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Cap-and-trade: a sufficient or necessary condition for emission reduction?

Michael Hanemann*

Abstract Influenced by the success of emission trading in the US for sulphur

dioxide (SO2), some economists have argued for an upstream, economy-wide cap-and-trade scheme as the primary tool for achieving the required reduction in greenhouse gas(GHG) emissions. This paper addresses that argument and concludes that cap-and-tradewill need to be accompanied by complementary regulatory measures. While it is anecessary component in a climate mitigation programme, it is unlikely to be sufficient byitself to accomplish the desired emission reductions. The paper reviews the evidence onhow SO2 emissions were reduced and the extent to which actual emission trading wasresponsible for the reduction as opposed to other innovations. It also identifiesdifferences between the past regulation of SO2 and other air pollutants and the challengespresented by the regulation of GHG emissions. What actually happened in the US withSO2 emission trading deviated in several significant respects from what would be

predicted based on the conventional theoretical analysis. While there was a dramaticreduction in SO2 emissions, it occurred because of several factors, some of which areunlikely to apply for GHG emissions, and others of which argue for an activist regulatorypolicy by the government as a complement to the functioning of an emissions market forGHGs.

Keywords: wordsJEL classification: numbers

* University of California, Berkeley, e-mail: [email protected] am extremely grateful to Cameron Hepburn and Giles Atkinson for very helpfulcomments.

I. Introduction

The success of allowance trading for sulphur dioxide (SO2) in the US under the 1990Amendments to the Clean Air Act (CAA) has been widely seen as creating a newparadigm for government regulation of the environment.

1Instead of the heavily

prescriptive command-and-control regulation that marked the first two decades ofpollution control regulation in the US, the new approach emphasizes the role of pricesignals as incentives for changing polluter behaviour. One way to create such incentivesis through emissions taxes, such as the SO2 and carbon taxes introduced in theScandinavian countries and elsewhere. In the US context, however, the introduction ofnew taxes is seen as politically infeasible. Hence, cap-and-trade (emission trading) has

1 As will become evident, this paper deals with domestic rather than international climate mitigation policy,and its focus is the US and, to a lesser extent, the EU, but notdeveloping countries.

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emerged as the preferred approach in the US.2 Compared to the prior regulatoryapproach, this involves a more minimalist role for the government. The government setsemission caps for individual polluters, distributes emission allowances according to thosecaps, creates a mechanism to monitor the emissions, and establishes a procedure wherebypolluters turn in allowances to cover their emissions. Having thus established the

parameters of a market, the government then sits back and allows events to proceed ontheir own. Polluters reduce their emissions or buy allowances. Private intermediariescome along. A market evolves. Emissions are reduced.

This is what happened in the US with SO2. Under Title IV of the 1990 Amendments tothe Clean Air Act (CAAA), emission trading was instituted in two phases. Phase I,lasting from 1995 to 1999, covered the largest and dirtiest generating units. Starting in2000, Phase II extended the coverage to virtually all fossil-fuel power plants in the US.The total SO2 emissions from the generating units covered by Phase I had been 9.4m tonsin 1980 and 8.7m tons in 1990. In Phase I these units SO2 emissions were capped at5.5m tons; by 1999, their actual emissions were 3.5m tons, a reduction of almost 60 per

cent compared to their 1990 emissions. With Phase II, the total SO2 emissions from theunits covered in that phase had been 17.3m tons in 1980 and 15.7m tons in 1990. Theseunits emissions were capped at a declining rate, starting at 10m tons in 2000 anddeclining to 8.95m tons in 2010, remaining fixed at that level thereafter. In 2008, theseunits emissions were capped at 9.5m tons, but their actual emissions were 7.6m tons, areduction of almost 52 per cent compared to their 1990 emissions.

The empirical success with SO2 reduction was not unexpected by economists. Theeconomic explanation dates back to Crocker (1966), Dales (1968), and Montgomery(1972). Several theoretical propositions about emission trading have been demonstrated.A cap-and-trade system achieves the set reduction in aggregate emissions at a minimumtotal cost. The economy-wide equilibrium is independent of the initial allocation ofallowances. The outcome of emissions trading is identical to the outcome with anemissions tax when the tax rate is set equal to the clearing price in the emissionsmarketequilibrium prices are the same economy-wide. Because the economy-wideequilibrium prices are independent of the initial allocation of emission permits amongindividual producers, the point of regulation makes no difference. Whether there is anupstream cap (e.g. the point of regulation is the point of entry of fossil fuels into theeconomy) or a downstream cap (the point of regulation is the end user of the fossil fuels,or the end user of energy derived from fossil fuels), the ultimate economic outcome is thesame.

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In this theoretical analysis, market prices are the drivers of behavioural change. When aprice is placed on a pollutant through a cap-and-trade system (or a tax), the prices of

2 As Convery (2009) points out, the European Unions Emissions Trading Scheme for CO2 (EU ETS),introduced in 2005, arose as the result of the European Commissions failure to introduce an effective EU-wide carbon tax.3 The equivalence result assumes that there are no deviations from perfect competition along the supplychain. It would not necessarily hold if, for example, the railroads which deliver low-sulphur coal havemarket power or the rates charged by pipeline companies are regulated.

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polluting commodities rise, reducing the demand for those commodities and raising thedemand for non-polluting substitutes. In turn, this lowers input demands by producers ofthe polluting commodities, reducing those prices and passing the cost burden backwardalong the supply chain. At the same time, there is increased demand for inputs that reducethe generation of emissions. The price changes radiate throughout the economy, inducing

a suite of price-driven demand and supply responses in sectors both upstream anddownstream of the sectors that are capped. Once the government establishes theparameters of the market, price signals take over and do their work.

Thus, both economic theory and the empirical experience of emission trading for SOallowances appear to support the concept of a minimalist role for the government in theregulation of pollution. However, in this paper I argue that what actually happened in theUS with SO2 emission trading deviated in several significant respects from what wouldbe predicted based on the theoretical analysis outlined above. While there was a dramaticreduction in SO2 emissions, it occurred because of several factors some of which areunlikely to apply for greenhouse gas (GHG) emissions, and others of which argue for an

activist regulatory policy by the government as a complement to the functioning of anemissions market for GHGs. Thus, emission trading is a necessary but not a sufficientcondition for an effective climate policy.

The remainder of the paper is organized as follows. Section II reviews the evidence onhow SO2 emissions were reduced from 1995 onwards and the extent to which actualemission trading was responsible for the reduction as opposed to other innovations. Iargue that other innovations played a major role, and these were due largely to the factthat the 1990 CAAA functioned as a performance standard rather than the technologystandard previously existing under the Clean Air Act. Section III examines the tradingthat did occur under Title IV and notes the occurrence of significant over-compliance andbanking of emission reduction, non-arms length transactions, and non-participation inthe permit market. In light of this empirical evidence, section IV discusses the possibilitythat some firms behaviour in reducing emissions may have been influenced not just bythe price of permits in the SO2 market but also by the cap set on their individualemissions. Section V examines the differences between the past regulation of SO2 andother air pollutants and the challenges presented by the regulation of GHG emissions.Given these differences, section VI examines the evidence regarding whether emissiontrading will be effective in promoting the degree of technological innovation that will berequired for GHG abatement. Section VII makes the case for governments to go beyondemission trading and become more engaged with GHG abatement by adopting variouscomplementary policy measures. Section VIII offers some brief conclusions.

II. How SO2 emissions were reduced

The experience with SO2 trading has played a crucial role in the US debate on climatechange policy, both in individual states and at the national level. It is regularly cited byproponents of emission trading as an important reason for applying this to GHGs.4 It is

4 For example, Stavins (2007, 2008).

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fell continuously throughout this period from (in 2000$) 9.7 cents per kWh in 1982 to8.05 cents in 1990, 7.66 cents in 1994, and 6.81 cents in 2000.

5Thus, although SO2

abatement may have raised the cost of electricity production by about 0.6 per cent in2000 compared to pre-Phase I, the retail price of electricity fell by more than 10 per centbetween 1994 and 2000.There also was no obvious reduction in the production of

electricitynet generation grew from 3,247 billion kWh in 1994 to 3,802 billion kWh in2000 (an increase of 17 per cent).

It also appears that the cap on SO2 emissions had virtually no effect in promoting eitherenergy conservation or the use of renewable sources of electricity. Net generation fromrenewables rose by only about 6 per cent from 337 billion kWh in 1994 to 357 billionkWh in 2000. One provision of Title IV created the Conservation and Renewable EnergyReserve, under which bonus allowances worth 300,000 tons of SO2 were set aside to beallocated to utilities for energy efficiency and renewable energy development. However,little use was made of these allowances; as of February 2002, only about 49,000 of theseallowances had been awarded (Vine, 2003).

Thus, the reduction in SO2 emissions was only partly the result of price changes radiatingfrom the electricity sector because the cap on emissions had raised the cost of producingelectricity. Induced innovation within the electricity sector itself and its immediatesuppliers played a more important role, whether in the form of market evolutionassociated with increased competition, or operational innovations by coal producers,railroads, boiler operators, and scrubber manufacturers and operators. Electricitygenerators and their suppliers were motivated to find new ways of responding to theimplicit price placed on SO2 emissions.

This should not be seen as implying that the introduction of emission trading for SO2 wasunimportant or of little economic benefit. Even setting aside the substantial reduction inSO2 emissions mandated, the manner in which the emission reduction was regulated wasa significant improvement compared to the prior regulatory regime established under the1970 Clean Air Act and the 1977 CAA Amendments.6

Instead of mandating a particular abatement technology, Title IV established aperformance standardfor SO2. The emissions limit established under Phase II of the SO2trading programme was the same as the prior NSPS limit, but the allowance trading wasvastly more flexible. Installation of a scrubber was no longer required. A power plantoperator became free to use low-sulphur coal, vary the dispatch order, substituteemissions among facilities, and/or purchase emission allowances in order to comply withthe emissions limit. The reduction in the costs of a scrubber has already been noted. One

5 There was a spike in electricity prices in 2001, but they then fell back to the range 6.916.99 in 20024.6 Under the prior regime, power plants in existence when the regulations implementing the 1970 CAAbecame effective in 1971 had to meet emission rate limits imposed by State Implementation Plans (SIPs),which the individual states were required to develop to ensure compliance with National Ambient AirQuality Standards (NAAQS) for six criteria air pollutants, including SO2. New power plants constructedafter that date were regulated more stringently. They were required to meet the New Source PerformanceStandard (NSPS) which, after 1977, required the installation of a scrubber in new power plants, ruling outany reliance on low-sulphur coal alone.

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factor that may have contributed is the flexibility provided by Title IV with regard toredundant scrubber capacity (Burtraw, 1996). Before the 1990 CAAA, scrubber systemsusually included a spare module to maintain low emission rates when any one modulebecame inoperative. The alternatives afforded by Title IV lessened the need to install aspare module, thereby reducing the capital cost of a new scrubber.

A performance standard is inherently superior to a technology standard because it affordsfirms the flexibility to attain their emission limit in whatever is the most cost-effectivemanner for them. The existing discussion of the SO2 trading programme has focusedlargely on differences in the marginal cost of SO2 abatement among different electricitygenerating units, and the resulting cost savings if emission reduction can be shiftedamong plants. This is how the gains from emission trading have been modelled in thetheoretical literature: emission trading is efficient because it reallocates abatement fromplants with high to low marginal costs. This is essentially a static analysis. The marginalabatement cost curves are assumed to be fixed over time, and the focus is on annualemissions, the marginal cost of annual abatement, and the cost-minimizing re-allocation

of annual abatement. In effect, this is a long-run analysis of where abatement shouldoptimally occur.

But, there are several other ways in which costs could be lowered because of theflexibility afforded by emission trading. One flexibility is the ability to reallocateemission reductions over time, which is enhanced by the fact the unused SO2 emissionallowances are bankable. This gives companies the ability to control the timing ofinvestments in new lumpy capital in the most opportune manner. If interest rates are low,for example, a company can install new abatement equipment before it is fully needed,and either bank or sell the excess emission reduction; or, a company can postponeabatement investments until more favourable financial circumstances arise, buyingemission allowances in the interim.

There are also gains associated withshort-run, cost-minimizing operatingflexibility asopposed to the long-run, cost-minimizing reallocation of emission reduction. One form ofoperating flexibility is the ability to respond to short-run fluctuations in operatingconditions on, say, a weekly, daily, or hourly time scale by reallocating abatement amongdifferent plants, either internally within a firm that operates multiple plants or externallyvia the emissions market.

A related source of operating flexibility concerns the firms ex ante uncertainty regardingwhat its emissions will be during the relevant regulatory period. A power plant operatorcannot know what the demand for electricity will be next week, let alone for the rest ofthe year, and he cannot be sure of future prices for fuels of different sulphur content. So,how can he know what his emissions will be during the balance of the regulatory period?However, SO2 and other emissions markets are designed so that emission generation andcompliance are asynchronous: emissions occur during a particular period (the calendaryear, for SO2.) while the emissions permits must be turned overat the endof the period,or shortly thereafter. Thus, emissions permits have a convenience value (Burtraw, 1996)which physical abatement equipment lacks: if there is a shortfall on 31 December, say, it

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is possible to acquire additional permits at the last minute, but it is too late to lower theyears emissions by installing a scrubber.

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Short-run operating flexibility and long-run reallocation of emissions reduction areclearly benefits arising from the existence of emission markets, but they are distinct

phenomena and they serve different purposes. Operating flexibility, while economicallyvaluable, does not necessarily lead to a long-run reallocation in emission reduction. Forexample, changing the dispatch order is a short-run fix to reduce emissions, but withgrowth in power demand it is not necessarily a substitute for the installation of new, low-emission generation capacity in the long run.

Short-run flexibility and long-run reallocation of abatement are likely to lead to differentpatterns of participation in the emissions market. If a firm decides on a long-run strategyof abatement, one would expect to find it consistently selling permits in the market. If afirm decides to rely on buying permits as a strategy because this is cheaper thanabatement, one would expect to find it consistently appearing as a buyer. However, if a

firm varies between buying and selling permits, that could be consistent with use of theemission market for short-run flexibility rather than for long-run reallocation ofabatement. At this point, it is an open question as to how much of the participation in theSO2 emission market was motivated by long-run versus short-run considerations.Nevertheless, the fact, noted above, that 85 per cent of the reduction in SO2 emissionsbetween 1994 and 2002 was associated with a reduction of emissions at individualgenerating units rather than with switching generation from high-emitting to low-emittingunits suggests a somewhat limited role for long-run reallocation of abatement via the SO2emissions market.

III. The nature of SO2

trading

In Hanemann (2009), I review the literature on the functioning of the SO 2 allowancemarket. Three distinctive features stand out. The first feature is over-compliance inemission reduction and the banking of allowances. In Phase I, 30 per cent of allallowances distributed during 19959 were banked; equivalently, the reduction inemissions was about twice what was required to meet the Phase I cap (Ellerman andMontero, 2007). Between 2000 and 2005 the bank was drawn downalbeit at a fairlymodest rateto cover emissions in excess of the annual allotment of new allowances. In2007 and 2008, there was again some over-compliance in emission reduction, and theallowance bank started to grow. In an analysis of banking between 1995 and 2002,Ellerman and Montero (2007) concluded that, contrary to the general impression ofexcessive banking, the amount of banking that occurred during this period was actuallyquite efficient based on economic fundamentals. At the time, Ellerman and Monteroprojected that an efficient bank would decline to about 3m tons in 2008. This is about

7 In addition, the purchase of permits is reversible (the permits can be resold), while the installation of ascrubber is irreversible; the difference in reversibility gives rise to an option value for permits (Chao andWilson, 1993).

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half the amount actually banked in 2008.8 It would seem that one cannot rule out thepossibility of over-compliance in emission reduction beyond that called for by pureeconomic efficiency.

The second feature is a significant degree of what Kreutzer (2006) calls autarky. This is

when firms do not comply with their cap by purchasing allowances in arms-lengthtransactions; they either reduce emissions to stay within the cap or, if there are excessemissions, they draw on their own past banked allowances or on allowances availablefrom other units that they control. One measure of this is the extent to which, when firmssubmit allowances to the Environmental Protection Agency (EPA) to cover theiremissions, these are allowances that had originally been allocated to them, rather thanallowances obtained from someone else. Kreutzer (2006) finds that, between 1997 and1999, about 70 per cent of the allowances retired each year were redeemed by the sameunit to which they had originally been allocated, and only about 30 per cent wereoriginally allocated to another unit.

9Between 2000 and 2003, the proportion of

allowances redeemed by the same unit to which they had originally been allocated was

lower, about 60 per cent, but still substantial.

Third, even when allowances are transferred, this may not be an arms-length transactionsince the same corporation may own multiple plants with multiple boilers, each with itsown allocation of allowances. In its annual summary of allowance transaction data, theEPA distinguishes between what it calls economically significant transactions (i.e.between economically unrelated parties), and transactions between related entities.10 In2007, for example, the EPA deducted 8.9m allowances from sources accounts to covertheir emissions that year. In addition, nearly 4,700 private allowance transfers movingroughly 16.9m allowances of past, current and future vintages were recorded in the EPAallowance Tracking System. About 9.1m (54 per cent) were transferred in economicallysignificant transactions. The other 46 per cent were transfers between related entities.The large proportion of transfers between related parties has been a constant feature ofthe SO2 allowance market.

Finally, while there clearly were significant cost savings from allowance tradingcompared to what would have happened under a command-and-control approach, theevidence suggests that the allowance market was not perfectly efficient and that not allgains from trade were successfully exploited. Carlson et al. (2000) find that, in the firstyears of Phase I, there were some differences in marginal abatement costs amongfacilities, and absolute compliance costs could have been reduced further with additionaltrades. Ellerman et al. (2000) reach a similar conclusion. In addition, plant-level studiesof production and abatement efficiency by Coggins and Swinton (1996) and Swinton

8 Their analysis was conducted prior to the proposed tightening of emission limits under the Clean AirInterstate Rule in 2005, which strongly affected spot prices and could also have affected banking. The rulewas set aside in July 2008. Risk aversion, not included in their analysis, may also be a factor.9 In a personal communication with EPA staff, I have been told that, until 2006, account IDs representedindividual boilers. Therefore, the same unit here means the same boiler.10 The EPA comments that transfers between economically unrelated parties are arms lengthtransactions and are considered a better indicator of an active, functioning market than transactions amongthe various facility and general accounts associated with a given company (US EPA, 2008, p 12).

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(2002, 2004) indicate that some plant owners did not take full advantage of the allowancemarket; they controlled emissions when it would have been cheaper to purchaseallowances.

IV. What caused the reduction in SO2 emissions?

The standard theoretical model on which most of the economic analysis of emissionmarkets is based (Montgomery, 1972), is a purely static model. A firm minimizes totalcost, which consists of abatement cost plus the cost of procuring emission permits (orminus the revenue from selling permits). Production and abatement technology are given.There is no effective distinction between capital and operating costs. To the extent thatcapital costs are involved, there is implicitly an instantaneous adjustment of the capitalstock, with no allowance for a time lag associated with the turnover in capital. Whetherthere is a tax or a cap on emissions, firms equate the marginal cost of abatement to the taxor the market price of emission permits. The introduction of a tax or a cap on emissions

causes the firms costs to rise. The price increase is transmitted upstream and downstreamfrom the polluting sector, inducing movements along demand and supply curvesthroughout the economy. It is the price signal that induces a reduction in emissions. Thecap on the individual firms emissions has no economic significanceper seonly theaggregate cap on emissions affects the outcome, because it determines the equilibriumprice in the market for emission permits.

As indicated above, what actually happened with SO2 does not exactly match thesestylized facts. No price signal was transmitted to electricity users downstream. All of theemission reduction occurred as the result of actions taken by the railroads and theelectricity producers themselves. Rather than movements along demand and supplycurves, the main mechanism of adjustment wasshifts in those curves induced by changesin railroad market structure and unexpected operational innovations in electricityproduction. The indication is that these innovations went beyond the ability to trade.

Then, what motivated the innovations? The market price of SO2 emissions permits mayhave had some influence but this can hardly be the entire explanation, given that manyfirms did not resort to the permit market to meet their obligation to the EPA. As notedabove, there was a significant degree of autarky. Many firms kept their emissions withintheir cap and/or relied on unused permits from previous years which they had previouslybanked. In addition, a substantial number of firms relied on internal transfers of permitsrather than arms-length market transactions. Moreover, the evidence of autarkicbehaviour by firms is not limited to the SO2 marketthere is similar evidence from otherpollutant trading schemes. With the US lead trading programme for gasoline, forexample, Kerr and Mare (1998) found a significant amount of non-arms length trading,in the form of internal transfers among different refineries owned by the same company.In their data, 67 per cent of the quantity of lead bought was bought within the samecompany, and 70 per cent of the lead sold was sold within the same company. Two recentstudies of firms confronting the EUs Greenhouse Gas Emission Trading System (EUETS) also provide evidence of some predisposition to autarky. In a survey of the 500

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largest companies worldwide conducted in 2004, 31 per cent of the German firms, 38 percent of the UK firms, and 61 per cent of the French firms expressed no interest in the EUETS, due to begin in January 2005, or stated that they will not participate at all (Pinkse,2008). A survey of Swedish firms in 2006 found that 46 per cent of firms thought theywould handle a potential allowance deficit by reducing emissions internally rather than

purchasing allowances (Sandoff and Schaad, 2009). In a different context, a recentexperimental study of allowance trading by Goeree et al. (2009) finds evidence of apredisposition to autarky when allowances are grandfathered, although not when they areauctioned.

Loss aversion is another possible factor that Kreutzer (2006) suggests might have comeinto play and promoted autarky in the SO2 market. A firm that does not sell allowanceswhen it should do so forgoes a gain; a firm that sells allowances when it should not do so,and then has to buy them back at a higher price, suffers a loss which may receive aheavier weight than a gain of the same magnitude.

If there is a preference for autarky, or more generally a wish not to bother with thecomplexity of the market, then the caps on individual firms emissions would themselvesdrive the reduction in those emissions. The individual caps have, in fact, been identifiedby some commentators as a major reason for the reduction in SO2 emissions.

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The caps could also drive behaviour if managers have a preference for complying withthe law and simply choose to keep emissions within the limit set for them by the EPA.Evidence of a compliance norm has been found in other contexts where firms responsesto regulation have been studied. Braithwaite and colleagues interviewed and observedfirm managers in a variety of industry sectors, including coal mining, nursing homeoperations, and pharmaceutical production.

12In an analysis of those studies, Ayres and

Braithwaite (1992) concluded that, in many cases, managers were motivated by socialresponsibility and sought to comply with the law. Gunningham et al. (2003) foundevidence of a compliance norm in their investigation of pulp and paper mills response toenvironmental regulation in the US, Canada, Australia, and New Zealand. They foundthat management style was a key explanatory variable, and they identified five styleswhich they characterized as laggards, reluctant compliers, committed compliers,environmental strategists, and true believers.

Are there any economic reasons why their individual caps would influence firmsbehaviour? The conventional economic model of emission trading based on costminimization by a polluting firm holds that the firms optimal emissions are independentof its cap (Montgomery, 1972). However, this result follows directly from the assumptionthat the marginal cost of obtaining permits through emission trading is constant; it doesnothold when the marginal cost varies. Thus, if there are transactions costs that dependnonlinearly on the number of emissions permits purchased, the optimal level of emissionswill not be independent of the cap (Stavins, 1995). Nevertheless, transactions costs maynot be a sufficiently significant factor in the SO2 market. There are many brokers and

11 For example, Malloy (2002, p. 549), citing US EPA (2001); also Driesen (1998, p. 318).12 Braithwaite (1984, 1985) and Braithwaite et al. (1990), cited by Malloy (2003, note 91).

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other market intermediaries who are active in that market and, in fact, trading costs areconsidered to be low (Joskow et al., 1998).

If one introduces risk aversion into the conventional model of cost minimization, thiswould cause optimal emissions to depend in part on the firms cap. For example, the cap

influences emissions if there is uncertainty regarding whether a permit transaction will beapproved which varies nonlinearly with the magnitude of the transaction (Montero,1997). There can also be uncertainties about future emissions, about future allowanceprices, and/or about future programme regulations which would make a firms optimalemissions depend on its cap.

The conventional economic model of emission trading represents the firm as a single,unitary decision-maker, with a single objective, namely profit maximization. This hasbeen characterized as the black-box model of the firm (Malloy, 2002). There is analternative view of the firm as an organization with a multiplicity of actors and certaindistinctive internal features. In economics, this view goes back to Coase (1937) and was

importantly developed by Williamson (1975). This view also is the central focus of theorganizational behaviour literature, where it received a powerful stimulus from Cyert andMarch (1963). Viewing the firm as an organization opens up additional explanations forwhy firms might be influenced by the cap set on their emissions.

It has been pointed out by von Malmborg (2008) that the decision to stay within onesemissions cap or resort to purchasing emission permits from the market is isomorphic tothe make or buy decision discussed by Coase (1937) and analysed further byWilliamson (1975, 1981) using a transactions cost approach. In this approach, thequestion of when firms choose to produce a good or service themselves as opposed tobuying it on the market is analysed in terms of three main factors: (i) the degree ofuncertainty/complexity inherent in the transaction, (ii) how frequently the transaction isto be made (the transaction density), and (iii) the cost of transaction-specificinvestments. If a transaction is seen as complex and is marked by uncertainty, whichWilliamson suggests is commonly the case, it is mainly the other two factors thatdetermine how the firm proceeds. Applying Williamsons logic to the circumstances of afirm enrolled in the EU ETS programme, von Malmborg concludes that, if transactiondensity and transaction-specific costs are both seen as low, the firm will choose to buyemission permits; if both are seen as high, the firm will engage in in-house emissionreduction (the hierarchical solution); if transaction density is seen as high whiletransaction-specific costs are low, the firm will resort to a bilateral solution, which in thiscase could be participating in a joint implementation (JI) or clean developmentmechanism (CDM) project; and, if transaction density is seen as low while transaction-specific costs are high, the firm will resort to a third-party solution, which in this casecould be investment in a fund such as the World Bank Prototype Carbon Fund. Forelectric utilities covered by the SO2 trading programme, transaction density is likely to beseen as high. If transaction-specific costs are high, this argues for the hierarchicalsolution of in-house emission reduction. If transaction-specific costs are low, in theabsence of a JI or CDM alternative the best bilateral solution might be emission reductionin another facility owned by the same company (trade with a related entity). Thus

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Williamsons logic could provide an explanation for the observed prevalence of autarkicbehaviour in the SO2 market.

The behavioural view of the firm as a system for allocating and coordinatingorganizational resources, such as capital, personnel, and information, can also lead to the

conclusion that the emissions cap may be more influential on firm decision-making thanthe market price of emission permits. Within the firm, there are multiple actors and, quitepossibly, multiple objectives. In a typical manufacturing establishment, there is amanager responsible for the purchase of energy services, a manager responsible forproduct design, and perhaps a manager in charge of product pricing, as well as the CEO.These people have different responsibilities, they face different incentives, andconsequently they may not all respond to a given price signal in an identical manner. Theconsequence is that the firm as an entity may fail to exploit some of the profitableopportunities that are available to it.13

By contrast, a downstream cap on GHG emissions could have more impact on the firms

decision-making. Compare an upstream cap versus a downstream cap on, say, theemissions associated with new model vehicles manufactured by Ford for sale inCalifornia.14 The upstream cap raises the price of gasoline, which affects both Ford as aconsumer of fuel, and also Fords customers. The downstream cap affects Ford moredirectly, because it limits what new model vehicles Ford can sell. It is not necessarily thecase that the same decision-makers within Ford are mobilized to deal with theconsequences of the two emissions caps, or that the same corporate response emerges.Because the downstream cap is more direct and visible, it makes abatement more salientfor senior managers and is likely to attract their attention more strongly than the pricesignal triggered by an upstream cap.15 With senior management more engaged, thedownstream cap can have a larger, and more rapid, impact on what cars Ford designs andon how it prices them than the upstream cap.

Malloy (2002, 2003) has argued that the behavioural view of the firm has importantimplications for the design of environmental regulatory policies, and casts doubt on someof the conventional arguments for market-based price incentives. Theoretical studies ofhow firms respond to regulatory incentives, he writes, typically fail to consider the roleof attention. Instead, they assume at the outset that all stimuli are created equal in terms

13 There is robust empirical evidence in the organization learning literature and business strategy literatureof such failures. It has also been documented in the pollution context by a number of researchers, includingDeCanio (1998), King and Lenox (2002), Saele et al. (2005), and Muthulingam et al. (2009).14 This is how the Pavley Bill (AB 1493) functions. Enacted by California in 2002 and implemented by the

Air Resources Board in 2004, it requires a 30 per cent reduction by 2016 in the overall emissions of GHGsof the fleet of new vehicles sold by each manufacturer in California. Implementation required a waiver ofthe CAA by the US EPA which was withheld under President Bush. The waiver was granted in June 2009.In September 2009, the US EPA and Department of Transportation announced a new national standard forGHG emissions from light- and medium-duty vehicles very similar to Californias standard.15 Gillingham (2009) has also suggested that, because of considerations of salience, a downstream cap mayinduce a larger behavioural response from firms than an upstream cap or a carbon tax. However, hisargument is slightly different: he suggests that the signal from the price of carbon in an emissions marketwith downstream caps may be more salient for firms than the signal from an increase in the price of energyresulting from an upstream cap or a tax. He attributes no influence to the cap on the firms emissions itself.

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of their ability to garner firm attention. However, he argues that the capacity of anyorganization to process information and to detect and respond to stimuli is necessarilylimited: attention itself is a scarce resource that is directed and allocated.16 In a casestudy of the regulation of toxic emissions from dry-cleaning firms in Southern California,Malloy and Sinsheimer (2004) present evidence that many of these firms appear

relatively insensitive to modest but non-trivial opportunities for increasing profit byadopting less costly and less polluting production technologies. The reason, they suggest,is that the novel technology loses out to the conventional technology in the competitionfor firm resources and managerial attention. Consequently, they argue that directregulatory intervention can be more effective than incentive-based approaches.

In summary, there are both economic and behavioural reasons why an emissions capcould turn out to be a more visible and salient trigger of change in a firms emissions thana price increase alone.

V. SO2 versus CO2

The obvious question is: could not emission trading work just as well for GHGs as it didfor SO2? At first glance, GHGs seem a better candidate for emission trading than SO2because there are no hot spots for GHGs: the environmental consequences of theiremission in terms of climate change depend just on the aggregate volume of emissions,regardless of the location where the emissions occur.17 However, there are several otherdifferences between SO2 and GHGs which make cap and trade unlikely to be as effectiveat accomplishing a large emission reduction for GHGs as it was for SO2. In this sectionwe enumerate the differences. The implications for emission trading are discussed in thefollowing two sections.

First, the emission of GHGs, especially CO2, is more widely diffused throughout theeconomy than for SO2. About 70 per cent of SO2 emissions in the US in 1995 came fromthe burning of fossil fuel in electricity generation, but only 34 per cent of the GHGemissions in the US today come from electricity generation.18 Nearly as many GHGemissions (28 per cent) come from transportation.

19The reduction of SO2 emissions

engaged a relatively small number of decision-makersjust a few hundred powercompanies accounted for the vast majority of SO2 emissions. However, narrowing the

16 Malloy (2002, p. 556). Saele et al. (2005) also identify lack of managerial attention as one of the factorspreventing organizations from implementing profitable energy-saving measures.17

The impact depends on the composition of GHGs emitted (with methane, for example, being more potentin the short run than CO2), but not the location. The consensus in the literature is that hot spots do not so farappear to have been a major problem with SO2 allowance trading (Swift, 2000; Burtraw et al, 2005).18 Electricitys share of CO2 emissions alone is 39 per cent (US EPA, 2009). CO2 accounts for about 85 percent of the 7.15 billion metric tons of CO2-equivalent GHG emissions in the United States in 2007; butmethane, nitrous oxides, and other gases also contributed. About 94 per cent of the CO2 comes from thecombustion of fossil fuels, with the rest from changes in land use (deforestation, etc.). The methane comesmainly from landfills and cows.19 In California, by contrast, electricity (including electricity imported from out of state) accounts for 22 percent of the CO2 emissions, and transportation accounts for 40 per cent of the emissions.

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focus of CO2 reduction to the electricity generation sector alone would leave the majorityof US emissions untouchedhardly a satisfactory outcome. To accomplish a moreextensive reduction in CO2 emissions requires somehow engaging with emissions fromother sectors, including transportation and buildings, and also forestry and agriculture.20

Second, unlike SO2, we cannot rely on existing technologies to achieve the requisitereduction in CO2 emissions. A 50 per cent reduction in SO2 emissions was accomplishedvirtually overnight without any major technological breakthrough. The emissionreduction was accomplished through technologies with which power plants operators hadlong been familiar. By 1995, scrubbers were a mature technology. Burning low-sulphurcoal in boilers designed for high-sulphur coal was a challenge for boiler operators andconstituted a significant operational advance, but it was hardly a major technologybreakthrough. By contrast, it will be necessary to develop new technologies to achievethe needed reduction in CO2 emissions from burning coal to generate electricity. There isno low- CO2 coal, and there is no end-of-pipe device, like a scrubber, that can beretrofitted in an existing coal-fired power plant. Carbon capture and storage (CCS) has

not yet been practised at the scale of a commercial coal-fired generating plant. A handfulof small-scale CCS pilot projects and demonstration projects are under way in the US andelsewhere. If all goes well, it is expected that a commercial version of this technologymay become available by 2020.21 Construction of new plants would then take severalyears.

However, for existing coal-fired power plants it is believed that retrofitting CCS wouldnotbe economically feasible because it would cost virtually as much as building a brandnew plant (MIT, 2007).

Working with existing power plants, one can reduce CO2 emissions by changing thedispatch order.22 CO

2can also be reduced by co-firing coal with biomass which, since it

is renewable, has effectively zero carbon intensity. Until recently it was thought thiscould be done on a very limited scale (under 5 per cent of biomass). It is now believedthis can be done with up to 15 per cent of biomass.23 This may improve further withexperience, as happened with the use of low-sulphur coal. But still, it seems unlikely thatco-firing with biomass will be as much of a boon as low-sulphur coal was for SO2reduction. Consequently, unlike with SO2, the only way significantly to reduce CO2emissions from existingcoal-fired plants appears to be to operate them less.

As noted earlier, renewable energy generation played no role in the reduction of SO 2emissions. With CO2, by contrast, there is a significant potential for non-fossil fuelelectricity generation based on nuclear power and renewables, but it will take some timeto realize this potential.

20 The discussion below addresses transportation and buildings, but not forestry or agriculture.21Wall Street Journal, The Long Road: Carbon Capture and Storage, 22 February 2010.22 Electricity from natural gas has about half the CO2 emissions of coal, and electricity from oil is abouthalf way between natural gas and coal.23 I owe this observation to Dallas Burtraw.

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Nuclear power plants based on existing designs are extremely expensive and take a verylong time to construct, especially in the US. The capital cost is the most important factordetermining the competitiveness of nuclear energy. The smallest nuclear power plant thatcan be built is typically larger than other power plants, making the nuclear option a muchlarger commitment of funds. With the increase in commodity prices around 2008, the

construction cost of all power plants has greatly increased, but the increase has beendramatically larger for nuclear than for coal-fired plants. MIT (2003) had estimated theconstruction costs for nuclear power, excluding interest (i.e. the overnight cost), at$2,000/kW in 2002 dollars. Du and Parsons (2009) subsequently updated this estimate to$4,000/kW in 2007 dollars; other estimates are even higher.24 Moreover, the recentliberalization of the electricity markets in the US and some other countries means that therisks of construction delays and cost overruns, and the risk of cheaper power becomingavailable from other sources, are now borne by plant suppliers and operators rather thanconsumers. This has made the economics of nuclear power less attractive for utilities.Efforts are under way to develop less costly new designs for nuclear power plants usingmultiple smaller reactors, but these technologies could take about a decade to be

approved and put into operation.

In the past decade there have been significant improvements in the technologies forgenerating electricity from wind and solar power. The cost of wind energy at a good siteis now close to being competitive with the cost of electricity from coal and natural gas.Solar thermal power (concentrated solar power) is still more expensive than coal ornatural gas, but is coming within range.25 However, wind and solar thermal face twodifficulties in competing with coal and natural gasintermittency and location. Wind andsolar thermal generate electricity only when the wind blows and the sun shines; both needsome form of storage to be fully effective. While it is an active area for research, thestorage problem does not yet have a definitive solution. Furthermore, many good windand solar thermal sites are located a great distance from where electric power isconsumed, and therefore need transmission in order to be effective. Construction of theneeded transmission will take time and will be expensive.

26While wind and solar thermal

hold promise for the future, their market shares are still very small. In the EU27, windaccounts for 5.5 per cent of electricity consumed, and all solar (photovoltaic plusthermal) accounts for 0.8 per cent. In the US, wind accounts for 1.9 per cent of electricityconsumed, and solar accounts for less than 0.1 per cent. All forms of renewableelectricity, including hydropower, geothermal, and biomass, as well as wind and solar,account for about 9 per cent of the electricity consumed in EU27, and 10.4 per cent in theUS. The EU has adopted the target of a 20 per cent share for renewable energy by 2020,and there has been some discussion of a similar target for the US. Even with 20 per cent

24 By contrast, Du and Parsons (2009) estimate the construction cost of a coal-fired plant at $2,300/kW in2007 dollars.25 For example, Heal (2009), gives the cost of electricity from coal and natural gas as between 6 and 7cents/kWh; that of wind (leaving aside transmission cost and intermittency) as between 6 and 10cents/kWh; and that of solar thermal as about 12 cents/kWh.26 A US Department of Energy (DOE) report estimates that wind could contribute 20 per cent of US energyby 2030; for this to occur it would be necessary to construct over 12,000 miles of new transmission lines ata cost of approximately $20 billion (US DOE, 2008).

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of electricity generated from renewables in the US and Europe, this would still leave thelarge majority of GHG emissions from electricity generation untouched.

The above discussion highlights a third point of difference between SO2 and CO2theneed for replacement of capital stocks in order to accomplish the reduction in CO2

emissions. With SO2, emission reduction was accomplished for the most part withexisting capital assets: it was possible to retrofit existing power plants with scrubbersand/or to modify the combustion for low-sulphur coal. There was not a wholesaleretirement of capital assets well before the end of their useful lives. By contrast, beforethere can be a major reduction in CO2 emissions from electricity generation, existingpower plants will have to be replaced by nuclear energy or renewable energy or by newcoal-fired plants using state-of-the-art technologies, such as supercritical combustion orintegrated gasification combined-cycle, and designed from the beginning to incorporateCCS.27 Similarly with transportation, the other major source of emissions, existingvehicle fleets will have to be replaced before there can be a major reduction in CO2emissions from transportation. The problem is that today we have the wrong types of

power plants, the wrong types of motor vehicles (gas guzzlers rather than highly fuel-efficient smaller vehicles), and the wrong types of urban development, with urban sprawland limited public transit. It is unlikely that the reduction in GHG emissions required bymid-century can be accomplished with existing capital stocks left mostly unscathed.

The fourth difference concerns the role of energy conservation and energy efficiency. Asnoted earlier, conservation by energy users played no role in the reduction of SO 2emissions. By contrast, conservation by end users and energy efficiency will have acentral role in the reduction of CO2 emissions, especially in the near term while we waitfor new technologies to be developed and deployed. It will be necessary to promote adegree of behavioural change among energy users throughout a broad swathe of theeconomy, a far more daunting challenge than was faced when dealing with SO

2emission

reduction.

Given the differences between what occurred when SO2 emissions were reduced andwhat will be required in order for CO2 emissions to be reduced, the question ariseswhether emission trading will be as effective with CO2 as it was for SO2. As explainedbelow, there are some reasons to doubt this.

VI. Emission trading and technological innovation

Since many of the technologies required for GHG reduction are still in their infancy,there is general consensus on the need for some form of research and development(R&D) policy to promote long-term technological change. Because information is apublic good, there is an impaired ability to appropriate all the rents from an innovation,

27 The situation is different in developing countries. In China, for example, it is estimated that over two-thirds of the electricity generating capacity in place by 2020 will have been built after 2005. But in theOECD, it is estimated that almost two-thirds of todays generating capacity will still be in operation in2030 (International Energy Agency, 2003).

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and this weakens private incentives to invest in R&D. Hence most economists agree onthe need to address this market failure through some government-sponsored climate-oriented R&D policy as a complement to a carbon tax or an emission trading system.

Schumpeter famously identified three stages in the process of technological change:

invention, innovation, and diffusion. Invention is the first development of a scientificallyor technically new product or process, which may involve both basic and appliedresearch. Innovation is accomplished when the new product or process iscommercialized, i.e. made available on the market. Diffusion is when the product orprocess comes to be widely used through adoption by many firms or individuals. In thecase of climate change, invention and innovation are the core issuesthe developmentand commercialization of technologies that do not exist yet or, at best, are stillexperimental (e.g. CCS).

In the pollution control literature there is some limited empirical evidence that morestringent environmental policies lead to invention, as reflected in increased patent

activity. Lanjouw and Mody (1996) found a positive correlation between the stringencyof environmental policy, measured in terms of pollution abatement expenditures, and thenumber of environmental patents granted in the US, Japan, and Germany. Using USmanufacturing data, Brunnermeier and Cohen (2003) also found a positive relationbetween pollution abatement expenditures and counts of environment-related patents. Ina more extensive international comparison, De Vries and Withagen (2005) analysedpatent counts relating to SO2 abatement in the US and 13 European countries over theperiod 19702000 and found some evidence that strict environmental policies lead tomore inventions.

A less settled question is how the choice of policy instrument influences the rate ofinvention. It is sometimes asserted that, by rewarding emission reductions however theyare accomplished, a carbon tax or an emission trading system would also provide broadincentives for inventions that lower the cost of emission reduction.

28

The actual experience of the promotion of technological change under emission tradingfor SO2 is more ambiguous. While scrubber operating efficiency increased and scrubbersbecame cheaper, there does not appear to have been any fundamental change in scrubbertechnology. The data on patent counts relating to post-combustion SO2 controltechnology actually show a decline in the number of new patents starting around 1990,and steepening after 2001.

29Moreover, there was no obvious boost to other low-emission

technologies for coal combustion, such as integrated gasification combined cycle (IGCC)which results in lower emissions of SO2, particulates, and mercury as well as improved

28 For example, Stavins (2007, p. 32).29 By 2004, the annual number of new patents was less than half the annual average for the period 19751989 (Taylor, 2008). Popp (2003) shows that there is a correlation between the increase in scrubberoperating efficiency after 1990 and the cumulative stock of new patents issued after 1990. But it is not clearwhether the specific focus of post-1990 patents related to operating efficiency, nor is it necessarily the casethat the relationship found by Popp is a causal one. His explanatory variable, the cumulative stock of newpatents, may function as similar to a time trend, in which case his regression shows merely that scrubberoperating efficiency rose over time during the 1990s.

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combustion efficiency compared to conventional pulverized coal.30 Developments suchas the burning of low-sulphur coal in boilers designed for high-sulphur coal and theincreased operating efficiency of scrubbers were primarily refinements in operatingpractices rather than fundamentally new technologies.31 As noted above, the increaseduse of low-sulphur coal and the improvement in scrubber operating efficiency can have

been due to the fact that the cap functioned as a performance standard rather than to theprice signal created by emission trading.

Thus, emission trading for SO2 (and also lead) promoted the adoption of technologies thatwere already available; in Schumpeters terminology, while there was diffusion, therewas no invention and no innovation.

With NOx, Popp (2006) examines patents over the period 19702000 and shows that, inthe US, the rate of patents for Nox-control technologies reached a peak in 1990.However, this is evidence of the impact of regulatory stringency on invention, rather thanof emission tradingper se. The 1990 Clean Air Act was the beginning of binding

regulation for existing stationary sources of NOx. The act significantly tightened limitsfor NOx emissions from power plants and, unlike the previous legislation in 1970 and1974, applied those limits to existing as well as new power plants. But, emission tradingfor NOx came later. In addition to acid rain, ozone was a second focus of concern withNOx in the CAAA. Seeing the need for a regional strategy for the Northeast Corridor toachieve compliance with the ozone standard, the CAAA created the Ozone TransportCommission (OTC). In 1994, the states belonging to the OTC recognized that emissionrate standards alone would not be sufficient for ozone compliance and agreed toimplement a summertime trading programme for large sources of NOx, including bothpower plants and certain industrial facilities. The trading programme commencedoperation in 1999. There was a small increase in the rate of patents for NOx control in1994 (for NOx post-combustion patents) and 1997 (for NOx combustion modificationpatents), but in each case this was followed by a subsequent decline.

Two papers have recently analysed inventions relating to climate change mitigationtechnologies. Glachant et al. (2009) employ a global patent data set covering 13 classesof technologies with significant potential for GHG emission reduction over the period19782003. Between 1978 and 1997, patents relating to climate change grew at the samepace as all patents generally. Between 1998 and 2003i.e. after the Kyoto Protocolpatents relating to climate change grew much faster than all patents generally. Moreover,the increase in climate-related patents occurred in countries which ratified the Kyoto

30 There are currently only two IGCC plants generating power in the , which started operating in 1995 and1996; several new IGCC plants are expected to come online in the US around 201220.31 A similar conclusion applies to the US lead-refining programme which operated from 1982 to 1987. Kerrand Newell (2003) examine a technology known as isomerization used by refineries to replace octane whenlead is restricted. The technology was introduced in the late 1960s. By 1980, the cost of isomerization hadfallen by about 40 per cent. During the 1980s, the cost fell hardly at all. More than half the adoption ofisomerization occurred after 1986, when the phase-out of lead trading had been set. In fact, the flexibilityafforded by lead trading may have permitted some refineries to postpone the installation of isomerizationfrom, say, 1985 to 1987.

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Protocol but notin the US and Australia, which did not ratify the Protocol.32 Onecommentator characterized this finding as climate policy does wonders for your green-tech patent count.33 However, this again should be seen as evidence of the impact ofregulatory stringency on invention, rather than of emission tradingper se. The twocategories with by far the largest annual number of patents between 1998 and 2003 were

lighting and fuel injection. These were followed respectively by waste (recovery of heatfrom waste incineration, recovery of waste heat from exhaust gases, and production ofenergy from waste or waste gases), solar, building efficiency, and wind. Solar and windpatents may be related to investments by power companies that are regulated in Europethrough the EU ETS, which was established by a directive in October 2003 and went intoeffect in January 2005. The other patent categories that experienced unusual growthbetween 1998 and 2003 are unlikely to be related to emission trading in the EU orelsewhere. It is noteworthy that, between 1998 and 2003, CCS had the smallest annualnumber of patents of all 13 categories.34

Johnstone et al. (2010) analyse a subset of the same data relating to renewable energy

technologies involving wind, solar, geothermal, ocean, and biomass/waste in 25 countriesover the period 19782003, Their focus is the effect on the rate of invention of alternativetypes of policy instruments. Since the data end prior to the institution of EU-ETS,emission tradingper se is not one of the instruments considered, but the analysis doescover tradable renewable energy certificates (RECs) in connection with renewableportfolio standards. The econometric analysis shows that RECs induced inventions inwind power, while targeted subsidies, such as feed-in tariffs, induced inventions in solarpower. The authors explain this by pointing out that a renewable portfolio standard is aperformance standard which leaves electric utilities free to choose any renewabletechnology; therefore it promotes innovation in a technology such as wind that is close tocompetitive with fossil fuels. By contrast, solar is more expensive than fossil fuels andtherefore requires subsidies in order to promote innovation.

In short, the empirical evidence demonstrates that the pace of invention is influenced bythe stringency of environmental regulation and perhaps also whether the regulationinvolves a performance standard, but not necessarily whether it involves emission tradingper se. Montgomery and Smith (2007) reach a similar conclusion. Commenting thatclimate policy demands a policy prescription that is effective in stimulating futuretechnology development without imposing inefficiently high costs in the near-term stagesof the policy, they concluded that the ability of the cap-and-trade approach to performin [this] manner has not been demonstrated by any of its previous applications, nor has itbeen explored adequately in modeling or in theory.

There are at least two economic reasons why the price signal generated by emissiontrading might not be sufficiently powerful, by itself, to promote the type of technological

32 Australia subsequently ratified it in December 2007.33 http://www.env-econ.net/2009/02/climate-policy-does-wonders-for-your-greentech-patent-count.html34 According to Glachant et al. (2009), annual patents relating to CCS increased sharply in the late 1980s,reaching a peak in 1992, but then fell for 5 years. Since 1997, the level of CCS patents has increasedgradually, but in 2005 it was still below the 1992 record high.

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will a minimalist policy of allowance trading alone secure the desired reduction in GHGemissions? For GHGs, the European Union has adopted a more comprehensive approachincluding, in addition to emission trading for CO2, measures to promote renewableenergy; improvements in energy efficiency in buildings, household appliances, andindustry; emissions standards for new passenger cars; and the reduction of methane

emissions from landfills. Similarly, the GHG legislation adopted by the US House ofRepresentatives in 2009 (HR 2454, WaxmanMarkey) has provisions relating to a federalrenewable portfolio standard, energy efficiency standards for buildings, lighting,appliances, and new motor vehicles, CCS, performance standards for new coal-firedpower plants, smart grid deployment, and R&D support for electric vehicle developmentalong with emission trading for CO2. Among the US states, Californias programme toreduce GHG emissions, being copied by its five partner states in the Western ClimateInitiative (WCI), involves a suite of complementary measures alongside emission trading,including efficiency standards for motor vehicles, appliances, and buildings; renewableenergy standards; a low-carbon standard for transportation fuels; governmentprocurement policies; and a performance standard for new long-term power contracts.37

However, whether there should be complementary measures to deal with GHGs, orsimply emission trading alone, is a contested issue. In contrast to the WCI, the RegionalGreenhouse Gas Initiative (RGGI), formed by ten north-eastern and mid-Atlantic states,relies solely on cap-and-trade covering power plants to limit CO2 emissions.

38While the

KerryBoxer bill currently before the US Senate adopts a broad approach similar to thatof HR 2454, the other bill before the Senate, the CantwellCollins bill, focuses morenarrowly on emission trading for CO2, without any complementary measures,

39 andadopts an upstream cap on fossil-fuel carbon as it enters the US economy. Also, manyeconomists have advocated a cap-and-trade system for CO2, or a carbon tax,unaccompanied by complementary measures other than an R&D policy.

40

As noted above, the actual experience with emission trading for SO2 and lead deviated insome significant respects from the standard economic model on which the economistsrecommendation relies. Moreover, as argued above, GHGs differ from SO2 and lead inseveral important dimensions that make cap and trade alone unlikely to be as effective ataccomplishing a large emission reduction for GHGs as it was for them.

The key fact about the past experiences with emission trading in the US is that all theemission reduction was accomplished by producers in the capped sector modifying theirproduction process or reformulating the product, without any substantial increase in

37

For a description of the package of complementary measures adopted by California between 2002 andthe present, which created a template for the other members of WCI, see Farrell and Hanemann (2009). Inaddition to the partner states, there are seven observer states, plus partner and observer provinces inCanada and observer states in Mexico.38 At least 25 per cent of the allowances have to be auctioned, with auction revenues directed to strategicenergy investments.39 All of the allowances would be auctioned. Of the revenues generated by auctioning permits 25 per centwould be allocated to a Clean Energy Reinvestment Trust which could finance emission reductionactivities.40 For example, Stavins (2007), Metcalf (2007).

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production costs. The reduction in emissions was notdue to price increases that chokedback demand for the product. The adjustments were on the supply side, not the demandside. The same outcome is not likely to occur with GHGs.

With electricity generation, unlike SO2, there is limited scope for reducing GHG

emissions from existing fossil-fuel power plants. Therefore, the main focus will have tobe on lowering the GHG emissions associated with new power plants. Renewable energywill not assume a large share of the power sectors in the US or EU overnight. The shareof nuclear power in those countries will increase, but also not overnight. For politicalreasons, coal will continue to account for a substantial share of new power plantconstruction, making the timing of CCS deployment and regulatory pressure for highthermal efficiency combustion technologies important determinants of the pace of GHGreduction in the electricity sector. Since power plants are capital-intensive and long-livedinvestments, it is doubtful whether the price signal from an emissions market will, byitself, be sufficiently powerful to produce a decisive shift in the selection of futuregenerating capacity away from fossil fuels or, in the case of fossil fuels, towards

technologies embodying high thermal efficiency combustion and pre-equipped for CCS.Not only an R&D programme but also complementary measures, whether performancestandards for new coal-fired plants, feed-in tariffs, purchase commitments, subsidies, orloan guarantees will surely be required.

Moreover, whereas demand-side management played no role in the reduction of SO2emissions, it seems clear that it will have to assume a significant role in order to attain2020 GHG emission targets. Together, residential and commercial buildings account for70 per cent of electricity consumption in the US. Approximately 38 per cent of the CO 2emissions in the US comes from the energy use associated with these buildings.41 Thelargest component of the CO2 emissions comes from the generation of the electricity usedin them (71 per cent), but emissions also arise from the direct combustion of natural gasand petroleum, especially fuel oil. The major uses of this energy include space heatingand cooling, lighting, and water heating.

42Thus, an effective strategy for GHG mitigation

must identify options for reducing these emissions, including both reducing emissionsfrom the current building stock and also tackling the buildings that will be constructed inthe future. Some of the options for reducing GHG emissions entail higher costs andinvestments; but others, especially those focused on increased energy efficiency, couldyield net savings. Major opportunities for improvements in end-use efficiency includespace heating (especially residential), air conditioning, lighting (especially in commercialbuildings), and water heating (especially in residences).

41 Brown et al. (2005). Twenty-one per cent of the CO2 emissions result from residential buildings and 17per cent from commercial buildings. In addition, industrial buildings account for another 5 per cent of CO2emissions.42 In the residential sector, 30 per cent of the energy consumed is for space heating, 12 per cent is for waterheating, 12 per cent is for lighting, and 11 per cent is for air conditioning; the remainder goes forappliances, electronics, and other purposes. In the commercial sector, the breakdown is 21 per cent forlighting, 12 per cent for space heating, 9 per cent for air condition, and 8 per cent for office equipment; therest goes for water heating, refrigeration, and other purposes (Brown et al., 2005).

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There are several reasons why it is doubtful whether the price signal from an emissionsmarket will, by itself, be sufficiently powerful to induce the improvements in end-useefficiency and the reduction in CO2 emissions. One factor is the sheer fragmentation ofdecision-making, especially in the residential sector. While about 500 firms control theoperation of the electric power industry in the US, there are over 110m occupied

residential housing units in the US. Of these, about 75m are owner occupied and 35m arerenter occupied. In this context, the principalagent problem is a significant obstacle toinvestment in energy-efficiency improvements. The problem arises whenever the energyuser does not pay for the cost of his energy use and/or does not choose the energy-usingappliances. The latter is not limited to rentersit can also apply to owner-occupiers.43First, in an existing home, the building insulation, the windows, the space-heatingequipment, and perhaps, to a lesser extent, some other appliances are likely to be pre-determined and changeable only at substantial cost. Second, with the significant mobilityof the US population, long-lived investments in improving energy-efficiency may seem arisky proposition to home owners who do not know how long they will continue to live inthe home and are not sure that they will recoup the investment if they sell it.44

In addition to the principalagent problem, there are behavioural impediments toinvestment by individual end-users in energy efficiency. One impediment is the highinitial capital costs of energy efficiency investments and the inability or unwillingness ofconsumers to finance these, even though there is a subsequent stream of operating costsavings. Empirical studies have demonstrated cases of high implicit individual discountrates,45 which could reflect high rates of time preference or, alternatively, the influencesof illiquidity or uncertainty and risk aversion. Whatever the cause, this is not an instanceof market failure. But, it is a market opportunity. The situation could be remedied if amarket intermediary were to come forward who was satisfied with conventional rates ofreturn, and was therefore willing to finance the up-front capital costs of energy-efficiencyinvestments in return for a guaranteed share of the future stream of energy cost savings.There is a missing actor who could arbitrage the differential between the rate of return onenergy efficiency investments and homeowners high individual discount rates. To plugthis gap, California and 15 other states have now enacted legislation authorizing localgovernments to form Energy Financing Districts (EFDs) which use bond or other funds

43 Davis (2009) compares appliance ownership patterns between homeowners and renters using UShousehold level data and finds that, controlling for household income and other household covariates,renters are significantly less likely to have energy-efficient refrigerators, clothes washers, and dishwashers.In the US, leasing/rentals are a larger proportion of commercial than residential buildings, and principalagent problems arising from leasing/renting are therefore likely to be more widespread for commercialproperty.44

The incomplete capitalization of energy-efficiency improvements in house values is noted by Dubin(1993). It has been estimated that, in the US, the principalagent problem is a potential obstacle to energyefficiency affecting up to 25 per cent of the energy usage associated with residential refrigerators, 47 percent of the energy usage associated with residential space heating, and 77 per cent of the energy usageassociated with residential water usage (ACEEE, 2007).45 For example, Hausman (1979) and Meier and Whittier (1983). It should be noted that the behaviouralimpediments to the adoption of energy-efficiency investments are not limited to householdsthey are alsofound in some businesses and other organizations. Muthulingam et al. (2009) find evidence that high up-front costs and a short planning horizon (economic short-termism) lead managers to overlook profitableopportunities for energy savings.

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the summer of 2008 there was a significant consumer response to the run-up in gasprices. Retail gas prices in the US rose from an average of about $2.92/gallon in JuneAugust 2007 to an average of $3.91 in JuneAugust 2008, an increase equivalent to acarbon price of about $113/CO2 ton. While gas prices rose by 34 per cent, vehicle milestravelled in the US fell during this period by about 4.6 per cent. The implicit short-run

elasticity was therefore about 0.14. This is notably larger than the conventional estimateof the short-run price elasticity of demand for gasoline, which the Congressional BudgetOffice (2008) sets at 0.06. The higher elasticity in 2008 reflects the response to the largeprice increase.

49

What would happen with the sort of carbon price envisioned in the current US debate onemission trading? The CantwellCollins bill in the Senate sets a price cap starting at $21per ton of CO2 in 2012; the KerryBoxer bill sets a price cap of $28/ton in 2012. Thelatter figure corresponds to an increase of about 25 cents in the price of a gallon ofgasoline. The current retail price of gasoline in the US in March 2010 is about$2.75/gallon. How substantial a reduction in gasoline consumption would be induced by

a 9 per cent price increase? Such an increase is well within the normal seasonal variationin the price of gasoline. In 2005, for example, before the major run-up in gas prices, theaverage weekly retail price of regular gasoline in the US varied from as low as$1.75/gallon, in the first week of January, to as high as $3.04, in the first week ofSeptember; the average for the year was $2.24. In that context, an increase of 25 cents pergallon due to a carbon price of $28/CO2 ton is unlikely to be visible, or salient, to mostmotorists.

There is a striking contrast between the end-user decision-making on fuel use forpassenger vehicles versus for commercial vehicles, commercial aviation, and freighttransportation. For airlines and trucks, fuel is the second largest cost of operation afterpayroll; during 2008, it became the largest cost item. Therefore it is both visible andsalient to them. Over the past decade or more, airlines and trucking companies appointedfuel managers whose task is to find and implement ways to raise fuel efficiency andreduce fuel use. For example, following the 2008 increase in fuel prices, airlinesreprogrammed flight trajectories and flight paths to shave energy use, overriding decisionmaking by individual pilots.

50Similarly, trucking companies have installed speed

controllers. Among the US corporations ranked most highly for their GHG reductions arethe shippers DHL and UPS.51 UPS operates the largest private alternative-fuel fleet in theUS. DHL has set a corporate goal to improve the CO2 efficiency of its worldwideoperations by 10 per cent in 2012, relative to 2008, and by 30 per cent in 2020.

52In short,

49

There is a parallel with the 1973 oil price embargo. Goel and Morey (1993) estimate that the priceelasticity of demand in the US during the period 197380 was more than double the mean elasticity during195273.50 For example, a recent story in the Wall Street Journalreports: By carefully planning flight paths andimproving communication among air controllers, carriers and airports, major airlines should be able toreduce fuel consumption by up to 2 per centor many thousands of tonson flights between Americanand Europe (10 March 2010).51 http://www.climatecounts.org/scorecard_sectors.php?id=2852 Besides truck operations, both companies are actively working to increase fuel efficiency and reduceGHG emissions in the operation of their aviation fleets.

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while a 9 per cent price change is neither visible nor salient to individual motorists, evena 2 per cent cost savings is salient to managers of large trucking operations and caninduce a behavioural response from them. However, individual motorists account for atleast 54 per cent of GHG emissions in the transportation sector. This necessarily limitswhat response can be expected to the price signal from emission trading if

unaccompanied by complementary measures targeted at the transportation sector.

Besides the end-users, two other actors influence the GHG emissions from transportation,namely the vehicle manufacturers and the producers of motor fuels. Fuel efficiency andthe carbon intensity of motor fuels are likely to be salient for them. Compared to a 25cent increase in the price of gasoline, it seems likely that more emission reduction wouldbe accomplished with a cap on automobile manufacturers based on the emissions of theirannual fleet of new vehicles, and a low carbon fuel standard (LCFS) for suppliers ofmotor fuels, both of which have been adopted by California.53

Because of limited attention, limited salience, and bounded rationality on the part of

many individual end-users of energy in the transportation sector and, in addition, theprincipalagent problems in the building sector, it seems questionable whether the pricesignal from a carbon tax or an upstream cap on CO2 emissions will, by itself, motivatesignificant reductions in CO2 emissions in those sectors. Rather, complementarymeasures such as building efficiency standards, appliance efficiency standards, GHGemission limits for new vehicles, and an LCFS, taken in combination with a cap-and-trade programme, may induce more decisive actions to reduce emissions in those sectors.

VIII. Conclusions

While it is essential that there be a price on pollution emissions, the evidence from SO2

trading suggests that its success was due not only to the price signal that it created butalso to the fact that it imposed a stringent but flexible performance standard on the firmsthat were regulated. Another part of its success was due to the fact that it impacted asmall number of firmsfewer than 500 power companiesfor whom it was highlysalient. By contrast, GHG emissions are widely diffused throughout the economy. Asubstantial reduction in GHG emissions can be achieved only through the actions ofmillions of firms and households, for many of whom the price signal generated by acarbon tax or an (upstream) cap-and-trade scheme is unlikely, by itself, to be visible orsalient.

To be sure, the downstream cap-and-trade scheme that I advocate will be more costly toimplement, and it will necessarily be less complete, than a carbon tax or an upstream cap-

53 The LCFS is sometimes characterized as a politically expedient substitute for a carbon tax which doesnot visibly affect fuel prices (Holland et al., 2009). However, its real significance is probably as a devicetargeted at the major oil companies to discourage them from making an irreversible commitment to thedevelopment of highly CO2-intensive oil from Canadian tar sands. Holland et al. criticize the LCFS using amodel that has no fixed costs or investment requirements for low- or high-carbon fuels. They find that anoptimal outcome can be obtained without a LCFS by just relying on emission trading. But, their analysisoverlooks the irreversible investment decision facing oil companies.

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and-trade scheme. In addition, some of the complementary regulatory measures may becostly in terms of administrative costs and also short-run economic efficiency before therequisite behavioural and technological changes are induced. Others, especially thosetargeted at improving energy efficiency and promoting technological innovation, arelikely to be profitable and to increase economic welfare. The regulatory measures are

required to overcome the impediments caused by bounded rationality and principalagentproblems in end-using sectors such as transportation and buildings.

Over time, attitudes and perceptions will surely change, and new technologies willemerge. Some of the complementary measures that are required now will becomeunnecessary, perhaps even counterproductive, and will need to be modified or eliminated.Moreover, emission trading may lead to some surprise outcomes, as occurred with SO2.Nevertheless, the empirical evidence suggests that, at present, an upstream cap-and-tradescheme unaccompanied by complementary measures is unlikely to be adequate to attainthe reduction in GHG emissions desired by policy-makers.

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