Cap-and-dividend: the worst possible way to regulate GHG emissions

Cap-and-dividend stinks. There are probably worse ways to regulate GHG emissions, but none that have gotten any kind of traction inside the beltway.

Its advocates — in particular, Peter Barnes and Sen. Maria Cantwell (D-Wash.) — are, so far as I can tell, truly motivated to find good policy solutions. I don’t know either of them personally, but I’m pretty sure I share their motivations, which makes me somewhat uncomfortable setting the time aside to criticize their ideas. But the ideas are really flawed. I have generally found that advocates of cap-and-dividend are like advocates of perfect markets: the model is predicated on an idealized theory of human behavior that doesn’t stand close scrutiny.

So what’s wrong with the theory?

1. Good carbon policy needs both carrots and sticks. We need explicit penalties to discourage CO2 release, but also need explicit incentives to encourage CO2 reduction. Pick whatever technology you think is going to be critical to controlling carbon (wind? solar? electric vehicles?) Whatever the technology is, we need to install a lot more of it, which means someone needs to be incentivized to do so, and cap-and-dividend provides no incentive to reduce CO2. Why not?
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2. Because a tax on your competitor does not make you wealthier. This is so obvious it shouldn’t need repeating. And yet it is perniciously present in the cap-and-dividend debate. Raising the cost of generating power from coal does not suddenly enhance the economic incentives to build a solar panel any more than losing your job makes it easier for your neighbors to finance an addition to their home. If we want to provide an incentive for carbon reduction, make an explicit payment per ton of carbon reduced; don’t simply bank on hopeful theories about how costs will ripple through the system as higher prices and profit margins. Maybe that happens in the long run — but in the long run, we’re all dead.
3. Markets fail when widget makers aren’t able to sell to widget wanters. Cap-and-trade, at its core seeks to solve this problem. When Clean Carl reduces a ton of CO2 and Dirty Dave releases one, the single best way to set a price that gets incentives and penalties aligned is to let them haggle it out — just like when you buy anything else. No one this side of Karl Marx would suggest that the best way to sell furniture is to have government set furniture production quotas, buy it all up and then distribute to each according to their needs. And yet that’s exactly what cap-and-dividend does with CO2 emissions. All the Dirty Daves get taxed and the receipts then get allocated around based on the wisdom of the central planner. Clean Carl’s access to those allocations depends primarily on their political connections, not on the amount of CO2 reduced.
4. The closer an incentive/penalty to the behavior, the more efficient the incentive/penalty. In the Cantwell-Collins bill, CO2 is not taxed at the point of CO2 release, but rather at the point of fossil fuel extraction/import. The theory says that these prices will all ripple perfectly through the system making this identical to a tax on CO2. By that logic, we ought to stop criminalizing gun violence and put a tax on bullets. Think of the savings! No more prisons, big increases in federal receipts and all sorts of social programs we could fund with our newfound largesse. Just like cap-and-dividend! Good CO2 policy puts the carrot/stick at the point of CO2 release, not at some upstream surrogate.
5. The sign of a functioning commodity market is consistent pricing. I’d pay a lot more for the new Springsteen album than I would for the new Miley Cyrus album, but I’ll drive a block out of my way to save 5 cents/gallon on gasoline. Such is the nature of undifferentiated commodity products that — in a functioning market — compete solely on price, with no substantial differentiation between buyers and sellers. CO2 is perhaps the ultimate undifferentiated commodity product; after all, even gasoline can get some premium with location, but CO2 markets ought to treat a ton of CO2 release or reduction no different whether it occurs in Chicago or Cameroon. An economy wide cap and tax does create consistent pricing for CO2 on the penalty side of the equation, but cap-and-dividend creates wildly different values for CO2 on the incentive side of the equation. The central failure of the “dividend” end of the model is that the proceeds are distributed without any regard to ones impact on CO2 emissions; the guy driving the Hummer gets the same payment as the guy who rides a bicycle-powered train to work.

The theoretically pure cap-and-trade solves all these problems. Government sets a cap, but then buyers and sellers are free to meet up and negotiate sales of (audited) CO2 reductions within that cap and mutually acceptable pricing. Dirty Dave’s cost per ton of CO2 release is exactly the same as Clean Carl’s revenue per ton of CO2 reduction. Prices are transparent, so the guy in Chicago knows exactly how much just got paid in Cameroon.

To be sure, the bills that have gone under the cap-and-trade banner — from Kyoto, through Lieberman-Warner to Waxman-Markey — aren’t theoretically pure. All fail one or more of these tests above as well, due to the political conventional wisdom that a theoretically pure cap-and-trade won’t pass. Maybe that’s true, and maybe it’s naïve to expect purity; try as hard as we can for purity, and then accept the inevitable consequences of political compromise. The problem with cap-and-dividend is that it doesn’t even try. It’s a tax, and a socialist wealth redistribution that has exactly zero theoretical possibility of incentivizing investments in CO2 reduction, minimizing the economic cost of CO2 reduction, or maximizing the total CO2 reduced.

That’s not to say it’s not without its advantages. It brings a ton of money into the federal government, giving resources for a host of social programs, deficit reductions, and any number of other social goods. It has obvious populist appeal given its redistributive nature. And in an age of banker-bashing, its effective guarantee that we will never develop liquid, sophisticated, complex financial markets in CO2 (and derivatives thereof) can be spun to a certain near-term political advantage. The trouble is, none of those outcomes have anything to do with regulating CO2.

When “is she pretty?” gets the old “she’s got a great personality” answer, we understand the subtext. When “will it reduce CO2 as quickly and as cheaply as possible?” gets answered with “it has populist appeal,” we ought to be no less skeptical.