The Intractable Flaws of Cap-and-Trade Scheme

Emission trading is a well-established method for managing certain kinds of environmental problems. Also called cap-and-trade, emission trading was used to eliminate lead from gasoline in the 1980s, and to control acid rain in the 1990s.

The basic idea is simple: Experts assess how much of a given pollutant can be safely put into an environmental medium on an annual basis (that's the cap), and shares (called permits or allowances) equaling that amount are given or sold to those who have historically emitted the pollutant.

Subsequently, emitters have to give the government permits covering their annual emissions. If they fall short in a given year, emitters can buy permits from those with a surplus. The number of permits available decreases annually, until a "safe" emission level is reached.

When they work, emission-trading systems allow markets to find lower-cost emission reductions, hopefully producing benefits that outweigh costs.

But emission trading schemes, like any other trading scheme, can go badly awry, particularly when the system is highly complex, and the potential for profiteering is large. That's clearly the case with regard to carbon. While one could write a book on the potential pitfalls of cap-and-trade, three stand out vividly: politicized permit allocation; economic strangulation; and energy price volatility.

Economists argue that if done correctly, cap-and-trade can work for greenhouse gas control. But that's only if all the permits are auctioned off to emitters. Otherwise, it's a mess.

President Obama knows this, telling the Business Roundtable in March, "If you're giving away carbon permits for free, then basically you're not really pricing the thing and it doesn't work -- or people can game the system in so many ways that it's not creating the incentive structures that we're looking for."

Budget Director Peter Orszag testified that giving away permits "would represent the largest corporate welfare program that has ever been enacted in the history of the United States."

Clearly, Rep. Henry Waxman, chairman of the House Energy and Commerce Committee, wasn't listening. His draft cap-and-trade legislation (now making its way through the House) gives away 85 percent of the permits to special interests.

Recipients of Orszag's "corporate welfare" under the Waxman-Markey cap-and-trade bill include electrical utilities, home heating oil users, oil refiners, heavy industry, renewable energy companies, hybrid-car makers, worker retraining programs, anti-deforestation groups, and, of course, low-income earners likely to vote for Democrats.

But allocation is only the first problem with cap-and-trade. The worst part will be living with it, because it isn't only carbon emissions that get capped, it is economic growth.

The United States is an energy society: Virtually everything we consume is produced with an initial infusion of energy and is re-infused as it is processed, packaged, shipped, and used.

When the economy grows, and we buy more stuff, we use more energy, which means we emit more greenhouse gases. That means producers will need to buy more permits, their costs will rise, and eventually, prices will rise enough to stifle demand, choking off growth. The tighter the cap grows over time, the tighter the strangulation hold that greenhouse gas controls will have on the economy.

Finally, if you've enjoyed gasoline price volatility in recent years, you will love living with cap-and-trade, which will bring volatility into your electricity pricing as well.

About 70 percent of our electricity is produced with fossil fuels, especially coal (50 percent) and natural gas (20 percent), both of which produce copious quantities of greenhouse gases.

In a particularly hot summer or a particularly cold winter, energy demand can increase dramatically, and when it does, emission permits will become scarcer, and more expensive. That cost is ultimately going to flow through to the consumer in higher electricity bills. It is a great irony that as part of protecting society from climate variability, Congress is preparing to make energy prices more -- not less -- sensitive to climate fluctuations.

Cap-and-trade is a venerable pollution-control approach, but it is ill-suited to the control of greenhouse gases.

Cap-and-trade's problems, from allocation favoritism to price volatility and economic strangulation, are not minor challenges: They are intractable flaws in the approach.

Congress should ditch cap-and-trade and, if it is really intent on reducing greenhouse gas emissions, consider a revenue-neutral carbon tax accompanied by the elimination of the crazy-quilt of energy regulations that distort energy markets, such as vehicle emission standards, appliance efficiency standards, light-bulb bans, and other regulatory foolishness.

Kenneth P. Green is a resident scholar at The American Enterprise Institute.