Cap and Trade (CAT) has been in the news for quite a long time now, and is big in the Climate Change domain. People have been citing this system as a solution to the externality problem of Climate Change, something I talked about in a previous post. It is also a market based solution and is lapped up by the developed world. I had alluded to it, briefly, in the last post on the Waxman Markey bill. Today, I wish to provide a primer to this concept.
I was looking for an apt analogy to present this concept for this past week until today morning! We had an Officer's Retreat of my dorm at MIT today, where all the elected/selected officials were huddled in a room trying to brainstorm about major problems for the coming year. A major concern has been the amount of paper wasted for trivial printouts,a s they are subsidized here, at the dorm's computer center and somebody proposed a cap and trade set up to reduce the number of printouts . Lo and behold, there was my analogy!:) And the sign to write my blog today! I must say, sometimes I have to believe in the concept of 'signs', the much hyped about concept in Hollywood/Bollywood but much maligned in the real world. What, aren't you convinced that this is a good enough sign!?!:P
Anyway, so back to the issue at hand. Let's take the case of papers we use for printouts. Say, and this is not that chimeric either, the incessant use of paper is causing a huge drain on the number of trees left. Things come to a point that we need to overtly preserve the trees and at the same time have enough papers for printing out the essential items. This can be done by calculating a sustainable yield of papers that we can use, without consuming too many trees that it threatens their existence. Lets say this number is 1000 pages. So, we have got to limit the number of printouts to less than or equal to 1000 pages.
Now that we know the number of pages we can possibly use, we need to find a way to distribute them among the people that need it. The market based solution, that is the Cap and Trade system, would go for an auction on the pages. So, people will bid a price and a certain number of quantity they want and the highest bidder will get his bid amount, say 100 pages, and then it will trickle down till all the allowance, i.e. pages, are sold off. There is a huge debate over the exact process of giving away the pages right now, for this will hurt a lot of people. The cost of printout, which so far used to be only the cost of the cartridge and the cost of paper, assuming an infinite flow of paper, will go up when the cost of paper goes up as a result of this auction. Not only is the cost of paper the cost of making it, but is also includes the externality of cutting down a tree, a valued resource and what monetary impact it might have on our future.
We will add a level of complexity here. If you assume that it was not an MIT dorm where only students, having similar economic statuses, live but a residential place where students and working professionals live together, you will have to agree that the cost would break the back of the students, who will not be able to afford such a high price and most necessarily need a lot of print outs. The professionals will most essentially be printing their movie schedules and their restaurants directions from google maps when the students have to solve their problem sets off the internet. A more telling situation would be if there were some students in the dorm who were sons and daughters of big oil barons in the Middle East, or their parents had deep pockets:) Wonder what that would do to the printout disparity!
Hence, the housing officials can decide to relax the rules a bit and give out free allocations to the students a minimum number of pages. This allocation would then reduce the pool of papers left to be auctioned and would raise the price for the professionals, the affluent sections, forcing them to use paper judiciously. We will play around with this analogy further to introduce all the concepts. But first, let us look at the real system to make the connection clear.
In the cap and trade system for the carbon dioxide emissions for climate change will need to start by, again, deciding the amount of CO2 we can emit that does not harm the environment beyond repair. Hence, we will need to define a sustainable rate of emissions, keeping in mind the different climate dynamics. The starting point will be deciding the atmospheric CO2 concentration at which we are comfortable. Lets say that is 450 ppm in 2100, refer to my first post for details here. From that concentration, we will have to figure out the amount of sustainable emissions each year that will keep the atmospheric concentration below 450 ppm by 2100. This is the most tricky part as a lot of climate science comes into play in this calculation between the atmospheric concentration and the amount of emissions. We shall look at some of the science later, once we are through with the economics! Afterall, economics is the more interesting part, right?:P
Once we have figured out the quantity of emissions, we could go on to auction all of them. This will raise the price of almost all commodities available, the price of your food, clothes, water, oil, housing repair etc. everything will go up since prices now includes the cost of externality of environmental damages! This will almost kill the underprivileged section of the society, who will not be able to bear the additional cost on essential items. Hence, to insulate them from this, the government can decide to give away the allocations free, something that the dorm officials did in the case of handing out papers free to the students. This is called the system of phased auction, which leads to a lot of interesting scenarios we will see in later posts!Just to point out here that EU has a Cap and Trade system in place for CO2 and they have been 'freely' allocating a major part of their allowance so far. Full auction will kick in at a later date.
We have seen the cap part of it so far, the part where the number of allocations are decided and then allocated through auctions or similar mechanisms. The second, and by far the more exciting part, is the trade part! Here, this system allows the entity to trade the allocations. So, if in the paper case, I had bought extra papers that I cannot use and somebody else is in a dire need of papers, I can trade my extra papers with him that it gives me a profit on my investment and is lower than the market price of the paper for the latter student. In the climate side, if an industry has allowances that it cannot use, it can trade them with one that needs them at a cost that is mutually beneficial.
This post can go on for another 15 pages and we will still be short of the exact nuances of a Cap and Trade system:) Hence, in the interest of time and space, I shall put this one to rest here. I hope I have been able to convey the basics of a Cap and Trade system and will pick it up from here for some other details of it.
Until then, take printouts with care. You never know when the externality kicks in:P I must say, my meagre graduate student salary will most essentially go into buying papers, if that happens!
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