10 Ways to Trade Up

though it's not been mentioned much lately amid the sea of bailout headlines, the global economy isn't the only thing melting down right now. So are the polar ice caps. As nasa climatologist James Hansen has warned, we are nearing—if we haven't already passed—the tipping point at which the concentration of carbon in the atmosphere becomes so high that feedback loops will cause it to keep increasing on its own even if humans never emit another CO₂ molecule again. To keep the planet habitable, he says, we must cut emissions not 10, not 20, but a full 80 percent by 2050; anything short of that will lead to "global cataclysm."

Fine then. We need to fix the climate, and we need to start yesterday. President Obama plainly understands this. His environmental rhetoric has focused mainly on things like wind farms and green jobs, but the backbone of his climate policy is actually an ambitious program that, if done right, will reduce greenhouse gases and raise desperately needed revenue—and, most important of all, has a fighting chance of making it through the congressional sausage factory in one piece. If he sticks to his guns, the idea will be a household term before the year is out. It's called cap and trade, and it springs from a simple yet surprisingly hard-to-answer question: What's the best, and fastest, way to reduce pollution?

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• Q&A: James Hansen

  James Hansen, head of NASA Goddard Institute for Space Studies, on why CO2 should be declared a pollutant.

• Diet for a Warm Planet

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• How to Fix It: Get NASA Back on Mission

• Trading Up: Caps for Sale

  Can selling pollution rights save the planet?

When serious environmental regulation began in the late '60s, the default approach was "command and control," which is exactly what it sounds like. Take, for example, the Clean Air Act of 1970. It gave the government power to regulate six airborne pollutants, and the epa did this by setting firm limits on these pollutants. That's the command part. States then developed various mechanisms for meeting epa standards; one was to require companies to install "Best Available Control Technology" for reducing pollutants. That's the control part.

Command and control works: Back in the mid-'70s, Los Angeles, the smog capital of the country, suffered through 200 days per year of ozone levels above the federal standard. Today it has fewer than 100. But is there a better way? More to the point, is there a cheaper, more flexible way? Enter cap and trade, a concept that's been the go-to approach in environmental wonk circles for years.

The theory is straightforward. Suppose you have two plants, and the first one is able to eliminate one ton of pollutants at a cost of $10,000. The second plant, perhaps because it uses a different fuel or newer boiler technology, can do the same for only $4,000. Under command and control, if you required them to remove one ton each, the cost would total $14,000.

But what if all you mandated was that two tons of pollutants be removed overall (the cap part) and allowed the plants to work out how to do it? Naturally, the first plant would just pay the second plant $4,000 to remove an extra ton of pollutants from its emissions (the trade part). At first this seems suspect: The first plant is being allowed to merrily pollute away. But you've still removed two tons of pollutants, and since it was done more cheaply—for $8,000 instead of $14,000—you can afford to ratchet down the cap. You can require that three tons of pollutants be eliminated overall, and since this still costs only $12,000, everyone comes out ahead. The public gets cleaner air, and the plants save money.

Sounds great, you say, but does it work in practice? We found out in 1990, when the Clean Air Act was modified to address acid rain pollution caused by sulfur dioxide from coal-fired power plants. Instead of requiring every plant to install a specific cleanup technology or meet a specific emission rate, the epa simply set a nationwide cap on the total volume of SO₂ emissions and required power plants to own a permit for each ton of SO₂ they emitted. Each plant was allocated a certain number of permits, and if a plant reduced its emissions to the point where it didn't need all its permits, it could sell them to the highest bidder.

The results were better than anyone expected. According to figures collected by the Environmental Defense Fund, power plants regulated under the Clean Air Act didn't just meet the cap but ended up with about 20 percent lower emissions overall—at about one-third the cost estimated before the law's passage. Not all of that extra reduction was due to the trading option, but it's clear that the flexibility of the permits—and the chance to make money by selling them—motivated plants to cut emissions as much as possible, as cheaply as possible. (You can check out the emissions market for yourself, if you'd like, the same way you'd check an online broker to see how your stocks are doing. At press time, emissions-credit broker Evolution Markets listed a permit for a ton of SO₂ at about $185.)

Carbon emissions, given that they are perhaps the defining feature of our economy, are a more daunting problem than SO₂ ever was. No single proposal will solve the problem—not solar panels, wind farms, green buildings, better cars, new train lines, or new power plants. But if there's a single force that can help drive all the other innovations we need, it's putting a price on carbon emissions. That's the base on which we'll build everything else. And the way that price will be set, it now seems, is the stuff of an epic political battle that will begin this spring if Congress takes up a global warming bill. So as the rhetoric heats up, here are the 10 key things to keep in mind.

1. Price matters. Honest. The whole point of cap and trade is to raise the price of emitting carbon. If power plants have to buy a $100 permit for every ton of carbon they emit, the price of electricity will go up, and people will use less of it. Likewise, if refineries have to buy a permit for every ton of carbon their gasoline produces, the price of filling your tank goes up, and you end up driving less.

True, this effect sometimes takes a while. Gasoline prices in the United States more than doubled between 2002 and 2007, for example, and drivers barely responded. In economic lingo, the "elasticity" of gasoline consumption is low: It takes a big increase to make any kind of impact on people's driving habits. Nonetheless, it does work. Total miles driven started to flatten out in 2006 and finally dropped sharply last year, when a gallon of regular hit $4. (Interestingly, driving hasn't increased significantly since—economists blame the recession.)

What's more, price signals allow all of us to cut our carbon use in our own way, instead of being stuffed into a regulatory straitjacket. For example, driving and eating meat are both fairly carbon intensive. If the government requires everyone to cut back on their gas use and meat consumption equally, most of us will have something to be unhappy about: Maybe I really love my sirloin, and you're attached to your suv. But if instead it raises the price of carbon—an increase that will be reflected in the price of carbon-intensive goods—we'll each give up the thing we care about least simply because the cost has gone up. You might keep your Jeep and eat more tofu, while I'll keep eating steak but buy a Prius. And carbon is reduced just as much.

2. Yes, it's basically a tax. If you think that buying a $100 permit to emit a ton of carbon is pretty much the same thing as paying a tax of $100 per ton of carbon, you're right. And if you talk to economists, you'll find that most of them actually prefer a straight tax. It's simpler, more consistent, and more predictable. Dan Rosenblum of the Carbon Tax Center, which advocates a straight-up tax, calls that approach the "gold standard" and asks, "If you're going to have a tax, why not have the best possible tax?" Even some conservative economists, like Greg Mankiw, a former chairman of George W. Bush's Council of Economic Advisors, support a carbon tax as a way of more accurately capturing the true economic cost of carbon emissions.

Cap-and-trade plans have a couple of specific disadvantages over taxes. They produce economic uncertainty because permits are sold on the open market and prices vary the same way stock prices do; that's a problem for companies trying to decide which technologies are worth investing in. As Rosenblum puts it, "If you don't know where prices are going to be in two or three years, you can't invest rationally." Moreover, international trade organizations have a lot of experience harmonizing taxes and tariffs, but they haven't been very good at setting quantitative rules for how much pollution should be allowed. And since the entire world eventually needs to agree on a set of carbon pricing tools, this matters. A lot.