Cap and Trade 101 Marlon G. Boarnet Professor of Public Policy Director of Graduate Programs in Urban Planning and Development University of Southern California July 10, 2010

An externality occurs when a market transaction affects a party who neither pays not gets paid Externalities Q (Televisions) MPC D = MPB $ QpQp MPC = marginal private cost MPB = marginal private benefit Q = quantity consumed (purchased) Private Markets

An externality occurs when a market transaction affects a party who neither pays not gets paid Externalities Q (Televisions) MPC D = MPB $ QpQp MPC = marginal private cost MPB = marginal private benefit Q = quantity consumed (purchased) Private Markets = MSC = MSB MSC = marginal social cost MSB = marginal social benefit

An externality occurs when a market transaction affects a party who neither pays not gets paid Externalities MPC D = MPB $ QpQp MPC = marginal private cost MPB = marginal private benefit Q = quantity consumed (purchased) Markets with Externalities MSC Q* Q (Driving) MSC = marginal social cost MSB = marginal social benefit Social cost exceeds social benefit for these trades

Photos: SQ AQMD and Los Angeles Times

Regulatory Approaches Price Controls (taxes) – Example: Value Pricing on SR-91 Quantity Controls (mandated limits) – Example: Clean Air Act compliance Emission Clean-Up (mandated technology) – Examples: Catalytic Converters; Unleaded Fuel MPC D = MPB $ QpQp Q (Driving) Social cost exceeds social benefit for these trades MSC Q* Tax = (MSC – MPC) Mandated emissions limit

Efficiency of Regulatory Approaches (Theory) Price Controls (taxes) and Quantity Controls (mandated limits) – Both lead to efficient externality reduction (to point where social costs of activity = social benefits) – Difference is in information available to regulator Emission Clean-Up (mandated technology) – Can regulator “pick” the right technology? – Why not let market forces choose clean-up technology?

Efficiency of Regulatory Approaches (Practice) 27% pop growth LA County (7.4 to 9.5 million) Stage 1 days from 117 (in 1978) to 0 (late 1990s) Data: SC AQMD and US Census

Market Based Regulatory Mechanisms Price Controls (taxes) Quantity Controls (mandated limits) – Cap and Trade – Variation on Quantity Control Emission Clean-Up (mandated technology) Incentive vs. outcome regulation Advantages of market based regulations – Creates incentives for clean-up – “self regulating” – uses incentives and markets to coordinate actions Market based

Cap and Trade Economy-wide cap on emissions (quantity regulation) – Similar to Clean Air Act concentration levels for traditional pollutants Firms get emission permits, which can: – Be used for emissions, or – Sold to firms that want extra permits Permits “depreciate” over time – cap binds more Firms that can clean up inexpensively will do more cleanup to sell permits to “dirty” firms More emission reduction from firms that can reduce emissions at lower cost

Example dirtyclean Firm 1Firm 2 $300$100cost for reducing 1st ton of CO2e $500$200cost for reducing 2nd ton of CO2e $700$300cost for reducing 3rd ton of CO2e $1000$500cost for reducing 4th ton of CO2e both firms initially produce four tons CO2e reduce four tons, two from each firm, cost = 1,100 two permits per firm and can trade, cost = 900 Firm 2 will sell a permit to Firm 1 at any price higher than $300 Firm 1 will buy a permit from Firm 2 at any price lower than $500

Does it work? SO 2 permit market, Clean Air Act Amendments of 1990; RECLAIM SCAQMD Conditions for Cap and Trade to be successful and issues – No “hot spots” – location of emissions is no concern – Sufficient number of permit-holders for market to work – Neither a shortage nor surplus of permits – Initial permit allocation issues

ARB Cap and Trade Economy-wide cap: 1990 CO2e emissions by 2020 Price stability measures – reserve permits to offer on market and effort to not be too slack Distribute early permits by allocation, auction later permits Measures to reward prior energy efficiency with permit allocation Economic impacts mostly distributional – 2.3% state GSP growth per year vs. 2.4% “business as usual”

Use of Auctioned Permit Revenues Reduce distorting taxes Dividends to consumers Clean energy? High speed rail?