Carbon ranching

Externalities and market failure have been on my mind lately - partly because we just finished that unit in my intro econ class, partly because I'm a public economist and that's a good chunk of what we spend our time thinking about, and partly because I've been reading a lot about California's new greenhouse gas emissions permits which went into place yesterday.

For those unfamiliar with the term, an "externality" is a type of negative spillover from market activity onto those not involved in the market.  Think of second-hand smoke as an example of a negative externality ... if you're not a smoker but someone next to you is smoking they are inflicting a negative cost on you in the form of increased lung cancer risk and smelly clothes.   Goods and services that have these types of spillovers have the potential for what economists term "market failure" in that the market will result in too much trade of these things if it don't realize the full cost of them ... the buyers (smokers) will chose to buy an amount that corresponds to their budget and their desire to smoke.  The sellers (tobacco companies) will chose to sell an amount that corresponds to maximizing their profits.  Supply will meet demand and an equilibrium price will result - Adam Smith and Paul Ryan's version of free market efficiency.  But, the issue here is that that market equilibrium is determined by what the smokers and the tobacco company want, and it doesn't take into account the cost of the 3rd party bystander who is inhaling smoke they didn't sign up for.  This is market failure.  It can happen when the spillovers are bad (second hand smoke, pollution, someone sitting next to you in class goofing off and distracting you, etc) or when the spillovers are good (education, a new invention, someone in class asking a good question and you getting to hear the answer without having to ask, etc). 

Anyway, that's the cliff notes version.  When externalities are present, markets have the potential to fail.  To prevent or fix this failure, some form of collective action is needed so that the full scope of the costs and benefits are realized by the actors in the market.  This can sometimes be as simple as defining property rights and letting the smoker and the non-smoker bargain over how much smoking will occur with one party compensating the other for the inconvenience they inflict on the other (see: Coase Theorem).  When these agreements are difficult or impossible to reach, the next step is to use a combination of government policies such as taxes, subsidies, quotas, 'Cap & Trade' permits and the like to attempt to internalize some of the externalities. 

For example, let's say that you're a non-smoker and your friend wants to smoke while you're hanging out together. Ignore cancer for the moment (calculating that cost is a whole other blog post someday) and let's say that the cost to you is that you're going to have to pay $4 in quarters to go do a load of laundry to get the smoke smell out of your clothes.  We would say that's a $4 external cost from the smoker's behavior.  Now, if this is your friend, it might not be too hard to come to some kind of agreement here - either you say "Hey, I'll give you $4 bucks if you don't smoke so I don't have to wash my coat" or they say "Hey, I really want to smoke, what if I pay the $4 and wash your coat for you?"  (We could even have this agreement reached on the supply end - maybe the convenience store owner is also your friend and she really wants to sell cigarettes so she agrees to open up a laundromat next door and allow you non-smokers to do free laundry.)  Either way, the full cost of the behavior is realized. 

However, if this is just some guy standing next to you who looks mean and surly instead of your friend, then it might not be so easy to reach this bargain.  In this case, plan B could be to impose a $4 tax on smokers (or provide a $4 subsidy to non-smokers).  This takes the bargaining problem out of the equation and makes the government responsible for doing the collection - this often works much better for larger scale problems where it's difficult or not feasible to have the parties in the market negotiate an agreement with the 3rd parties being affected. 

Back to California.  California has a long history of concern with air quality and smog.  I was first introduced to this concept as a kid watching Price is Right with Bob Barker ... every time they gave away a car, Rod Roddy in his colorful suits would tell us that it included "California Emissions" which I always was confused by.  This was later reinforced for me in the lyrics to one of my favorite Neil Young songs, 'L.A.'  (embedded below for you to listen to while you read the rest of this ... "City in the Smog.  City in the Smog.  Don't you wish that you could be here too?")


Anyway, back to my main point here:  California is implementing a Cap & Trade pollution permit system for carbon emissions to address the market failures which are resulting in air pollution (I would like to write "Climate Change" here, but for those of you who are still holdouts on that, we'll call it air pollution so we don't delve down that rabbit hole).

This is not new - carbon permits exist in Europe and on the East Coast for power plants.  (Interestingly for the EU case, the permit market has actually virtually collapsed as a result of a prisoner's dilemma between the countries - each nation issues its own permits and as the economy has gone south there has been a flood of permits to sell for tax revenue, driving the price essentially to zero and defeating the purpose.  There are parallels to currency and national banks and there is now a call to develop a "Carbon Central Bank" which would manage the permit market in the same way the Federal Reserve manages the money supply - but this is also probably a whole other blog post topic). 

What is new about the California system is the scope it is being implemented on.  Previous attempts at carbon permitting have been primarily limited to power plants or other very large scale carbon producers.  This program (AB32), however, is targeted at a much much broader set of carbon users. 
Each would be limited in the amount of emissions they could produce by the number of permits they are able to obtain (some of which will be given away and some will be auctioned).

To me, one of the most interesting outcomes of this global carbon permitting push has been the development of a separate market for "Carbon Offsets."  Essentially, you have three options if you are a company (or government organization like a University of California campus):  (1) clean yourself up and reduce your carbon emissions (2) continue to emit carbon but obtain a permit to do so (3) purchase a "carbon offset."  

This last option fascinates me as an economist - the concept is well described by NPR here and summarized in this quote:

"The basic idea is to provide rich countries that emit lots of climate-warming gases another way to reduce their carbon footprint besides replacing or retrofitting factories and power plants. Instead, they could just pay poorer countries to keep their forests, or even expand them. Forests suck carbon out of the atmosphere. It's like paying someone to put carbon in a storehouse."

My economist models of efficiency tell me this is brilliant.  My sense of human decency, however, along with the influence of my colleagues like Tom Pearson and Nels Paulson over the last few years make me feel fairly icky about it.  (I'm really hoping they and others will wade into the comments on this post).  At least it feels a little better to be paying people to grow trees for us than it does when we pay them to take our toxic garbage (but they are still taking our toxic CO2 garbage, it just happens to be that the way to do that is grow trees). 

 This is not just being done across international borders.  It is also being done within the U.S. and within California under the name "Carbon Ranching."   Another NPR story summarizes this here. 

"So if you run a power plant in California, you might reduce your footprint by buying new, cleaner equipment. But that can be expensive.  Instead, you could help pay to protect a growing forest, because it sucks carbon dioxide out of the air. Or you could pay a farmer to capture methane from a pond of pig waste."

They continue by describing another scenario which would flood an area that had been dammed up and by doing so:

"Flooding would return the land to the way it used to be. However, that would reduce acreage for farmers and ranchers. But if they can get paid enough for the greenhouse gases they capture, it could be profitable. Local rice farmers are interested too, since they flood land to grow rice, and that could capture greenhouse gases too."

This raises any number of questions, but chief to me are these: widespread implementation of these policies may have large impacts on the food supply and food prices, much the same way that subsidizing corn ethanol has impacted corn prices.  Secondly, it seems that most of these carbon offset plans involve growing things in areas where they are not currently growing - what will this do to our water situation?  If the price of carbon offsets gets high enough, are we going to start diverting water resources to arid regions just to grow a forest there?  At what point does this become counter productive, and are opening up these options for offsets making the problem worse rather than better by limiting the incentives to simply take the plunge and modernize our factories?  I feel a bit like we are becoming the old woman who swallowed a spider to eat the fly. 

I don't know why we swallowed that fly.  I guess we'll die.