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Emissions Trading*

Emissions Impossible?

While Genoa burned -- a topic we take up at greater length here -- bureaucrats in Bonn continued to fiddle with a dead treaty, the Kyoto Protocol on global warming. Japan and Europe appear more determined than ever to resuscitate the treaty without the United States. At the risk of sounding flippant, we ask: Why bother?

The whole idea behind Kyoto is puzzling at best, outrageous at worst. Why require the nations of this planet to spend the hundreds of billions of dollars necessary to reduce carbon dioxide and other emissions when we don't even know if the earth's climate is getting permanently hotter or if that temperature change is caused by human activity or if that change is even dangerous?

Why, indeed. Except that if new and more sophisticated research proves that human-generated greenhouse gases are a menace to civilization as we know it, then it is better to start now to control them and far better to do so in the most cost effective fashion. And that's why we harbor a certain fondness for one part of the Kyoto treaty -- emissions trading.

Emissions trading -- part of a package called "cap-and-trade" -- is one of the incentive-based market strategies that has been developed as an alternative to traditional fiat-based, nanny-sez-so regulation. The idea is simple: a lower level of pollution is agreed upon and targeted; permits reflecting that level are issued, or even sold, to polluters; firms that produce emissions below their targets can sell their excess permits to firms that exceed their targets. Firms have a straightforward incentive to come up with emission-reducing innovations because they can keep the financial rewards of their innovation through reduced abatement costs, reduced payments for emission permits and/or selling unneeded permits.

Thus, by providing flexibility and financial incentives, a cap-and-trade program will result in more abatement from those firms who can do it at relatively lower cost and less abatement from those firms who can only do it at relatively higher cost. The net will be the same amount of overall pollution reduction, but achieved at lower cost than would obtain under traditional regulation.

And cost is really mega-important. Consider the tab if -- as mandated by Kyoto -- the U.S. had to reduce its carbon dioxide emissions 7% below its 1990 levels by 2012. Without the ability to buy permits from other countries, compliance would have to be achieved mainly by switching from coal-fired plants to natural gas plants, resulting in the premature retirement of tens of billions of dollars of capital stock, the zooming of energy costs throughout the economy, and the loss of millions of jobs. According to the Energy Information Administration, the cost could be as much as 4% of GDP.

Now, however, consider the cost if the U.S. could meet its targets by buying permits from other countries. In a scenario offered back in 1998 by the Clinton Administration's Council of Economic Advisors, if the U.S. buys permits for its "excess" emissions -- so that it doesn't have to reduce by very much its own emissions -- the cost would be only 0.1% of GDP.

If you doubt these estimates -- and we agree that the models they are based on are technically complex -- then how about a real-life example? Look no further than the fabulously successful cap-and-trade program for sulfur dioxide. The program, which was started in the U.S. in 1995 as part of the effort to cut the emissions that cause acid rain, saves about $700 million annually compared with the cost of traditional regulation and has been reducing emissions by four million tons annually. When the program is fully implemented, sometime over the next couple of years, cost savings should be as much as $2 billion a year -- that's twice as much as originally estimated by the EPA.

In fact, the idea of emissions trading to reduce pollution has proved so attractive that some firms -- which are under no legal obligation to cut greenhouse gases -- have begun to set up programs for internal trading of permits. For firms interested in external trading, there are already several "pre-compliance" markets where permits can be traded across companies and across national borders.

So, who needs Kyoto? While whatever number of government bureaucrats are filling the air in Bonn with carbon dioxide, the private sector is going ahead with its own cap-and-trade solutions. Not surprisingly, European leaders would rather bureaucrats control the ebb and flow of private sector emissions and have bad mouthed cap-and-trade proposals in the past. Recently, however, even the Euros are beginning to see the light.

President Bush got it exactly right when he dissed Kyoto. And after Kyoto is pronounced dead in Bonn, the Bush Administration should propose a domestic cap-and-trade program for carbon dioxide that could, of course, be easily expanded to Canada and Mexico. And then to Latin America. And then the world.

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