Cap-and-Trade's Market Failure

Cap and trade died even before Congress shelved legislation...for now. News of the death of cap and trade last month didn't appear in the obituary section of daily newspapers. Instead, it appeared on page C1 of the July 12 edition of The Wall Street Journal in an article titled "Changes Choke Cap-and-Trade Market."

The Journal reported that the cap-and-trade market for sulfur dioxide (SO2) emissions in the United States, created in 1995 in response to what was thought to be the connection between SO2 emissions and acid rain, had "collapsed" in spectacular fashion.

Changes in EPA guidelines -- caused by court rulings -- rendered current SO2 emission allowances useless. Allowances that once traded for as much as $1,600 per ton were trading at less than $3, and traders predicted that they would go to zero shortly.

Spokespersons for environmental advocacy groups pushing for a cap-and-trade program for carbon dioxide (CO2) claim that the failure holds no lessons for their proposal, but they could hardly be more wrong. The SO2 market arose from concerns remarkably similar to those behind the push for CO2 markets, and the mistakes leading to the collapse of the existing market portend disaster for the one on the drawing board.

The market for SO2 emission allowances was created to address widespread concern that SO2 emissions from power plants were causing acid rain, which in turn was acidifying lakes and damaging forests. That connection, though heavily hyped by environmental groups and the media and still regarded as an article of faith in both circles, was never scientifically proven. Shortly before the cap-and-trade legislation was enacted, a massive research project called the National Acid Precipitation Assessment Program found that most of the damages attributed to acid rain were in fact due to logging and natural processes. But it was too late: Congress didn't want to be confused by the facts.

The parallel to global warming couldn't be clearer. Congress is taking up cap-and-trade legislation for CO2 emissions even as the scientific community backs away from the sensational claims by Al Gore, James Hansen, and the like. Even one-time leaders of the alarmist side of the global warming debate, such as Phil Jones, now admit that the warming of the 20th century was not unusual or evidence of a human impact on climate. Estimates of the effects of "man-made global warming" on sea levels, wildlife, and weather have all been called into question or scaled back dramatically in recent years.

The SO2 trading program had a fatal flaw that only a few astute observers (such as economist Jim Johnston, at the time working for Amoco and now retired) commented on at the time: It did not give emission allowance the legal status of private property. This meant the government could change the rules of the game without fear of being sued by businesses and investors whose allowances became worthless. Predictably, government officials couldn't keep their hands off the program, and their meddling with the rules since 2005 destroyed the system.

Johnston further predicted that the failure to give property rights status to emission allowances would discourage businesses from buying the allowances, causing the market to be too thin to have much effect on emissions. He was right again: The volume of trading never approached that of successful "real" markets. This remains a strange blind spot for many reporters: An illustration in the July 12 Wall Street Journal article, for example, shows the collapse in SO2 prices and refers to "the once-robust market in sulfur-dioxide allowances." But high prices don't reveal whether a market is "robust." Volume does.

If the SO2 trading program wasn't responsible for making major reductions in emissions affordable, what was? An obvious candidate is the coming-to-market of low-sulfur coal from new mines in Western states, the legacy of environmental policies crafted and huge investments made during the Carter administration.

Could substituting low-sulfur coal from the West for high-sulfur coal from the East and Midwest all by itself account for the lower-than-expected cost of reducing emissions? Jim Johnston, in his retirement, took up the challenge of proving this point in a clever way: by demonstrating that changes in the price of SO2 allowances prior to 2005 closely tracked the price of natural gas.

During periods of peak demand and output, many utilities face the choice of increasing generation from their coal-powered plants, thereby increasing emissions and necessitating the purchase of additional emissions allowances, or buying power from other utilities that generally use natural gas for deliver peak-load capacity. Natural gas futures and options are therefore a substitute for emission allowances, and the prices of the former will dictate the price of the latter.

If most emissions allowances were being traded to reward firms with the lowest cost of reducing emissions, the correlation between allowance and natural gas prices would be weak or nonexistent. Johnston's data showed that traffic on the market was occurring for an entirely unrelated reason: to allow utilities to hedge against volatile natural gas prices.

Once again, the relevance for plans for CO2 trading is obvious. The SO2 market was not "highly successful" or "robust," as is so often reported. In fact, it was too thin to have had anything to do with the cost of reducing emissions. This means a CO2 market without property rights cannot be counted on to reduce the cost of lowering CO2 emissions, either.

The latest proposals for CO2 trading deny property rights status to the emission allowances. Does anyone believe politicians will keep their hands of a CO2 cap-and-trade system and allow the market to work? Do you want to buy a bridge in Phoenix?

The death of SO2 cap-and-trade in July 2010 should be duly noted by every thoughtful observer. It should signal the defeat of any proposals for CO2 emissions trading. If a CO2 cap-and-trade program were ever enacted in the U.S., its collapse would be spectacular indeed compared to the one that will have foreshadowed it.

Joseph Bast (jbast@heartland.org) is president of The Heartland Institute, a nonprofit research and education organization based in Chicago.