Can cap-and-trade really reduce GHG emissions?

Mark Hulbert says the better question to ask is whether we have the political will to actually make them work

(Mark Hulbert, an author and longtime investment columnist, is the founder of the Hulbert Financial Digest; his Hulbert Ratings audits investment newsletter returns.)

CHAPEL HILL, N.C. (Callaway Climate Insights) — California has recently acknowledged what many critics have been alleging for some time: The state’s much-vaunted carbon cap-and-trade program is unlikely to live up to expectations for reducing greenhouse gas (GHG) emissions — at least over the next decade.

It would be easy to chalk up the program’s shortcomings to the Covid-19 pandemic and collapsing oil prices. And they certainly didn’t help. But the program has more fundamental shortcomings, and it’s incumbent that those be addressed if there’s to be hope that GHG emission targets will be met.

Carbon cap-and-trade programs, of course, have great appeal in theory. They harness the power of the marketplace to find the most efficient way of reducing harmful emissions. That’s why economists generally are in favor of them.

Politicians also like them, since the alternative would most likely be an outright carbon tax. And we know how palatable the word “tax” is. The Paris Climate Agreement goes so far as to explicitly endorse cap-and-trade programs as a primary way for countries to meet their climate goals. A number of countries around the world have instituted such programs, with many using California as a model.

With a cap-and-trade program, an overall cap for total emissions is set (the “cap”) and emitters are given the option of either reducing their own emissions or paying for the right to do so (the “trade”). Specifically, companies get emission allowances adding up to the total cap; a company can either save allowances that it doesn’t use or sell them to other companies. By progressively reducing the number of emission allowances, climate goals can be eventually met.

There have been notable past successes for cap-and-trade programs. One such program in the U.S. between 1994 and 2010 is credited with greatly reducing sulfur dioxide emissions, the source of acid rain. Another was the NOx trading program between 1998 and 2009 that reduced nitrogen oxide emissions.

Why, then, has California’s cap-and-trade program fallen short?

One answer is that it over the years has given away too many emission allowances to various industries. As a result, there are so many unused allowances floating around that climate goals don’t appear attainable.

In fact, in research published last December, three Stanford University researchers reported that by the end of 2018, California companies already owned more unused emission allowances than the total amount by which the program was projected to reduce emissions from 2021 to 2030. The researchers commented that this raised “questions about the [cap-and-trade] program’s ability to achieve its expected reductions.”

Note that this research was published in December, before the pandemic and before oil prices plummeted. So those two factors at most contributed to a glut of unused emission allowances that already existed. They were not the cause.

Are cap-and-trade’s shortcomings inherent to the approach?

To be sure, these failings of the California cap-and-trade program are not inherent to the approach. After all, the state could have set a lower cap, for example. And it could have given away fewer allowances.

They didn’t do those things for political reasons, of course. To secure widespread support for the cap-and-trade program, they reduced its bite — at least in the early years. This helps account for what ProPublica reported in a study published last November: In the first three years of California’s cap-and-trade program, a majority of companies actually increased their GHG emissions.

Since we weren’t in the room where it happened, we perhaps shouldn’t be too quick to judge California’s politicians for whatever Faustian bargains they had to make in order to get their cap-and-trade program passed in the first place. As Otto Von Bismarck famously once said, “Politics is the art of the possible, the attainable — the art of the next best.” And having a weak cap-and-trade program is better than none.

It nevertheless is difficult to escape the conclusion that we collectively still don’t have the will to make the hard choices necessary to meaningfully reduce GHG emissions. We solemnly swear that we will meet ambitious targets for reducing those emissions, but it’s as though we have our fingers crossed behind our backs when making that vow. We are willing to move towards that goal so long as we don’t have to cut back our energy usage — and only so long as prices don’t go up.

We see the same half-hearted commitment to climate goals in the investment arena, as I’ve written in past columns. We want our portfolios to promote a greener climate, but only so long as we make money doing so or at least don’t have to forfeit any performance.

Perhaps the best way of thinking about cap-and-trade programs isn’t the theoretical question of whether they are a good idea or could work, since they are and they can. The better question to ask is whether we have the political will to actually make them work.

Above, Yosemite National Park. Photo: Jim & Robin Kunze/flickr.