The debate over whether carbon dioxide emissions can warm the earth and alter the climate goes back more than a century, when the Nobel Prize-winning Swedish scientist Svante Arrhenius first proposed his “hot-house theory” of industrial emissions in 1895. Like some still today, Arrhenius thought a little global warming would be a good thing, leading to greater agricultural productivity.
My review of the literature and interviews with scientists, researchers, and business and insurance executives has convinced me, however, that the dangers of global warming are real, and that the rhetoric of denial will not roll back rising temperatures or hold back swollen seas. I believe that failing to address these dangers will have punishing effects on our environment, economy and public health–and that we don’t have the luxury of another century, or even another decade, to debate this issue.
I believe that the solutions to global warming are primarily economic and technical. This means that solutions can be simple in our market economy–if they are well designed. Past experience shows that a properly devised environmental program can stimulate economic growth and solve environmental problems at the same time.
Following these basic premises, Senator John McCain and I drafted and introduced the Climate Stewardship Act in 2003, resubmitting it earlier this year as the Climate Stewardship and Innovation Act. We drew our inspiration from Adam Smith himself, who taught us in The Wealth of Nations (1776):
It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.
Smith was no cynic, but the most astute observer of his day of market-based economic systems. He saw that such systems were based not on utopian ideals, but on the capacity of free and competitive markets to engage human instincts to efficiently set prices and allocate resources. Similarly, our Climate Stewardship Act will provide a cleaner environment not by depending on the benevolence of the operators of power plants, factories or other industrial facilities; but by creating markets that will make emissions reductions a matter of their own interests. And that is in all of our interests, as well.
The challenge of drafting legislation to combat global warming was to find ways to introduce market mechanisms where markets did not exist. Pollution tends to occur when there are few direct consequences for the firms that produce it. For instance, industrial activities such as energy production create emissions like sulfur dioxide (SO2) and carbon gases that create huge negative costs for society at large–like acid rain or global warming, respectively–while the costs to any individual producer are negligible by comparison. Past environmental legislation–specifically, the Clean Air Act of 1970 and the Clean Air Act Amendments of 1990–provided us with clear examples of the best way to harness the market to resolve what are, in essence, market failures.
Building on the lessons of these acts, our Climate Stewardship and Innovation Act has these three key characteristics:
The bill specifies that by the end of the decade the United States will reduce emissions to the levels they were in 2000.
The bill creates a “cap and trade” system under which a nationwide greenhouse gas emissions target is set for all major sectors of the economy. Individual sources of greenhouse gas emissions–like power plants and factories–are then granted marketable emissions permits, or “allowances”, that they may use, buy, sell or save depending on whether they are over or under their emissions limit, or think they may be in the future.
The bill directs the federal government to allocate a portion of greenhouse gas emissions allowances to an independent corporation that supports research and development furthering public purposes. The corporation may sell the allowances on the open market and use the proceeds to fund new technologies. We estimate that the sale of these allowances would raise at least $1 billion annually, funds that would be used to spur innovation by shepherding new technologies through what economists call the “Valley of Death”–the early state of innovation in which good ideas not ready for commercialization often die because venture capitalists are unwilling to assume the high risk of investing in them.
Although some believe Senator McCain and I have set the bar too low in targeting 2000 emissions levels, we chose this moderate target for two reasons. First, these levels are achievable and affordable given present technology; and second, a reasonable target improves the chances of getting the “cap and trade” architecture firmly in place. Once up and running, public and private participants can build upon this architecture to further advance the climate change agenda.
Indeed, the core component of the Climate Stewardship and Innovation Act is the “cap and trade” concept. I believe that this model is essential to a prompt spurring of investment in climate-friendly technologies. A quick review of the Clean Air Act of 1970 and the Clean Air Act Amendments of 1990 shows why.
Lessons of the Clean Air Act
The Clean Air Act of 1970 demonstrates the futility of “command and control” remedies for market failures such as unchecked greenhouse gas emissions. Such remedies are understandably tempting because they make intuitive sense to most people: If businesses are polluting, then just make them stop it. Congress tried this approach in the original Clear Air Act (and again in the first Clean Air Act Amendments of 1977), and found that it yielded mixed results–in some cases it even made the problem worse.
For example, the Act inadvertently created economic incentives to keep older, higher polluting electrical generating facilities in use because they were “grandfathered” out of the new requirements. Policymakers had assumed they would be retired in the near future, but since the legislation rendered them cheap alternatives, they kept operating–and polluting.
The 1970 legislation also required states to design plans to meet new air quality standards. Many states chose to mandate taller smoke stacks. That may have lowered pollution locally, but pollutants were consequently spewed higher into the atmosphere and over a larger area, which created more acid rain.
Another flaw of the original Clean Air Act was that it regulated the equipment doing the polluting, restricting the rate of emissions discharge but not total emissions. As long as a firm’s equipment met the operational requirements, it was not held responsible for surpassing emissions targets. In effect, even though the Act was a noble and much needed effort at the time, Congress and the Environmental Protection Agency (EPA) increased the burden of regulation on businesses without achieving the result that mattered–reducing pollution.
By contrast, in the 1990 amendments to the Clear Air Act, President George H.W. Bush and we in Congress together created a simpler, market-friendly formula to limit the SO2 emissions that cause acid rain. The cap and trade system was designed to reduce directly the levels of acid rain in the environment, while simultaneously easing the regulatory burden on firms. It was clear to all of us that acid rain was not only poisoning forests and rivers–and the wildlife they sustain–but was eating away at bridges, roads, buildings, crops, cropland and other physical capital and infrastructure upon which the economy depends. All these consequences had costs that Americans had to pay in higher taxes, higher insurance costs and higher prices.
The 1990 amendments placed a national cap on sulfur dioxide emissions–just as our Climate Stewardship Act proposes to do with greenhouse gas emissions. Within that total SO2 cap, electric utilities were allocated a permitted number of emissions “allowances”, or tons of pollution. A power plant that reduced its emissions below its limit could bank its unused allowances for future use, or sell them to a power plant for which it was cheaper to purchase extra allowances than to meet its target. The beauty of this system was that it encouraged businesses that could most easily reduce emissions to do so–and at a profit–while those that could not afford to do so immediately could choose the more affordable option of purchasing emissions credits.
No matter how many or how few allowances are transferred among private entities, total SO2 emissions always remain at or below the national cap. This has been guaranteed by imposing two automatic penalties on plants whose total annual emissions exceed their number of allowances: payment of a hefty fine that is more expensive than the cost of cutting pollution, and a deduction from the number of allowances they receive for the year immediately following the violation. Since these penalties render it senseless for plants to exceed their allowances, they do not.
Congress consciously played to this economic logic in designing the 1990 amendments. During the debate that led to the legislation, Congress rejected all “quick fixes” and easy exit ramps off the compliance highway. It did not, for instance, set a price ceiling, which would have allowed producers to increase their emissions if compliance costs rose above a specified level. Congress also rejected adding a growth cap, which would let producers increase emissions if they adopted certain technologies or met certain emissions rate standards. There could be no assured national cap if either of these exceptions had been instituted.
Because it was clear in the design of the 1990 amendments that there would be no escape from the emissions cap, firms immediately began investing in ways to comply in the near and long term. As they did so, they unleashed an intense competition to achieve compliance at the lowest possible cost. And this competition did succeed in creating innovations that drove down compliance costs. Proof of the success of the market lies in the current cost of SO2 reductions, as reflected indirectly in the price of traded emissions allowances: It has remained far below the cost predicted during the initial debates on the program. And despite fears that “cap and trade” would cripple the electricity sector, that sector has grown steadily; even coal-generated power production–the source of most SO2 emissions–has grown more than 10 percent.
Congress’ gamble that the market and the market alone would create the path to a low-cost, effective program was clearly vindicated. For the past ten years, the acid rain program has yielded impressive environmental results. While flawlessly complying with the amendments’ requirements during Phase I–1995 to 1999–power plants reduced SO2 emissions 22 percent more than the allowances allotted them by Congress. That amount was equal to 7.3 million tons of extra emissions reductions. The extra reductions represented a concrete economic asset for businesses and industry because of the saving and trading provisions of the allowance program. These “early” reductions were economically valuable because producers could use them to cover emissions increases in future years as electricity generation grew. At the same time, these reductions were economical, endowing producers with “banks” of low-cost compliance options. The presence of these low-cost banks was key to the market’s cost-cutting power. All other compliance options had to compete against the low-cost compliance banks in order to participate in the compliance market.
In 2000, the program entered its second phase as the cap level was lowered. According to the annual compliance reports of the EPA’s Clean Air Markets Division, all affected energy producers continued their perfect compliance record, even with the tighter emissions cap. The market continued to keep allowance prices and overall costs lower than predicted–thanks mainly to the use of saved-up allowances from previous years. But even with the use of saved allowance credits, cumulative emissions remained below required levels overall.
The genius of the acid rain program is its simplicity. The program replaces the regulator with the individual polluter as the pivotal decision-maker in how to comply with the emissions limitations. Polluters are legally responsible for achieving a specified level of emissions reductions, and for little else other than monitoring and reporting their emissions. Such minimal regulatory interference enables firms to pursue the strategies best suited to their own operations.
Adapting Cap and Trade
Given the record of the 1970 Clean Air Act and the 1990 amendments’ acid rain program, it was clear to Senator McCain and me that the best policy tool for our climate change legislation was a cap and trade strategy. Still, getting the design right for the Climate Stewardship and Innovation Act required taking into account a host of concerns specific to the unusually daunting challenges of global warming. Greenhouse gases are the by-product of virtually every fundamental, resource-based economic activity in both industrialized and developing societies. So in drafting our legislation we asked ourselves: What are the key tests that a sound, market-based solution for such a broadly sourced problem must pass? We discerned three such tests.
First, of course, we wanted to achieve a credible level of greenhouse gas emissions reductions in the short term. A policy solution that does not begin to make a measurable difference cannot claim to be serious. But to be sustainable, the direct costs of reducing greenhouse gas emissions must be reasonably affordable to the economy–or the legislation will not pass. To achieve affordability, the emissions control market must be both deep and robust, with very strong market participation to be both efficient and cost-effective.
Second, we wanted our legislation to establish a governing framework that would endure well into the future. Our belief is that giving businesses long-term certainty about the program is almost as important as achieving real emissions reductions in the short term. That framework must be as close to seamless as possible so that affected private economic actors can integrate compliance into the overall conduct of their business. At the same time, the level of regulatory intrusion and market distortion must be minimized as far as possible. The program’s framework must also establish an architectural foundation that policymakers can build upon with future legislation as they learn more about the science of climate change and the economics of achieving emissions reductions.
Third, the current scientific consensus strongly suggests that the world not only will have to curb the near-term growth of greenhouse gas emissions, but also, over time, achieve major reductions. As a result, greenhouse gas policies must address the perennial problem of private-sector underinvestment in innovation. We wanted to design legislation that encouraged substantial–even breakthrough–technological development and innovation.
Our bill, unlike other recent proposals, passes all three of these tests. Taking a moment to examine the differences between our legislation and other proposals will show clearly why the Climate Stewardship and Innovation Act would create by far the most effective policy to address global warming.
Some in the policy community, including the National Commission on Energy Policy (NCEP), believe that the best way to minimize costs is to put an outright limit on the cost of compliance by allowing emitters to pay an “escape” fee if the incremental cost of reductions exceeds a certain level. As the acid rain program illustrated, however, one of the keys to achieving cost-savings and flexibility for firms was the willingness of businesses and investors to make low-cost reductions early–literally before they were needed–and save them for future use. The driving force behind that behavior was the knowledge that the cap on acid rain emissions was fixed; there was no getting around it. While it may sound counterintuitive, insisting on emissions reductions fueled the investment and creative responses by firms that ultimately held down their costs.
A program such as the NCEP’s that allows sources to “pay their way out” of making reductions would inevitably reduce incentives to invest early in a supply of low-cost reductions, and instead encourage firms to rely on a future cost cap. In the absence of this investment, the market and the attendant cost-reducing dynamic would be far slower in forming. A program with a cost cap, or any form of “safety valve”, would most likely be more expensive than an emissions trading market free of what would amount to regulatory price distortions.
Since greenhouse gases are largely the by-product of energy use and production, others propose to place regulatory limits directly on fossil fuel producers and distributors–for example, on coal mines and natural gas pipelines. One of my Senate colleagues circulated a draft proposal with this feature.
I looked carefully at this idea and concluded that it is deeply flawed. It is essential that as many different economic actors as possible be encouraged to devise low-cost reductions and technological innovations. Leaving the job just to the relatively small number of fuel producers undercuts this imperative. Investors in technologies that can limit direct emissions of greenhouse gases–which is where an enormous range of cost-saving and innovation opportunity lies–would have no chance to participate in a system in which only fuel itself (as opposed to the emissions generated by that fuel) was the point of market regulation.
Still others, such as Resources for the Future, propose discarding emissions limits altogether and simply imposing an energy or greenhouse gas emissions tax on industry. I reject this approach. What makes a market is not just a price signal but genuine competition. Although a tax might be effective in spurring investment in greenhouse gas reduction strategies–depending on the level at which it was set–only the element of emissions trading pits different technologies for reducing emissions in an intense, cost-saving competition with one another. We need a market where producers can shop for reduction options for their own operations, or for allowances from firms who can more cheaply reduce emissions themselves. In the absence of this competition, cost savings and the drive for innovation are unlikely to achieve their full measure.
Beyond the technical issues, political obstacles would be much greater for a tax-based proposal. Taxes are more likely to encounter either wholesale rejection or political tinkering to an extent that severs any real connection between the tax levels set and the reductions needed. Even if adopted, taxes would be relentlessly subject to opposing constituencies, whereas a cap and trade market spawns investors and asset holders who can quickly claim a stake in the system and support its survival.
Finally, others believe that the key to a successful climate policy is stand-alone technology development, and thus argue that policy should focus exclusively on incentives or subsidies for new technologies. In June, the Senate passed an amendment to the energy bill that purports to do just that, as does a proposed Asia-Pacific climate agreement that would include the United States, Australia, China, Japan and India as signatories.
Surely, technology is the key to any long-range solution to global warming. But without a cap and trade system, no true market will arise to spur new technology creation. Technological innovation demands a portfolio of policies that will drive market demand for it. Our bill includes a comprehensive program for supporting both the development and deployment of new technologies that radically reduce or eliminate greenhouse gas emissions. An emissions trading cap will drive these innovations to market because it creates the demand and the trading mechanism, which in turn will ensure the high-intensity competition that will propel the best innovations forward. At the same time, our technology funding program helps nurture new technologies through the “Valley of Death”, helping to bring them closer to the point where private-sector investment is more readily available.
We have structured our program so that it fosters the widest range of potential technological innovation and directs funding at three critical phases of innovation: prototype engineering of new designs; construction of demonstration facilities; and the commercialization of new technologies, products and services. At the same time, subsidized innovators under our program must compete for funds against each other and against a set of environmental and economic criteria.
The U.S. Role in an International Effort
The rest of the world, fortunately, has learned the same lessons we did about the success of the U.S. acid rain program. As a result, the design of the Kyoto Protocol–which entered into force earlier this year–and of the European Union’s greenhouse gas emissions reduction policy are both explicitly modeled on the U.S. acid rain program. Emissions allowances are allocated to emitters and reduction requirements are imposed on them directly. Neither the international treaty nor the EU policy includes cost caps or other “safety valves.”
When the United States finally adopts its own greenhouse gas reduction policy, it is essential that it be able to integrate seamlessly with the emerging worldwide emissions trading market. Our proposal is the only one that has been designed with our multinational business community in mind, so that American businesses will easily be able to mesh their environmental obligations with those of the rest of the world. Our legislation permits U.S. producers to count emissions reductions achieved overseas in their overall reduction targets. Equally important, this link with overseas reduction would bring the U.S. economy into the global market for innovative solutions for reducing emissions.
On July 8, 2005, President George W. Bush finally acknowledged the scientific consensus that climate change is man-made and signed the Gleneagles Communiqué, which the seven other leaders of the G-8 industrialized nations also signed. Citing the threat of global climate change, the Communiqué declared, “We know enough to act now and to put ourselves on a path to slow and . . . stop and then reverse the growth of greenhouse gases.” Accompanying the Gleneagles Communiqué was a detailed Plan of Action aimed at promoting greenhouse gas reductions as well as investments in clean energy technologies. The Plan of Action cited a variety of existing international institutions that would be used as forums for achieving these objectives.
Although the Gleneagles Communiqué and Plan of Action are not binding, President Bush’s willingness to endorse them may signal a shift in the U.S. debate on climate policy from “whether” to take action to “when” and “how.” Less than three weeks before the Gleneagles Summit, the U.S. Senate began to answer that question when, during debate on an omnibus energy policy bill, it adopted a resolution calling for the enactment of a mandatory, market-based program to slow, stop and reverse the emissions of greenhouse gases.
However promising the Communiqué, the Plan of Action and the Senate resolution may be, business leaders and legislators still have the hard work of defining the policies that will give meaning to the oft-repeated mantras of “clean energy technology” and “market-based programs.” I have enumerated the critical objectives of our climate strategy–preserving prosperity, creating technological breakthroughs, ensuring a seamless and flexible regulatory environment for business–objectives that are easy to reach provided that our society’s vast ingenuity and resources come together in an ensemble effort.
History has shown that no better instrument exists for orchestrating such a complex effort than a well-designed market. Policymakers must go beyond rhetoric and do the real work of ensuring that programs are designed carefully and precisely so that the allocative, organizational power of markets can be unleashed. This legislation represents our own best effort to do just that. Adam Smith’s wisdom–this time from his Theory of Moral Sentiments (1759)–again shows why:
The man of system . . . seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chessboard. He does not consider . . . that, in the great chess-board of human society, every single piece has a principle of motion of its own, altogether different from that which the legislature might choose to impress upon it.
These insights guided Senator McCain and me as we drafted the Climate Stewardship and Innovation Act. Rather than trying to dictate the moves of individual pieces across the national or global chessboard, we are establishing a simple set of rules so that all the actors can choose for themselves how best to play the game–a game we can all win.