This week a very interesting study came out about Canadian’s views on climate change. I will blog a bit more on that topic later as I am still drilling through the data supplied by the authors but one feature of the article really stood out, it was the fact that so many people in the survey supported a cap and trade system for addressing climate change. The question asked in the survey was:

There is a proposed system called cap and trade where the government issues permits limiting the amount of greenhouse gases companies can put out. If a company exceeds their limit, they will have to buy more permits. If they don’t use all of their permits, they will be able to sell or trade them to others who exceed their cap. The idea is that companies will find ways to put out less greenhouse gases because that would be cheaper than buying permits.

Now I have made it clear in this blog that I believe that putting a price on carbon is the best way to reduce out national carbon footprint. I have not written a lot about the other methods of addressing the issue and, for the most part, have avoided discussions on cap and trade systems. Personally, I am not a fan of cap and trade nor their kin: carbon offsets (about which I have written a post Carbon Offsets: a Basilica to Bad Policy). I see both as being too prone to being gamed. Unfortunately any system invented and run by regulators is subject to being gamed by intelligent and unscrupulous operators and I foresee the headlines 10 years hence where the next generation’s Enron is discovered to have made millions because they found a loop-hole to exploit.

On a moralistic level, I also have a strong dislike of the cap and trade system for carbon emissions that has nothing to do with gaming the system and everything to do with how the system is typically implemented in our modern era. There is an old saying that “the road to hell is paved with good intentions” and nowhere is that saying more true than in the case of carbon cap and trade systems. The reason for this is simple, cap and trade is an excellent theoretical model if implemented when a problem is initially identified (like with acid rain) so that all players arrive at the starting line at the same time. Unfortunately, that is not the case in Canada with respect to carbon pollution. When implemented in an existing marketplace cap and trade can have the ironic outcome of punishing the virtuous and enriching the slow-adopters. To explain how this occurs let me provide an incredibly simplistic example.

Imagine there are two companies that both make a widget: Virtuous Inc. and Gluttony Ltd. Both companies have the same underlying total cost to produce the widget (say $100) however the two companies go about producing the widget by substantially different means. Virtuous Inc., as its name suggests, is a forward thinking company that recognized the threat of global warming years ago and has spent the last decade optimizing their system. They invested heavily in the newest clean-energy technologies and have a plant to produce a widget using only 100 units of (our unitless) carbon dioxide equivalents. To achieve this laudable goal they borrowed from the bank and have a huge loan outstanding so the unit cost of their widget is broken down to be 50% financing costs, 40% input and materials and 10% energy (carbon dioxide equivalents).

Gluttony Ltd., on the other hand, has always made widgets the same way. They pump huge amounts of energy into the process, but because they have been around for a long time they have no debt, their equipment is paid for. Their unit costs for the widget are 40% inputs and materials and 60% energy (carbon dioxide equivalents).

Now all things being equal we have two virtually identical widgets, one which takes 10 carbon dioxide equivalents to produce and the second 60 carbon dioxide units to produce. From a climate change perspective we would want to minimize the number of units produced using the high-energy pathway and maximize the amount using the low-energy pathway, but that is not how cap and trade works. Instead, using the method that the cap and trade systems have been implemented to date, on the day the cap and trade system comes into place Virtuous Inc. is initially only allocated 10 carbon dioxide units (their historic average) while Gluttony Ltd. is allocated 60 carbon dioxide units (their historic average). So right off the bat Virtuous Inc. has been put at a disadvantage. Their competition has just been allocated an allowance (that will have a value in the coming years) based almost entirely on their historic bad business practices.

Now how cap and trade actually reduces emissions is that on a year-by-year basis each person who has obtained an allowance will lose a fixed percentage of it and will have to improve their efficiency or go out into the public market and buy someone else’s allowance to continue to operate. Happily for Gluttony Ltd. when you are ultra-inefficient it is amazingly easy to improve efficiency. Even better for them, they will be able to sell some of their allowance to get the money to pay for that efficiency increase. Ironically enough, one of the people in the market for their excess allowance will be their more efficient competitors.

In our sample case a 1% efficiency gain by Gluttony Ltd. will reduce their emissions at the same level as a 6% efficiency gain for Virtuous Inc. Now sadly for Virtuous Inc., they already did the heavy lifting to get efficient (and have a huge mortgage to show for it). In order to continue to operate they will have to buy further units and in our simple model the easiest person to buy from is Gluttony Ltd. Gluttony Ltd. meanwhile can then take the money provided to them by Virtuous Inc. and invest it in efficiency gains. This results in them improving efficiency. Now in isolation this seems like the system has worked. Average emissions per widget produced are down and the inefficient users are being forced to become more efficient but look what happened to the previous high-achievers? They have just been pushed off a cliff. Virtuous Inc. still has a huge mortgage and now has to pay a less efficient competitor for their quota which allows the less efficient competitor to improve their production without the need of a mortgage. Virtuous Inc.’s cost per widget is now more than Gluttony Ltd….and the process is additive. Every year the amount of carbon is going to decrease and Gluttony Ltd.’s initial advantage (being awarded a huge free allowance from the government) will likely allow it to kill its now over-leveraged competitor. The best of intentions ended up with the worst of outcomes.

Now to be clear, this is a very simplistic scenario. Some will argue it is too simplistic. Unfortunately, it is not an unfair one. Every system in place for cap and trade acknowledges the issues raised by my scenario and each model tries to help the virtuous members of the community, but unfortunately, none do a very good job of it. In Ontario and Quebec the government will allow Virtuous Inc. to bid on outstanding carbon units so that Virtuous Inc. does not have to directly subsidize their competition, but even that is a band-aid since Gluttony Ltd. can always sell their quota to someone else. Ultimately, the inequity of the system was established the day the allowances were issued.

The simplest approach to addressing this issue would appear to be performance benchmarking carbon quotas except that process has not been used very often as it is “administratively and technically complex and can create challenges for regulators”. Established industries have lots of money and lots of clout and they have, to date, been pretty good at ensuring that on day one of implementation they get more than their fair share.

Consider the Quebec example, in an attempt to avoid “leakage” Quebec basically gave Gluttony Ltd. all it could have hoped for

During the first few years of the cap-and-trade system, Quebec took measures to avoid “carbon leakage”—i.e., the relocation of industry to jurisdictions that do not have a cap-and-trade system—by granting emitters the maximum emissions allowances required to comply with the system free of charge; however, the system provides for a gradual reduction in the number free allowances granted annually.

The most even-handed way of addressing the problem is to ensure that all emissions are sold under an auction system. However, even in an auction system you have an unfair competition, because the early adopters typically don’t have the financial wherewithal (due to their debt to modernize) to compete with the big boys.

The reality is that virtually every cap and trade system implemented to date has had serious consequences for the Virtuous Incs. of the world. The reason for this is simple, cap and trade is an excellent model when implemented when a problem is initially identified (like with acid rain) so that all players arrive at the starting line at the same time. Unfortunately, that is not the case in Canada with respect to carbon pollution where the virtuous have long since started the transitions to a low-carbon future.

Alternatively, the argument goes that you have to break a few eggs to make an omelet. This is also true, but it sure is a shame that the eggs in this analogy happen to be the most virtuous of the players in the game. It is too bad as the business theory goes “the early bird does not necessarily get the worm”.

This brings us back to my preferred policy, putting a price on carbon. Putting a price on carbon provides an initial boost to the most efficient energy users and rewards the early adopters. As well since it is not controlled by regulators there are fewer opportunities for the unscrupulous to game the system. For this reason I will continue to support BC’s approach to addressing climate change over Ontario and Quebec’s. That being said, I welcome arguments to the contrary. I am always learning in this field and hope we can come up with a tool-kit of means by which we can achieve a low-carbon future.

Author’s Note: I recognize I have simplified the system tremendously in my example. I did so because the vast majority of my readers are not policy wonks. They are the same people who answered “yes” in the survey described in the first two paragraphs. Moreover, I have read countless articles on the pros and cons of cap and trade and I have yet to see one that explicitly looks at how the virtuous early-adopters are favourably treated under a newly implemented trading regime.