Cap-and-trade systems are not doing the real carbon work

A conversation with Cullenward & Victor, part three.

Happy Friday, Nuts & Volts! We’ve almost made it to the end of this cursed year and a vaccine is on the near horizon, so I hope everyone is making plans to stay safe and cozy at home this holiday season. By next year (knock on wood), we’ll be back to celebrating with our loved ones in meatspace, having verbal Slacks and face Zooms.

This week of Volts has been pretty heavy, wonkery-wise. There are some graduate-level terms and concepts flying around without much background explanation. It was perhaps an unnecessarily daunting way to start off a newsletter that I hope to make a helpful educational aid for energy beginners, but it’s just how the timing worked out. Next week, we’ll get into some lighter fare.

Today brings the third and final part of my conversation with Danny Cullenward and David Victor, authors of the new book Making Climate Policy Work, an extended argument that carbon pricing, as attractive as it is in theory, has not been working and is unlikely to work, at least as the primary instrument of climate policy.

In part one we discussed the attraction of carbon pricing as a theory and the reason it hasn’t spread to cover the whole economy like it was supposed to. In part two we discussed the political problems with carbon offsets and the reason carbon pricing systems haven’t expanded to more states and countries.

Today we hit two final topics. One is the crucial concept of “Potemkin markets,” which is to say, carbon markets that look like they are cheaply reducing emissions (because carbon prices are low) but are in fact drafting on sector-specific regulations that are doing most of the real work.

Second, we talk about the Green New Deal, Biden’s climate plan, and the general turn in the US climate community toward support for more direct state intervention. That allows us to hit a topic close to my heart: the need for a competent, effective state. Fun stuff!

Let’s jump in.

“Potemkin markets” are more sizzle than steak

David Roberts

I found the notion of “Potemkin markets” quite illuminating. What does it mean for a carbon market to look better and more functional than it actually is?

David Victor

This argument is key to the book. It also helps reveal the difference between cap-and-trade systems and carbon taxes — we are much darker on cap-and-trade.

If you've got a bunch of contrary political forces working against you, as we have tried to systematically lay out, it’s going to make governments wary about using cap-and-trade to do real work to cut emissions. The cost is going to be toxic and hard to manage. It’s going to make them reach for regulatory instruments and industrial policy.

What happens when you’ve got a cap-and-trade system sitting alongside of all these other regulatory instruments is that the regulatory instruments do most or all of the work [of reducing emissions]. The cap-and-trade system trades the residual, the leftovers.

That's why these cap-and-trade systems produce prices that are so low, because they're not revealing the real marginal cost of effort. They're just revealing what it costs to trade what was left over after all the regulations.

David Roberts

So the cost of complying with the regulations does not show up in carbon prices.

Danny Cullenward

From the perspective of the regulated industry, or society, it may be really expensive to mandate a technological change. But from the perspective of the market, it's a supply of zero-cost abatement. So as David said, you're only pricing the residual. If you do 80% of the work with regulations, the market price is that last 20%.

David Victor

You show up at the village and you've got this beautiful carbon market on the facade. But when you look behind the facade, what you see is that the regulations are doing the work.

A carbon tax doesn't have that problem. A tax is seen by firms regardless.

A lot of our strategy is around cap-and-trade systems, which are often easier to set up than tax systems, because it's easier to adopt “environmental measures” in many legal systems than fiscal policies. Wherever possible, we recommend reforming those cap-and-trade systems to be more tax-like, so firms always see a marginal price from them and they don't have this Potemkin quality to such a degree.

That's de facto what the Europeans have done. It's a pretty complicated scheme, but in effect they’ve created a central banker in the European emissions trading system who can withdraw permits from the system and manage prices in a way that makes it a little more tax-like.

David Roberts

A cynic might argue that having regulations doing the real, expensive work behind the scenes while a low-priced carbon trading systems serves as the facade is the best of both political worlds.

Danny Cullenward

I guess you could tell a story about that being a pragmatic political strategy, but the problem is, a lot of people don't understand that. When I talk to colleagues in Europe, they think California is using a cap-and-trade program to achieve its climate reductions, when that is manifestly not the primary instrument the state has relied on.

Neighboring states have been talking about adopting comparable policy portfolios. If you tell them the cap-and-trade program will take care of everything, you're replicating these political problems without arming them with the information and strategy needed to resolve them.

We are totally fine with the existence of politics. None of it makes us blush. But I do think it's a real problem when you push strategies that aren't anchored to what's actually going on, because most people aren't paying enough attention to figure out what to do. And when you put people in political traps that nobody can back their way out of, you're propagating political and strategic dead ends.

That is the big concern: more and more people copying models that actually aren't working very well.

David Roberts

Arguably California has fooled itself about the efficacy of its cap-and-trade system — it is relying on it a lot more in the next phase of emission reductions.

Danny Cullenward

In California, the perception that the market has solved the problem has armed industry opposition with the talking point to say, “don't touch anything, the cap solves all problems.” That is the trap we are stuck in. I am desperately interested in keeping other people from getting stuck.

We're not on track for any of our climate goals [in California], because we made a rhetorical pivot to saying the market will do it without having the politics to implement the market design necessary to do that.

David Victor

Let me say two things about the trap here. One is that to do better does require a lot of government. We can't delude ourselves into thinking you can wave a magic wand over this climate problem, with a market that doesn't require a lot of detailed design and high-quality intervention. Having government back off is the opposite of what you need.

The other thing is that climate change is fundamentally a followership problem. You've got all these pioneer places doing things, California for example. But ultimately, the message has to spread more widely. So if the jurisdictions on the front lines are lying to the rest of the world about how they're doing it, you completely undercut the whole dynamic you need for generating widespread diffusion of the policy instruments that actually solve the climate problem.

The Green, er, Biden New Deal highlights the importance of a competent state

David Roberts

What do you guys think about Biden's plan? It’s in line with your prescriptions, is it not?

David Victor

In principle, yes. I mean, people say a lot of things during a campaign, but now we're in a world where the median voter in the Senate is plausibly Joe Manchin [of West Virginia]. So I think we have to see what's actually feasible. My hunch is that because of the ongoing gridlock in Washington, we'll get whatever funds are possible in terms of stimulus, and that'll have green elements to it. Hopefully, it will be spent on the lines of what we're discussing here.

David Roberts

It seems to me that Biden’s plan and the Green New Deal that inspired it are indicative of a shift in left climate opinion in the US, away from carbon pricing and toward sector-specific standards and investments. You should be thrilled with that, no? Is that how you see things?

Danny Cullenward

You needed to give David a trigger warning when you said “Green New Deal.” It’s a sensitive topic.

Broadly speaking, the alignment toward a more active role for the state, for public finance, for regulatory standards — it's brilliant insight. And it is more politically functional than the 1990s market consensus on environmental policy. So I will make the case that the broader thrust of the GND is 100% on target. I don't want to fight about what to call it — I don't want to fight about any of that silly stuff.

What’s totally lacking from my friends on the left is a serious discussion about what administrative capacity and competence look like in public management. Everybody just invokes public ownership and public investment. But nobody knows how to run these programs. If you're going to have a big role for the state, the state has to be extraordinarily competent.

David Roberts

So David, given that the GND is, broadly speaking, a turn toward industrial policy and public investment, what exactly is the problem?

David Victor

The drama over the GND and the language around whether we need to eliminate all fossil fuels — those symbolic dramas have gotten in the way of what's really needed, which is a large-scale, systemic state intervention. I think that's what we're about to see. It'll travel under a different name, which will be more about stimulus, but I actually think we're on the cusp of something big here.

The one thing I'd say both sides have really missed is how you administer this, and in particular, how you administer it under conditions of uncertainty.

If you know what the right technologies are, there are lots of policy instruments available to you. But when you don't know, that's when you need to be more experimental. You need to have teams of firms and governments trying lots of stuff, learning quickly what works and what doesn't work. It’s the skill set needed for what I call “experimental governance.”

Danny Cullenward

Last thing to say on this: if you just delegate some of these problems to a particular stakeholder, you're going to get special interests. You're going to get regulatory capture. We don't talk about that in the environmental movement.

When the scale of money and influence is as big as it is just in our pilot systems — let alone what a serious national program would look like — we have to be really open-eyed about conflicts of interest and the way people will maneuver to capture and direct large-scale revenues.

So the role of a financially disinterested state administrative apparatus is really critical. They have to be smart and flexible. And they also have to be attuned to these financial conflicts. All these pieces of the puzzle are not talked about.

How to build a state apparatus others will want to emulate

David Roberts

The US is responsible for a relatively low proportion [~15%] of current global emissions. Reducing our emissions is not nothing, but the bigger question is how our actions do or don’t bring others along — whether they produce “followership,” in your terms.

So, let’s say we abandon the dream of a single comprehensive carbon pricing system and instead turn to sector-by-sector industrial policy. What’s the right way to do that to produce followership?

David Victor

It's a critical question. Part of the answer is that you try to shift the technological frontier — push it forward to make it easier for followers to follow. One of the reasons more folks aren't doing serious things to cut emissions is that it's expensive. The politics are hard because of the cost. So as you lower the cost, it eases the politics.

Part of the answer is credibility. The big challenge right now for the Biden team is, it'll be easy for them to rejoin the Paris agreement, but will the rest of the world believe what we're doing? That requires acting more inside the country, recognizing that some of the regulatory measures can be rolled back. What you're trying to do is create strong incentives for industries, so they keep traveling in that direction even if some new guy takes over the White House and rolls everything back.

And part of the answer is, you have to get the incentives right. Border adjustments [carbon taxes charged on imported goods] are going to be a big part of this debate. One of the implications of our book is that, in the real world, border adjustments are going to be complex to design and sustain. Because the real effort of a country is not just going to be a simple carbon tax, where you can observe what the number is. The real world is going to be a bunch of industrial policies that are hard to measure. But that's completely like what happens all the time in trade policy, where there are adjustments for differences and non-tariff measures and so on. That's quite familiar to the trade world.

David Roberts

Earlier, you mentioned one of the recurring themes in your book: the need for a competent state apparatus and effective state administrative capacity. This tacks a bit against the neoliberal trend of the last few decades, with its emphasis on the superiority of markets and private institutions. Do you see yourself as consciously pushing back against that?

David Victor

The idea of integration of markets is not incompatible with the idea that the state would also become capable. That's the welfare states of Europe, for example, which are consistent with neoliberalism.

We are pushing back hard against libertarianism, the idea that the state is always incompetent and always the worst answer to the problem. What's striking in all of this is that, although the libertarian movement and the far right have had rhetorical success in trashing the state, when you look at what's actually happened to state administrative capability, it has gone up.

We have radically improved the ability of, for example, the Department of Energy to pick portfolios of winners and allocate funds to them. That's what ARPA-E is about. That's what the loan program is about. These programs are not building white elephants in the desert, they're actually doing pretty well.

The arm of the California government that does a lot of air pollution work [the California Air Resources Board, or CARB] also happens to oversee the cap-and-trade system. They do a terrible job on the cap-and-trade system, but in their traditional air-pollution role, where they're working directly with firms, literally picking winners and adjusting standards, they do really well. Same on electric vehicles.

I'm not proposing that we hand over the keys to the economy to a bunch of bureaucrats and have them do everything. But success here requires allocating resources, making choices, and putting firms and governments in collaboration, and that's the role of the state. It’s a huge part of what’s needed.

Danny Cullenward

I graduated from college a few years before the financial crisis, so my coming-of-age experience was watching the entire financial market implode. And then I had an internship at the US Treasury Department while I was in law school and I got to meet and talk with a lot of people who slept under their desks for three months trying to keep the ship afloat.

If you're not taking the role of public service seriously, you're missing the boat.

All right, that’s it for carbon-policy nerdery for a while. Thank you for indulging me. Tune in next week for a discussion of the huge energy bill that looks like it’s about to pass Congress. (Bet you didn’t know about that, did you?)