Analysis & Opinions - Vox

Why Cap-and-Trade Should (and Does) Have Appeal to Politicians

| April 13, 2010

Are cap-and-trade schemes working? This column presents a summary of eight existing schemes arguing that half meet the independence property whereby the initial allocation of property rights does not affect the environmental or social outcome and the scheme is cost-effective. This success is a contrast with other policy proposals where political bargaining reduces the effectiveness and drives up cost.

Economists have long recognised that both price and quantity mechanisms, such as emissions taxes and cap-and-trades systems, can be cost-effective ways of improving environmental quality (Pigou 1920 and Dales 1968). The politics of the two approaches is a different matter.

The political appeal of cap-and-trade can be explained, in part, by the fact that politicians can fiddle with the initial distribution of property rights (the permits or allowances) without affecting the final equilibrium (in the sense of not affecting the environmental performance or aggregate cost). Furthermore, under certain conditions, the final equilibrium will represent a least cost solution to the problem of achieving a given environmental target (Montgomery 1972) — something that may surely be desirable from the standpoint of allocating resources more efficiently. The Montgomery result is closely related to an idea presented in Coase (1960), where he shows that under certain conditions, the initial distribution of property rights between the generator or recipient of an externality does not matter for achieving an efficient result.

Because of its potential political importance, we have decided to examine a version of what we call the "independence property" for cap-and-trade (Hahn and Stavins 2010). A cap-and-trade system is said to satisfy the independence property if the final equilibrium is both cost-effective and does not vary with the initial distribution of allowances (i.e., property rights).

Theory: What can go wrong, in principle

Markets don't always work perfectly and environmental markets are no exception. We investigated a number of ways in which these markets might violate the independence property. One obvious way is if a firm or group of firms had market power in the allowance market. A related way is if a firm had market power in both a product market and the allowance market. In such cases, the initial distribution of allowances will frequently affect the final distribution of allowances in the allowance market, and the cost-effective allocation of allowances may not be achieved. A dominant firm or group of firms may find it in their interest to offer too few or too many allowances for sale in the allowance market (relative to the cost minimising solution), depending on their initial allocation (Hahn 1984).

The independence property also may be violated when there are transaction costs associated with trading. Such costs can arise from bargaining, monitoring and enforcement, and search. Stavins (1995) shows that when marginal transaction costs are not constant, this can lead to a violation of the independence property.
Another factor that can affect the final distribution of allowances is uncertainty. In particular, uncertainty regarding future allowance prices can lead to violation of the independence property under two conditions: risk aversion on the part of regulated firms, and limits to transferability of allowances (transaction costs). The consequences are that firms with small initial allocations would be expected to tend to over-invest in abatement technology in order to hedge against possible high future allowance prices, and firms with large initial allocations would tend to under-invest in abatement technology in order to hedge against possible low future allowance prices (Badlursson and von dehr Fehr 2004).

If firms are not cost minimisers, then the final allocation of allowances can be tied to the initial allocation of allowances. There are a variety of potential sources of such non-cost-minimising behaviour. An interesting case is that of government-to-government trading. The international emissions quota regime established under Article 17 of the Kyoto Protocol allows trades in national targets ("assigned amounts") among nations. There is no reason to assume that nations are simple cost-minimisers, or even if they sought to be, that they would have the necessary information regarding their national abatement costs to carry out cost-effective international exchanges.

Behavioural economics provides several potential explanations for other sorts of non-cost-minimising behaviour. For example, the endowment effect describes situations in which firms or individuals "overvalue" items already in their possession (Thaler 1980 and Kahneman et al. 1990). If the firms granted emissions allowances tend to value them more highly than other firms simply because they happen to hold them, then fewer transactions will occur than would otherwise be predicted by market forces. If firms initially endowed with permits tend not to sell them, independence will not hold.

The way regulators treat different allowance trades will also affect the market. If firms receive different regulatory treatment, then initial allocations of allowances can affect equilibrium allocations, performance, and cost. State-level regulation of electricity producers, such as rate-of-return regulation, can discourage or even prevent firms from cost-minimising with respect to emissions (Hahn and Noll 1983 and Oates and Strassman 1984). In addition, regulators may discourage trading, due to concerns about local pollution (Fullerton et al. 1997). Finally, if a cap-and-trade system is interstate, then jurisdictions may be regulated differently. In all of these cases, the equilibrium allocation will not be independent of the initial allocation, and the outcome will not be cost-effective.

The real world: Things actually look pretty good

Market imperfections are present in most real-world markets. For example, in most markets, there are transactions costs in bringing buyers and sellers together. The question is whether these market imperfections turn out to be important in terms of leading to significant violations of the independence property. We have examined eight past and present cap-and-trade systems.

We have reviewed both indirect (circumstantial) evidence regarding the presence and importance of various factors in past and present cap-and-trade systems, as well as direct (statistical) evidence of the violation of the independence property in these systems. Looking at eight past and present cap-and-trade systems (Table 1), we find that support for the independence property is strong in half of the systems, and moderate in two others.


The independence property is of great relevance to the practical development of policy, because it allows equity and efficiency concerns to be separated. In particular, a government can set an overall cap of pollutant emissions (that is, a pollution-reduction goal), and leave it up to a legislature to construct a constituency in support of the program by allocating shares of the allowances to various interests, such as sectors and geographic regions, without affecting either the environmental performance of the system or its aggregate social costs.

Because of the importance of this property, we considered the conditions under which it is more or less likely to hold — both in theory and in practice. We find that in theory, a number of factors can lead to the independence property being violated. These are: particular types of transaction costs in cap-and-trade markets; significant market power in the allowance market; uncertainty regarding the future price of allowances; non-cost-minimising behaviour by firms; and specific kinds of regulatory treatment of participants in a cap-and-trade market.

Of course, the fact that these factors can lead to violation of the independence property does not mean that in practice they do so in quantitatively significant ways. We find that, in practice, there is support for the independence property in some, but not all cap-and-trade applications.

The fact that the independence property is broadly validated provides support for the efficacy of past political judgments regarding constituency-building through legislatures' allowance allocations in cap-and-trade systems. Repeatedly, governments have set the overall emissions cap and then left it up to the political process to allocate the available number of allowances among sources to build support for an initiative without reducing the system's environmental performance or driving up its cost. This success with environmental cap-and-trade systems should be contrasted with many other public policy proposals for which the normal course of events is that the political bargaining that is necessary to develop support reduces the effectiveness of the policy or drives up its overall costs.


For more information on this publication: Please contact Harvard Project on Climate Agreements
For Academic Citation: Hahn, Robert W. and Robert N. Stavins.“Why Cap-and-Trade Should (and Does) Have Appeal to Politicians.” Vox, April 13, 2010.

The Authors

Robert N. Stavins