Markey bill that passed the House).
While I do not express a preference for a particular system, it is highly likely that any system targeting carbon will be an optimal regulation method. In other words, it will likely be predicated on classic externality theory, a key concept in economics.
Command and Control (CAC) Systems
The main regulatory method used by the EPA continues to be CAC. CAC systems are very straightforward: regulators require a certain standard, and the polluter is required to achieve it, regardless of how much it costs. This can be seen in the way criteria air pollutants that create smog were regulated for many years. Quite simply, the goals had to be met, and no emitter would be able to get a permit without using the “best/maximum available control technology” (BACT/MACT). For some firms, this would cause them to incur a very high cost, while others it would be a very low cost.
If the administration chooses to regulate carbon through the EPA, it will take this approach since it is the method promulgated by the Clean Air Act. Not surprisingly, dirtier firms will hate this approach since it does not allow them to have the flexibility they could have under an optimal regulatory scheme or, alternatively, business as usual. Additionally, it is not clear what the BACT for carbon is. Is it carbon capture and sequestration (CCS)? Co-firing with biomass? IGCC coal? Not even the EPA knows.
Optimal Regulation Methods: Carbon Taxes and Emissions Trading Schemes Formerly Known as “Cap and Trade”
In recent years, a lot of the focus in environmental policy has been on regulatory methods that treat pollution as a factor of production that can be regulated in an “optimal” way. Much of the work in this realm comes from externality theory.
Externalities and their Relationship to Pollution Abatement
An externality, for those who do not have training in economics, is a cost to society that is not included the price of a good or service. For example, an externality of the sale of vodka to an alcoholic could be the cost of the alcoholic crashing their vehicle after consuming the vodka. Since the government knows that vodka can contribute to crashes, the government makes sure that the vodka partially reflects the damage inflicted by the crash and from thousands of other crashes by imposing a sin tax.
Pollution is a classic externality. In the production of a good, like electricity, a firm (utility) will sell you that electricity. A factor of the production of that electricity is the emission of pollutants, ranging from coal ash to carbon dioxide. However, if the government does not step in to correct the externality, the cost of the externality to society as a whole will not be reflected in the cost of that electricity. Hence the artificial cheapness of fossil fuels.
An optimal regulation system assumes that an externality can be controlled at the lowest cost to society. This optimal point, in the case of pollution abatement, is at the intersection of the marginal social benefit (MSB) of abating one additional ton of pollution and the marginal abatement cost (MAC), aka the lowest cost to society. If you’ve taken a basic microeconomics class, this point is much like the point where profit is maximized. In this case, however, it is the point where the benefit to society is maximized at the lowest possible cost.
As the graph shows, optimality is reached at P* and Q*, respectively. P* is, in a sense, the “price” of a pollutant (in this case, carbon). It is akin to a tax per ton or the price of a single permit in an emissions trading scheme.
Trading or a Carbon Tax? Doesn’t Really Matter!
The illustration above should indicate that there is no difference, economically, between a carbon tax and an emissions trading system, assuming that the marginal benefit to society from abating carbon, which can be derived from the total damage caused by carbon emissions. However, for many reasons, this is not so simple, but that’s for another diary and another day.
But if our regulators can do this even reasonably well, we can choose taxes or trading, or even a combination of the two. In the case of a tax, pollution is limited by a flat tax per unit, while an emissions trading system (cap and trade) places a quota on emissions.
Why is Regulating Carbon So Important for a Clean Energy Economy?
Putting a cost on carbon is critical for a clean energy economy. That’s because nations/firms/people that are subject to a cap will look for cost-effective ways to reduce their carbon footprint. In general, the aggregate marginal abatement curve (MAC) represents the lowest abatement cost per ton for industry. Therefore, the blue shaded area under the permit price represents theoretically cost-effective investments that carbon emitters will theoretically undertake prior to purchasing carbon permits. On the other hand, the red shaded area represents cost-inefficient investments with abatement costs above the permit price.
The Beauty of Optimal Regulatory Systems
The beauty of an optimal regulatory system for carbon emissions is that it would very likely encourage firms to reduce abatement cost and flatten their MAC curves. This will happen as they adopt abatement measures such as wind, solar, energy efficiency, nuclear and other technologies. As a result, society would be able to abate more carbon dioxide at the same price!
It’s also why your electric bill probably won’t go up much over the long run – it’s more likely that abatement technology in a carbon-constrained world will become cheaper as firms engage in innovation in order to respond to the price placed on carbon.
The abatement cost of a given technology is its cost divided by the number of tons of pollutant that can be avoided by using it. The consulting firm McKinsey and Co. came up with a great graphic that shows different “abatement costs” for clean technologies. In general, nuclear power and energy efficiency retrofits tend to have lower abatement costs (efficiency has negative costs, actually), while wind, solar and CCS have higher abatement costs.
So the rub is this: the higher the cost we put on carbon, the better, because the more expensive the technology is, the more likely a polluter will choose to use it given the tradeoff between clean technology and the price of a permit. And the more that we give firms an incentive to adopt clean technology, the cheaper the clean technology will become.
(From Milliman, 1989)
The Moral of the Story: Push For More, But Let's Make Sure We Get A Bill
Therefore, our objective as activists, moving forward, must be to press for a bill that results in the highest carbon price possible. However, as Waxman-Markey showed us, powerful electric utilities like AEP and Exelon will come to our aid with key senators if we allow for a “transition period” that allows utilities and others to move away from fossil fuels. By giving away free allowances, we can get them on our side. We must, given that their support will make this deal possible.
Also, we must be at least open to a deal that gives nuclear a boost, given the right conditions. Making nuclear power more affordable and streamlining the permitting process will help to more rapidly eliminate our dependence on coal for baseload electric power. We should also be open to some offsets (internation and domestic), given that they can provide for extremely low cost abatement, assuming good monitoring and verification.
Nevertheless, we should push as hard as we can to get the highest price for carbon that we can. Unlike health care, an emissions trading system is far more modular and easier to change (read: make tougher) over time.
Conclusion
I hope you all have learned a little bit more about how carbon regulation works, and I also hope that we all can become the new force behind the climate bill, which will create millions of jobs and save the planet, too.