Environmental Capitalism: The Power of Cap and Trade

Seton Hall University
UNIVERSITY HONORS PROGRAM

Thesis Advisor: Dr. Peter G. Ahr, Ph.D.
ENVIRONMENTAL CAPITALISM
THE COST-EFFECTIVENESS AND PRODUCTIVITY OF CAP AND TRADE
BRANDON L. CAROPRESE
2010
Environmental Capitalism B. Caroprese
Table of Contents:
 Introduction
 Scientific Case for Environmental Change
 Factors in Arriving at the Instrument of Choice
 Current Environmental Policy Analysis
 The Opposition to Climate Change
 Taxation: A Necessary Comparison
 Cost-Effectiveness and Productivity
 Capital Investment Decision Factors
 Conclusion
 Annotated Bibliography
A special thanks to Dr. Ahr and the Honors Program
for providing me with an excellent education, and also to Colin, Sean,
Dominick and James for their help in making this a success.
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Introduction
The mal-distribution of wealth around the world, the plight of millions of people in
developing countries and the inescapable greed of self-interested businessmen each contribute to
questioning the virtue of capitalism in society today. It is true that capitalism has been traced to
crimes against innocent laborers and struggles between social classes; however, there have been
many instances in which capitalism has been highly beneficial. The intellectual and economic
development of Eastern Germany after the fall of the Berlin Wall and the rapid economic growth
of modern Italy after World War II are two illustrative examples of the potential benefit that
comes about from free-markets. Despite the disappointments of capitalism‟s rapacious history,
it is difficult to envision a society which is not consumed by greed. It can even be argued that
Russian commissaries were motivated by covetousness. The truth is that the world runs on
individuals pursuing their self-interests. The greatest achievements in this world did not come as
a result of bureaucracy or government order. Thomas Edison was not instructed in the
development of the light bulb and Albert Einstein was not directed in the advancement of his
mathematical models. Henry Ford did not become one of the greatest proponents of mass-
production under order from government officials. On the other hand, the worst cases of severe
poverty and restricted human rights are in those societies which depart from capitalism and the
vast economic power of free-trade. The productivity and development which is unleashed by a
strong democracy and a capitalist economy can quickly limit the threat of humanity‟s most
critical problems.
Throughout the last two centuries, economic development and the industrialization of
society have caused an astounding increase in the quality of life around the globe. Property
rights and the right to choose, which in the past were freedoms only the aristocracy enjoyed, are
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now privileges many members of developed and developing countries take for granted. This
period of wealth accumulation and economic development faces a frighteningly imminent risk
which threatens the lives of future generations. Increases in industrial output are responsible for
many of the profits that brought progress to society. Unfortunately, the drastic increase in
industrial production augmented the combustion of fossil fuels and the subsequent emission of
deleterious gases. The emission of manmade greenhouse gases has slowly developed into a
severe threat to human life. This threat effects all global populations and has made it crucial for
innovators to use the power of free-enterprise in pioneering ventures to save this planet.
Large amounts of anthropogenic gases have been dispersed into the air by burgeoning
businesses and have been naturally absorbed by the atmosphere. These processes have caused an
increase in heat in the Earth‟s atmosphere, melting parts of major ice masses and causing violent
climate events to occur more frequently. The high productivity of industrial development
created this situation in which current atmospheric levels of carbon dioxide significantly exceed
naturally sustainable levels. A change in human‟s perception of the environment is a necessary
change global businesses must acknowledge to offset the upward trajectory of carbon dioxide
emissions. Offsetting dangerous emissions requires innovative changes for many different
sectors of the globalized world. Businesses will need to reengineer operational processes and
consumers will need to rethink normal day-to-day purchases. Various alternatives and systems
to redirect the global emission trends have been proposed throughout the last twenty years and
some parts of the world have already begun the process of emissions abatement through cap and
trade programs or the taxation of emissions. As the abatement process continues and
environmental reform advances, the innovators of the business world will be asked to redevelop
production processes, just as Ford did, toward the goal of sustainability. Companies will need to
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calculate environmental footprint and account for new regulations. While most businesses view
large-scale attempts at reducing emissions of anthropogenic gases as too costly on their
operations, cap and trade and its ability to promote innovation and investment is a highly cost-
effective and productively efficient solution for today‟s globalized economy.
The new millennium can be characterized by extensive political and economic interaction
among many nations. Climate change and its broad impact requires meticulous coordination of
international interests. The case for environmental policy reform shares an interesting fact with
many other cases for change which often delays action: change rarely appeals to the majority.
Even though it seems as though we are trending toward catastrophe, people still oppose the very
thought of environmental reform. The natural human tendency to oppose change makes
scientific evidence crucial to any argument supporting climate change. Reducing anthropogenic
gases from the Earth‟s atmosphere may be viewed with less apprehension once policy makers
scientifically arrive at convincing evidence for change.
Scientific Case for Environmental Change

Earth‟s climate is affected by various factors, the most important of which are the sun and
the moon. In addition, other factors such as greenhouse gases in Earth‟s atmosphere have
dramatic long-term effects on Earth‟s global temperatures. Many greenhouse gases exist in
Earth‟s atmosphere including carbon dioxide (CO2), nitrous oxide, methane, sulfur hexafluoride,
hydro-fluorocarbons and per-fluorocarbons1. During Earth‟s natural carbon cycle, carbon
dioxide is transferred throughout the biosphere, atmosphere, and hydrosphere and is also stored
underground. An example of this process is photosynthesis, a process by which carbon dioxide
is converted to oxygen by trees and released into the atmosphere (Field, 3).
1
Intergovernmental Panel on Climate Change
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The belief that greenhouse gas emissions interfere with Earth‟s natural cycle is not a
revolutionary thought. Arrhenius announced in 1896 that the combustion of fossil fuels and
continued emissions of carbon dioxide into the air would lead to a warmer planet (Field, 1).
Many climate models and studies of past trends have formidably supported his fundamental
hypothesis. Since Arrhenius‟ conclusion on the climate, scientists continue to develop his
argument, and the powerful stream of emissions from global business continues to confirm his
theory.
While the natural process of carbon conversion and storage warms the Earth, greenhouse
gases emitted into the atmosphere from human activity have significantly outpaced this natural
warming. The increase in greenhouse gases is directly related to the increase in the adverse
consequences of the greenhouse effect—the artificial warming of the Earth‟s surface.
Greenhouse gases have a powerful effect on Earth‟s temperatures through the planet‟s absorption
of the gases and subsequent emission of infrared radiation (Field, 3). In the Arctic specifically,
the absorption of gases has caused glaciers to melt, thereby threatening countless species of
wildlife. In an article “Arctic to be Ice Free in summer in 20 Years”, Peter Griffiths of Thomson
Reuters presents the point of view of Dr. Peter Wadhams, professor of ocean physics at the
University of Cambridge. Dr. Wadhams argues that substantial melting will take place before
2020 even though some winter ice will remain for hundreds of years. The article also cites the
interesting work of a British explorer, Hadow, whose team determined that the average ice
thickness is 1.8 meters by drilling 1,500 holes in ice glaciers. The scientists hypothesize that this
degree of ice thickness is too thin to sustain summer heat and continued infrared emissions
(Griffith). If the ice melts and dark sea water is exposed, the dark water will absorb more heat
and accelerate the melting process. The Arctic glaciers have a critical role in Earth‟s climate
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system; removing these masses from the climate equation would make Earth a much warmer
place. Glacial melting threatens not only Arctic ecosystems, but also coastal areas far removed
from the Arctic (Keohane, 54). Areas below or near sea level may face the catastrophic
consequences of sea level rise.
Warming at the Earth‟s poles is not sufficient for many businesses to begin changes
because the majority of them occupy inland areas that are miles away from the coast. For
example, energy plants in the central U.S. would not experience direct impact from rising sea
levels. However, climate change poses significant risks to citizens all around the globe, no
matter how far removed from a coastline. When Earth experiences significant warming, coastal
cities are more vulnerable to flooding and devastation which have undesirable economic
spillovers. In the article “Climate Science in 2009” published by Nature Reports: Climate
Change, author Kurt Kleiner reports on research conducted at the University of Washington on
Antarctica‟s warming trends:
In January, climatologist Eric Steig of the University of Washington in Seattle and
colleagues reported that warming was widespread across the continent [Antarctic
continent]. Using satellite measurements and historical weather station data to interpolate
Antarctic temperatures over the last 50 years, they found that the average temperature in
West Antarctica had increased 0.1°C per year.
Additional research conducted by the British Antarctic Survey supports these findings. One
study on an ice core take from the southwestern Antarctic Peninsula revealed warming of 2.7°C
over the last 50 years.
A 2009 Oxford report put the economic impact of global warming into dollar terms. The
report notes that with another 4°C of warming, “we could look forward to the destruction of
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US$1 trillion worth of gross domestic product and the displacement of 146 million people if sea-
levels rise, as well as starvation, disease, fire and flooding” (Kleiner). Eliminating US$1 trillion
would certainly cause inland businesses to reconsider the externalities of emissions.
Since the Industrial Revolution, human activity such as burning oil, coal, and gas, as well
as deforestation and motorized transportation has caused CO2 levels to drastically increase. In
2005, global CO2 levels were 35% higher than before the Industrial Revolution2. According to
the National Oceanic and Atmospheric Administration (NOAA)3, carbon dioxide concentrations
increased from approximately 280 parts per million (ppm) prior to the Industrial Age to 385 ppm
in 2006. In fact, according to the EPA‟s website on greenhouse gas emissions, carbon dioxide
emissions have increased by 20% from 1990 to 2004. The following regression analysis helps to
illustrate the abnormal CO2 concentrations in the Earth‟s atmosphere following the Industrial
Revolution:
2
Environmental Protection Agency. http://www.epa.gov/climatechange/science/recentac.html. 11/3/2009.
3
National Organization of Atmospheric Administration. http://www.esrl.noaa.gov/gmd/aggi/. 11/03/2009.
4
Graph supplied by the Environmental Protection Agency.
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As the graphs clearly demonstrate, CO2 concentrations have exponentially increased during the
modern era. Records of Earth‟s CO2 concentrations demonstrate that the sharp spike in CO2
levels coincides with the beginning of the Industrial Revolution. Forecasts show that by the end
of this century, the mean global temperature is likely to rise between three and five degrees
Celsius above pre-industrial levels if emissions are not curbed (Keohane, 54).
This drastic rise in emissions can eventually cause serious damage to the Earth; yet, this
disquieting data still has not triggered explicit action. In a recent New York Times article Paul
Krugman wrote, “climate scientists have, en masse, become Cassandras—gifted with the ability
to prophesy future disaster, but cursed with the inability to get anyone to believe them”5. Change
is never easily accepted by the public, however recent catastrophic disasters represent the need to
act. Throughout the past few decades, calamitous storms have caused severe damage throughout
the world and are becoming more frequent. For example, Hurricane Katrina tore down cities and
left thousands without a place to live in New Orleans. A tsunami ended the lives of hundreds of
thousands of people in Southeast Asia. Sand storms and dust-bowls have caused severe
circumstances for citizens in the southwest United States. While it is unreasonable to argue that
all catastrophic events of the past are directly related to carbon emissions and global warming, it
is reasonable to expect a higher frequency of these events if no changes are made to divert the
current upward trend of greenhouse gas emissions.
Much of the disbelief in climate change is based on the lack of significant changes in the
pattern of climate events in Earth‟s inhabited regions. Although the changes are not self-evident,
the risk of global warming is a significant threat to global security, international business, public
health and general welfare. The danger is profound and a decisive reaction is needed. The
overwhelming data support the theory that global warming is influenced by mankind, and people
5
Krugman, Paul. Cassandras of Climate. New York Times, (2009).
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must act on this data in the hope of living sustainable lives. Denying that Earth‟s absorption of
man-made gases has no effect on life in highly populated coastal-areas and around the globe is
irrational, especially when scientific data indicates a calamitous trend between emissions and
industrial expansion.
Factors in Arriving at the Instrument of Choice

Environmental advocates believe that the unsustainable release of greenhouse gas must
be reduced to prevent adverse consequences. Despite weak public support, climate policy has
become one of the most pivotal issues in current political discourse. Policy makers in countries
around the world are beginning to realize the importance environmental change has on the safety
of future generations. At the Massachusetts Institute of Technology, U.S. President Barack
Obama stated:
There are those who will suggest that moving toward clean energy will destroy our
economy, when it‟s the system we currently have that endangers our prosperity and
prevents us from creating millions of jobs. There are going to be those who make cynical
claims that contradict the overwhelming scientific evidence when it comes to climate
change, claims whose only purpose is to defeat or delay the change that we know is
necessary.
Despite the cynics, many international agencies, large companies, citizen leaders, and policy
makers believe in the value of climate reform for the safety of future generations and for the
creation of new-sustainable jobs and lifestyles. The real controversial issues regarding climate
policy relate to designing the appropriate control instrument to achieve a certain reduction in
emissions without adding drastic costs to corporations‟ profit formulas and household budgets.
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Any method of climate reform undoubtedly impacts business. Companies, called upon to
lead the movement toward environmental safety, would need to creatively consider ways in
which affordable emission reductions can be achieved. This attempt at reducing business‟
impact on the climate will challenge companies around the world to reengineer their operations.
Business‟ apprehension towards strict regulations incites the possibility of mitigating this impact
through the use of free-markets. The two main market based alternatives are a tax-based system
and a cap-and-trade system. Other possibilities exist, such as subsidies and performance
standards, however both are only general tools available to policy makers that can reduce the
burden on a particular sector in the economy.
Carbon dioxide is a natural element and has never been owned or regulated at any point
in history. Carbon dioxide and other greenhouse gases have always been emitted freely. The
infinite supply of greenhouse gases was not addressed until Arrhenius because the only major
concern had been increasing production possibilities for businesses in the pursuit of profits.
Modern business demands higher productivity with litter regard for the environment. Through
the creation of a market based system regulating these noxious gases, supply and demand would
dictate the price for each ton emitted through cap and trade or the quantity emitted through tax;
this process is commonly referred to as “commoditization”. Even though the commitment many
firms have to corporate social responsibility leads them to make socially beneficial decisions,
there continues to be apprehension toward investing in sustainable business practices due to the
perception of higher operational and implementation costs. This paper discusses the
commoditization process involved in a cap-and-trade system and highlights its superiority to a
tax-based system. In doing so, this paper seeks to discredit the notion that sustainable business is
too costly.
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Both cap and trade and taxation apply a common price per ton of greenhouse gas to
emitters. As such, regulated entities would have an incentive to utilize all abatement
opportunities until the marginal cost of reducing emissions equals the emissions price (Goulder
et al., 154). More simply, every emission source would have an incentive to invest in
reengineering the polluting sources with new clean-technology until the cost of doing so equals
the emissions price set by the tax or the market. Once the marginal cost of abatement equals or
exceeds the price of the right to emit (i.e. the tax or market price), the emitter will pay the tax or
the allowance price6 to meet requirements and forego any operational changes.
In order to maximize the efficiency gains from either system a price must exist that
clearly indicates the marginal costs for all agents involved in the program (Goulder et al., 154).
To achieve this, a market must reach equilibrium where the supply of emissions clears at the
market price. The market clearing price accurately accounts for the supply and demand of all
emissions and abatement opportunities available. Consequently, the more comprehensive a
program allows for the most efficient pricing and the lowest costs.
Deciding the best way to achieve a system in which emissions are reduced with the least
burden on business and society requires an in-depth understanding of cap and trade. This paper
seeks to provide this understanding through a comparison of cap and trade to a tax based system,
highlighting the main points of interest and illustrating the strengths in design. The basis for this
analysis comes from research on countries which have already begun the process of
implementing policy. Others countries are also mentioned to analyze how delayed action can
exhibit the key elements of design instruments which yield the greatest result for the greatest
amount of people—a truly utilitarian technique.
6
Allowance price is the price to be paid for the right to emit one ton of a greenhouse gas. In cap and trade, the
number of allowances represents the “cap”, and they are traded between two parties on an exchange.
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Current Environmental Policy Analysis

The most common technique employed by various countries to reduce greenhouse gas
emissions is cap and trade, also known as emissions trading. Emission trading schemes (ETS)
are either developing rapidly or are being proposed steadfastly through the establishment of
actively managed carbon accounts and the implementation of binding emission reduction
agreements. While some nations have defined the rules of the agreements, others have not yet
finalized the options for their plans. Studying trial and development phases indicates that each
nation currently develops a National Allocation Plan (NAP), which organizes goals and sets the
time frame for a nation‟s scheme (Ellerman and Buchner, 45). Each nation independently takes
into consideration its own growth prospects, industry types, emission history and environmental
goals in its attempt at creating an effective plan.
The European Union Emissions Trading Scheme (EU ETS) is currently the largest
functioning scheme in operation and covers over 11,400 industrial installations (Hoffman et al.,
1232). Since January 1, 2005, a price has been paid for approximately half of the carbon dioxide
emissions in the EU (Ellerman and Buchner. 44). The EU ETS sets forth legally binding
restrictions on EU emissions of the core greenhouse gases and coordinates this effort with the
Kyoto Protocol. The EU ETS is one of the first schemes to provide installations with the ability
to buy and sell the right to emit a greenhouse gas. The buying and selling of an intangible
substance through the use of permits is an American innovation, developed to harness the
market‟s power to quickly achieve a goal. Although Kyoto technically gave birth to emissions
trading in the EU, the EU ETS is designed as part of EU supranational law, independent of
Kyoto. December of 2007 marked the end of a trial period for the EU ETS, and the first true
commitment period began in 2008. The binding restrictions for the EU ETS are established by
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the Kyoto Protocol (Ellerman and Buchner, 45). Kyoto Protocol governs the stringency of the
targets for the EU ETS.
The EU ETS is most importantly a multilateral trading system among sovereign states of
the European Union. Although the Kyoto design mainly focuses on emission goals for the entire
EU, each nation is considered sovereign and is allocated allowances based on a Burden Sharing
Agreement (BSA). Once the BSA allocates allowances to a nation, the nation then must pass
approval of its NAP, thereby earning the right to allocate permits to installations—the regulated
polluting entities. The potential global influence of the EU ETS goes beyond its role as a
multilateral trading system. Equally as important, the EU ETS establishes a community of
interest that makes it possible for countries like the U.S. and China to engage in talks about
implementing a similar scheme.
Several other emission trading schemes are being developed outside of the Kyoto
Protocol. For example, the first regional scheme in the United States‟ began operations in 2009
as the Regional Greenhouse Gas Initiative (RGGI). In 2007, Australia entered the environmental
arena by announcing that it was in the midst of designing an ETS. Canada proposed to cap
greenhouse gas emissions intensity in several industries such as electric, oil and gas. The New
Zealand government proposed a detailed framework for a domestic ETS in September of 2007
(IEA Reinaud and Philibert 5). Market mechanisms remain relatively high on the agenda for
many governments faced with environmental policy decisions. Many government leaders, such
as the authors of the “Safe Climate Act” Senator Waxman and Senator Markey, believe in the
power of developing an ETS mainly due to its ability to provide pricing signals for gases. In
addition to providing price signals, an ETS is a financial tool that can deliver economic
incentives to the private sector as it begins to implement the use of clean-technologies.
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The adoption of the Clean Air Act in 1990 was the first time a cap and trade program
took center stage in the environmental arena. The program was implemented with the intent of
quickly reducing the emission of an anthropogenic gas from the air, a task the program easily
achieved. The program‟s success in reducing sulfur dioxide (SO2) emissions led The Economist
magazine to crown the program, “the greatest success story of the past decade” (July 2002).
According to the Environmental Defense Fund, the cap and trade market for sulfur dioxide
furnished a market price of about $100-$200 per unit throughout the duration of the program.
This market price quickly prompted businesses to use advanced technologically in improving
processes that reduced SO2 pollution to below required levels. As a result, this cap and trade
program for acid rain achieved one-hundred percent compliance in reducing emissions and some
sectors even exceeded requirements by twenty percent (Environmental Defense Fund).
Although many ETS agreements exist throughout the developed world, the EU ETS
serves as the best example for an analysis of the current environmental policy decisions being
made by the world‟s leading officials. The EU ETS is now in its second operational phase which
began in 2008 and will continue until the end of 2012. Commissioned by the European Linking
Directive, the EU ETS legally binds the twenty-seven EU nations to an agreement on emission
reductions over a group of commitment periods that vary in length but average about five years
each. In every specific commitment period, each country is allocated allowances based on its
BSA and its required emissions reduction. For example, if Germany‟s emission total for 2005
was 1 billion metric tons of CO2, and the commitment period ending in 2007 called for a
reduction of five percent, then Germany would be allocated allowances for 950 million metric
tons—a reduction of 50 million tons of carbon from the atmosphere over three years. At the end
of 2007, if German entities were to emit more than what was allocated, the emitting sources
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would be required to go the market and purchase additional allowances. Such demand to cover
requirements would cause an increase in the price of carbon7. If the emissions were less than
expected, the sources would be legally entitled to sell excess allowances at market prices. To
help envision this process, the exchange of allowances in the carbon market is executed in a
similar fashion to the exchange of securities, such as stocks and bonds, in financial markets.
That is to say that there are both buyers and sellers who contractually agree to exchange a
specific quantity of allowances at an agreed price. On the settlement date, the exchange is
executed and both the allowances and funds are transferred.
Two options for allocating allowances are being debated in environmental policy
discussions. One option is free-allocation of allowances and the other is auctioning of
allowances. Free-allocation distributes allowances without payment in proportion to a source‟s
past emissions, while auctioned allowances are sold by the government to the regulated entities
irrespective of any information on past emissions. An industrial company with large polluting
factories would be a net-buyer of allowances in an auction design. If such a source which has a
high level of emissions does not purchase enough “permits” during the auction period, it would
be required to go to the market at a later point during the commitment period to purchase the
needed allowances. Unfortunately there is a risk for this heavy polluting entity because mid to
late year prices may trade higher than opening auction prices.
Deciding which method to use is mainly political, but also has certain implications on
capital accumulation. Authors Julia Reinaud and Cèdric Philibert illustrate in their article for the
IEA that general market sentiment is in favor of auctioning as a more efficient option than free-
allocation. The authors write:
7
This is a hypothetical situation to explain how a country‟s commitment period and allocation work together.
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Auctions are first and foremost a distributional mechanism—they redistribute at
least some of the revenue created by ETS from firms to government. The
government can recycle revenues in the form of lower taxes to businesses
impacted by the ETS, or use the funds to invest in clean-technology (24).
Free-allocation, on the other hand, essentially compensates firms for the introduction of a cost
on carbon by apportioning firms a valuable asset without payment.
This paper does not attempt to prove either method as better than the other; in fact, the
majority of plans combine the two methods to help reduce the initial burden of environmental
legislation. By combining the two methods, government leaders can more effectively manage
the political image of emission trading plans by partially allocating allowances on a free basis to
heavy industry partners that would likely suffer initially from environmental regulation. Even
though combining free-allocation and auctioning offers leaders flexibility in discourse, early
trading in schemes like the EU ETS indicates that NAPs target high-emission sectors like power
generators and heavy industry by imposing more stringent targets and encouraging quick
changes. Many nations monitor and reduce their carbon emissions, however there still remain
skeptics of environmental reform who, based on a string of misconceptions, falsely worship
inaction.
The Opposition to Climate Change

In 2009 world leaders attended a global discussion on a new climate treaty in
Copenhagen. There has yet to be any formidable sign of a long-term reduction in carbon
emissions from the world‟s greatest sources of greenhouse gas emissions—the USA and China.
Despite the RGGI‟s progress in the United States, many nations participating in Copenhagen
remain dissatisfied at the lack of America‟s commitment to climate change efforts.
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Even more troubling is the opposition to climate change by individuals and corporations
despite the mounting scientific evidence supporting human‟s impact on carbon concentrations.
This opposition is largely based on the inconvenience associated with remedial efforts to combat
climate change by reducing greenhouse gas emissions. For many individuals, claims by
scientists about impending disasters are fanciful since climate change is not patently obvious.
The initial mistrust is understandable; the concept of a “global” temperature is outside the
perception of an average individual, especially since bone-chilling temperatures during the
winter months of January and February run counter to global warming theory.
Multinational corporations fear that climate reform will needlessly impose additional
expenses and costs into already competitive markets. Consider Duke Energy, an energy
producer which operates 17 coal plants in continental USA. Duke is the third largest emitter of
greenhouse gases in North America and the twelfth largest globally (Walsh). Earnings from
companies which operate similarly to Duke are entirely contingent upon whether the company
can freely pollute the air. If this privilege is revoked, the future would be very unclear for these
companies as they would be forced to redesign their energy plants and come up with a new way
to provide the same services to their customers. In fact, the Securities and Exchange
Commission recently updated disclosure requirements for businesses that emit greenhouse gases.
According to the New York Times article by Joel Kirkland, the SEC seeks to provide greater
protection for investors which may be at risk by a stringent regulatory environment. Additional
disclosure will increase transparency for companies and their investors, and also ease the
transition to a clean economy. The change in regulations, however, highlights that some small
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and mid-cap firms which have a high level of emissions may not have enough flexibility to make
adjustments that pass regulations8.
The political success of elected officials is assessed largely on the immediate impact
legislation has on constituents. Since the benefits of enacting climate change policy are not
realized in a four year term, politicians have little incentive to enact this type of legislation. For
this reason, and possibly this reason alone, most politicians opt to play both sides of the fence by
arguing in favor of environmental policy without ever enacting some form of legislation that puts
a price on the emissions of all greenhouse gases. Another political risk is that corporations are
often primary opponents of environmental policy, and much to the politician‟s dismay, they are
also the primary contributors of political campaigns. As such, politicians need to juggle making
a choice that appeals to the average American voters and environmental agencies, as well as one
that appeals to the executives of Fortune 500 companies who contribute large sums of money to
political campaigns and philanthropic foundations.
In the Wall Street Journal article “The Climate Change Climate Change”, Kimberley
Strassel highlights that a significant number of nations which need to be key participants in a
global plan doubt the efficacy of environmental strategy. For example, she mentions that both
Poland and the Czech Republic deny that humans are a factor in climate change. Strassel also
mentions that the President of France, Nicolas Sarkozy, is negotiating with the French scientist
Claude Allegre, who openly denies that global warming can be attributed to man, in an effort to
bolster the country‟s industry and economic performance. In the same article, Strassel notes
several prominent scientists who deny global warming. The Norwegian Nobel Prize winner for
Physics Ivar Giaever, for example, has decried global warming as the “New Religion”.
8
Kirkland, Joel. “SEC Issues Climate Risk Guidance Despite Tough Political Environment”. The New York Times.
Jan 31, 2010.
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In the United States, the most ardent disbelievers are affiliated with the Republican Party
which traditionally represents the interests of American business. This political party is known
to defend its opposition by highlighting mysterious cost expectations. Republican
representatives fervently declare that strict environmental legislation would have a devastating
effect on the economy by pushing up the costs businesses will need to pay to run their operations.
Additional costs, they argue, would cause companies to reduce expenditures elsewhere, such as
in employment or in capital reinvestment. The argument linking economic disaster to
environmental reform is the exact type of argument this paper seeks to contradict. Prior
experiences have proven that environmental legislation can quickly achieve its goals and provide
vast economic benefits. These economic benefits, such as employing additional 1,000-4,000
employees to build a clean-energy nuclear power plant9, are very important to building a
foundation for economic growth over the next century. Although near-term investments are
required, the future economic benefits of a lower unemployment rate and rapid economic growth
outweigh the initial expenses.
The green-investments which have been made in the past have been less expensive than
originally expected. Directly before legislation was signed for the acid rain program in the
United States, the EPA estimated that the program would cost about $6 billion annually once
fully implemented. That program, which brought sulfur dioxide emissions to well below
regulatory targets, cost only $1.1 billion—a mere twenty-five per cent of expectations
(Environmental Defense Fund). Whether one chooses to believe that humans are responsible for
the drastic increase in the Earth‟s carbon concentration is less important in this discussion than is
understanding that environmental policy is not as expensive as is commonly believed. The “Safe
Climate Act” is the latest environmental legislation being discussed on Capitol Hill. It begins
9
Kanellos, Michael. “Should the U.S. Expand it‟s Nuclear Power Capacity”. SeekingAlpha. Jan. 25, 2010.
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with a definition of the bill‟s intent: “A bill to create clean energy jobs, to achieve energy
independence, to reduce global warming pollution, and to transition to a clean energy economy”.
The writers of the bill clearly believe that global warming poses a significant threat to global
security, the economy, and to physical health of the general public. Although this bill safely
passed through the U.S. House of Representatives in July of 2009, there still are many Senate
leaders who do not support it on the basis of high cost expectations.
Warren Buffet and David Sokol, two very famous proponents of “Corporate America”,
argue that climate reform is going to increase the price of electricity and punish the impoverished
members of society. While their positions are influential, especially as Buffet is the acclaimed
“Oracle of Omaha”, a strong understanding of the inner workings of a cap-and-trade system will
demonstrate how the “Oracle” is sadly mistaken. This paper will further illustrate how long term
prices may decrease for consumers and how profit opportunities will surface for savvy
businesses which choose to embrace sustainability in their production lines.
The disingenuous attempts to distort the reality of climate change are based on an
incorrect assessment of environmental policy‟s economic impact. Paul Krugman once wrote,
“The campaign against saving the planet is based mainly on lies”10. The lies have delayed
investment for over twenty years, and the risks are becoming clearer. Short-term change is
needed to reduce the risk of catastrophe, but legislators lack a clear plan to devise a cost-
effective system to reduce emissions. Emission trading is about reducing greenhouse gases at
the lowest cost possible. Governments that wish to limit the risk of high costs through cap and
trade have several options that help smooth out deviations and a few project based mechanisms
that help firms manage their exposure to greenhouse gas regulations. One of the leading
concerns of environmental policy is whether it can effectively reduce the level of these gases in
10
Krugman, Paul. It‟s Easy Being Green. New York Times, 2009.
21
the Earth‟s atmosphere without causing stress on economic factors such as employment and
growth.
Taxation: A Necessary Comparison

Comparing cap and trade to the tax alternative highlights its cost-effectiveness and
productivity, and explains the efficacy of various policy instruments and different design
variations. In a tax system, the government sets the price per ton of carbon emitted. In cap and
trade, regulatory targets set the quantity of emissions allowed over a certain time period and the
market generates the price. Both systems are considered market based because in a tax system
the market sets the quantity of emissions, whereas in cap and trade the market sets the price of
emissions. Uncertainty surrounds both alternatives, but it is important to consider which
uncertainty is a greater burden to society. Through an extensive analysis of the two solutions,
the cost-effectiveness and productivity of cap and trade is discovered and is convincing.
A carbon tax is a directly-regulated tax on the emission of carbon. A carbon tax sets a
fixed price per metric ton of CO2 and allows the quantity of emissions to “fluctuate”. The tax
has significant revenue potential which allows policy makers to use this revenue in offsetting
other non-friendly taxes or in subsidizing investment in green technology. Although a clear
price is provided through a tax system which allows companies to consistently account for the
cost of carbon, a fixed price defies dynamic efficiency and does not accurately reflect the need to
pollute or the negative externalities of emissions. In addition, a carbon tax does not focus on the
main goal of environmental policy: controlling and reducing carbon emissions. Since the tax
locks in a price for emissions, the amount of emissions in any given year remains a variable.
Both market responses seek to reduce the marginal benefit that a firm receives from pollution,
thus forcing these carbon sources to choose the socially beneficial level of emissions
22
(PriceWaterhouseCoopers, 14). However, a cap on emissions is more able to assist the program
in gradually accomplishing its goal of significant reductions.
The government must assume responsibility for the taxation through one of its already
existing government bodies. The government can levy the tax either “upstream” or
“downstream”. “Upstream” taxation is levied on the fuel producers and energy providers rather
than “downstream” or directly on fuel users. For example, the United States had 1,415 mines in
2005 (Metcalf, 66). In the “upstream” scenario, the tax would be based on the amount of coal
extracted, and the mining company would be responsible for paying the tax rather than the
millions of users who actually benefit from using the coal. Any unrecoverable broad based
carbon tax that does not provide businesses with flexibility to offset large tax provisions would
cause the tax liability to flow through to the customers‟ account statements, even though it is
levied “upstream”. Consequently, consumers would be justified in expecting increases in energy
costs if a new tax is implemented. “Downstream” taxation would likely be more effective in
reducing users‟ reliance on fossil fuels as the tax would be more visible to the actual user. A
more visible tax discourages the use of high emission products. Users‟ awareness of the costs
may encourage them to invest their “dollar-votes11” in products and services from geothermal,
solar, nuclear or even natural gas sources and other household products that comply with
environmental safety standards such as Energy Star.
Even with a transparent tax, it is not guaranteed that emissions would be reduced over
time because the emission levels are variables in the equation. Businesses can easily obscure the
large carbon payments in the millions of bills they send out to customers during the year, most
especially in the less-elastic energy markets. According to G.E. Metcalf‟s literature on the
11
This is a term commonly used in entry level economics to demonstrate that in a capitalist system, customers are
casting a vote by paying for a product.
23
carbon tax, a $15 tax per t/CO2 would raise the price of gasoline by 13 cents a gallon and the
price of natural gas by 54 cents (69). Based on the experiences of 2008 when gasoline prices
soared to the $4 and $5 range per gallon, a 13 cent increase would do little to change
consumption and less to correct the unsustainable trajectory of carbon emissions. The ability for
a carbon tax to encourage the needed investment is highly unlikely.
Analyzing Cost-Effectiveness and Productivity

The basic purpose of an emissions trading scheme (ETS) in a cap and trade program is
simple, yet many market applications need to be instituted to make the market as efficient as
possible. Designing an emissions trading scheme involves significant planning and strategy but
the design, as it will be laid out, convincingly demonstrates great social and economic benefits.
The foundation of the ETS is based on limiting the total allowable emissions with a legally
binding “cap”. The “cap” is the total amount of carbon emissions the policy maker will allow
during a specific commitment period. Once the “cap” is established, the regulatory body issues
allowances representing one ton of carbon each. Any emissions in excess of the “cap” and not
matched by an allowance would result in a fine, usually equal to double the market‟s allowance
price. Throughout the regulation period, an allowance can be bought or sold on the market
through an exchange transaction or an over-the-counter12 transaction. Each covered facility must
monitor and record its emissions, and surrender an amount of allowances equal to the total tons
emitted in an account with the governing body by the end of the period (Hansjurgens, 168).
A truly efficient ETS requires certain provisions that foster the exchange of information
in the market. High levels of information smooth the price of carbon over a time period to
reduce the inherent volatility risk in security markets. One such provision is the banking and
12
Over-the-counter trading takes place directly between two parties, whereas exchange trading occurs on an
exchange such as a stock exchange or a futures exchange.
24
borrowing of allowances throughout the duration of multiple commitment periods. Banking and
borrowing allows for inter-temporal flexibility. For example, an entity that emits less in year one
can transfer the excess allowances into the future to decrease costs in year two or three when
emissions are expected to increase. With this provision, emission expectations for the future
would be embedded in current prices, and historic data would continue to be factored into future
prices. Although future expectations are continuously modified, this provision allows regulated
entities to maintain foresight of potential risks in the future that require near-term changes.
Banking and borrowing effectively assists the reduction of emissions with its capacity to provide
smooth transitions from one period to another. This flexibility helps businesses avoid excessive
market risk (Keohane, 43).
The method of issuing allowances in an ETS causes many concerns for regulatory
agencies and installations. As previously mentioned, efficient trading schemes would
realistically consist of some form of both, depending on the sectors being regulated. It is
important to realize that, regardless of the issuance method used, the market provides an
equilibrium price for the allowances. Free allocation can cause high amounts of “windfall gains”
since the market still generates a price for the allowance. The “windfall gains” occur once an
entity, which receives allowances without an expense, can sell the allowances and thus profit if
by the end of the commitment period it buys back the needed allowances at a lower price.
Although both systems technically generate a market clearing price, a combination of the two
provides for the greatest benefit. In a system that has part auctioning and part free allocation,
economic productivity is enhanced since the governing body can still capture some of the
revenue needed to reduce the public burden of other federal taxes on labor and capital (Keohane,
44).
25
Reducing the risks posed to the majority of the world‟s population requires international
effort and coordination. Countries must harmonize cap and trade systems in order to establish
the international cooperation needed to significantly mitigate the effects of uncontrolled
emissions. An entity regulated by the EU ETS able to exchange pollution rights with an entity in
the United States adds to the liquidity of both markets which, as a result, decreases price
volatility. Since price volatility is a function of market risk, market risk would also be reduced
by harmonizing systems. This provision enhances price efficiency as more information is
embedded in the market price and includes more marginal costs from a wider range of abatement
options. Harmonizing the emission trading schemes increases the scope of environmental reform,
bringing more participants to the market and allowing various installations to face similar costs
for reducing pollution. Similar costs should also likely dissuade businesses away from relocating
in the attempt to avoid more stringent policy areas like Germany. Overall, global cooperation
would increase the probability of successfully reducing emissions to acceptable levels. Author
Nathaniel Keohane states, “Averting dangerous climate change will require deep cuts in
greenhouse gas emissions by the world‟s advanced economies as well as meaningful reductions
from middle-income and developing countries” (49). If a few nations control emissions while
other nations allow emissions to run rampant, the overall success of the global plan would be
minimal.
The financial markets must play a key role in controlling the risk of uncertainty in cap
and trade to ensure that entities continue to operate at maximum efficiency. The cap and trade
system is inherently risky due to the volatility of allowance prices during trading. This risk can
be offset or managed by the type of financial products available to control risk, such as
derivatives. Derivatives trading, most importantly call and put options, allow for regulated
26
entities to limit volatility risk. For example, if an entity is a “net-buyer” during a specific period,
that entity would be concerned with the potential increase in prices toward the end of the
commitment period when it executes most of its purchases to reconcile ending balances.
Through the use of financial instruments, entities can enter into a contract to have the right to
buy a certain quantity of emissions at a fixed strike price. This ability to hedge positions through
the use of derivatives eliminates much of the risk inherent in cap and trade‟s volatility because it
gives the entity the opportunity to lock in a price for its carbon purchases.
Another element of an efficient ETS is the allowance reserve or liquidity provider. Once
international cooperation and harmonization is established, a global fund run by the International
Monetary Fund should be established to purchase allowances and store them in the event of
illiquid market runs. If markets become illiquid and prices drastically increase, regulated entities
would have to incur major losses in order to meet the requirements of emission regulations. The
allowance reserve would sell allowances into the market to relieve upward pressure on carbon
prices. This fund would act as a lender of last resort to provide liquidity to worthy entities in
times of extreme need (Murray, Newell and Pizer, 84-90). Just as the Federal Reserve and other
central banks act as lenders of last resort for large national banks around the world, the IMF‟s
carbon fund would add liquidity to the carbon market if atypical events occurred.
The final design element of an effective cap and trade system is the establishment of
certified offsetting projects that reward investments in emission offsets that reduce greenhouse
gas emissions in excess of regulatory requirements. The creation of a mechanism to set project
standards and issue credits for emission reduction is very important to lower the global cost of
“going green” and to persuade entities to make changes quickly. Currently two largely popular
mechanisms exist: the Clean Development Mechanism (CDM) and Joint Implementation (JI).
27
Both systems are run by the United Nations to foster “green” investment in developing nations.
If an alternative energy project fits the mold of either CDM or JI, a credit for each ton of carbon
abated is issued and can be used for compliance in the ETS or sold for cash (Hansjurgens, 25).
The primary concern that arises when implementing environmental policy is determining
whether the policy is effective without significantly burdening society or increasing the costs
consumers and businesses pay for goods and services. In both cap and trade and taxation there is
a level of uncertainty that must be adequately addressed in order to achieve greater social
benefits. The following discussion on cap and trade will be consist of the following key
elements for environmental policy that answer the uncertainty questions and achieve the greatest
social and economic benefits: efficient prices that adjust to market expectations and irregular
events; equalized marginal costs of various abatement opportunities; incentives for regulated and
non-regulated emitters to invest in clean-technology; medium-term commitment periods to
monitor emission reduction goals; international agreement which enable various countries to
cooperate; and, a policy framework that fosters job growth in the economy13.
Efficient pricing of carbon
Many industries have a key response to a given problem, frequently referred to as an idée
fixe. A great example is vehicle transportation, for which traffic is a problem. To reduce
congestion on the roadways, an architect uses design and engineers use structures, while
economists use pricing mechanisms. The “right” price needs to reflect scarcity and allow supply
and demand to bring the price into equilibrium. In order to form a market price, property rights
must exist and be divisible. Without these property rights—the right to buy, sell, lease, inherit
and divide—neither supply nor demand is discovered and market failure destroys the ability to
bargain or even engage in a transaction. Once a system with property rights is established,
13
Please note that the actual argument is not necessarily in this order.
28
supply and demand drive the market and guide that actions of market participants to the level at
which the market clears itself of excesses. The market clears once supply and demand stabilize
at a specific price and quantity. Environmental economics attempts to find the optimal price
where the scarcity of allowances is appropriately recognized by buyers and sellers in the market
(Convery and Redmond, 88).
In order to avoid market failure in a new carbon market, assets (allowances) must be
owned, legal rights for the assets must be honored, and institutional mechanisms or brokerages14
must be in place to facilitate transactions between parties. The carbon market without any such
cap and trade legislation fails, mainly because no property rights have ever existed for carbon as
they do for other commodities like gold or corn. The Earth‟s capacity to absorb anthropogenic
gases is not owned, it is not divisible, no legal rights are distributed, and no institutional
mechanisms exist to enable exchange. An emissions trading scheme creates the trading
mechanism that distributes rights and enables emitters to buy and sell them in order to pollute
CO215. The trading of these allowances, specifically the European Union Allowances (EUA),
produces a price signal for emitters via exchanges just as the futures market does for gold and
corn. Legal directives provide explicit ownership of the allowance to whomever purchases it—
legally giving that entity the right to emit carbon into the atmosphere. This creates scarcity in the
market as there is a limited number of allowances available which need to be allocated to the
emitters in a given sector, industry or country. The extent to which the “need” to emit CO2 rises
above or drops below the allowable emissions level drives the price up or down.
Emission levels, or the demand for allowances, depend on a number of factors including
weather, commodity prices and gross domestic product (GDP). These factors add to the
14
Brokerage is a liquidity provider for the market, also known as a market-maker.
15
Currently trading platforms for carbon markets are provided by companies like Climate Exchange and Blue
Source.
29
volatility of equilibrium prices as the prices trend up or down in relation to the aforesaid price
indicators. In fact, experiences in the EU ETS demonstrate that carbon prices can be very
volatile during the course of a given commitment period. For example, “on January 3 (opening),
the price of EUA for delivery in Dec-2005 was €8.38. Twelve months later (December 2005),
the closing price was €21.10” (Convery and Redmond, 103). This dramatic price increase sheds
light on several aspects of a dynamic ETS. First, it quickly absorbs information about future
emission levels. The closing price more accurately reflects demand as emitters flooded the
market to reconcile any balances by making purchases before the end of the year. This price,
due to the inter-temporal flexibility of banking and borrowing provisions, also includes
information about the emission levels for 2006 and on. The market price at the close of 2005
includes information about several different aspects of the carbon market, even speculative bets.
The market equilibrium price is the optimal price since it contains the most information about the
market; price optimality only comes about thanks to the liquidity provided by exchanges and
OTC markets. The following visual demonstrates price volatility for various allowance vintages
from 2005 to the present (courtesy of Point Carbon).
A major goal for policy makers is to maintain stability throughout the introduction and
implementation of environmental policy. As the graph above indicates, carbon prices are far
30
from being stable. Yet, it would be absurd to discount the ability of a market to yield socially
and economically beneficial results solely based on the fluctuation of prices. One of the greatest
abilities of an ETS is the capacity for businesses to use financial instruments to hedge the risk of
price uncertainty. The volatility indicated by the chart will most likely always exist to some
extent, but businesses can account for it through derivative trading that could ideally reduce risk
to near-zero levels. For example, consider an option trade for an allowance. By purchasing this
option for a premium, the business now has the right to buy or sell the allowance at a given price.
If the market price rises above the call option strike, the business will exercise the option.
Similarly, if the market price falls below the put option strike, the business will exercise the
option. The simultaneous use of call and put options allows businesses to maintain stability by
establishing both a floor and a ceiling for market prices.
In addition to options there are spot, forward and swap trades. All derivative instruments
help carbon portfolio managers reduce the risk of drastic price increases or decreases. Each
derivative has an underlying value that is also exchanged between parties in a transaction, thus
creating additional profit opportunities that help reduce the cost of cutting emissions. Financial
markets give companies the ability to meet reduction goals, and ease the fear of economic
breakdown. The profit opportunities from policy provisions are robust but only truly succeed
when a company actively reduces its emission of greenhouse gases.
An emissions trading scheme offers several benefits to all members of society and to the
market participants who engage in trading in the spot and future markets. As mentioned above,
the most efficient price is one which equates the marginal cost across the greatest number of
options for abatement and which reflects the demand for emitting carbon. The demand for
polluting, just like the demand for any other asset, is the most important driver of price. A tax is
31
a fixed price which is enacted by a long legal process—a process that cannot frequently or
accurately assess demand for an asset. This tax does not reflect changing market conditions in
fuel prices, weather patterns or output levels. The tax does not take into account rising
commodity prices or increased demand for paper products. A tax does not reflect the demand to
pollute and thus does not represent the cost to abate emissions; rather, a tax represents the price
legislators believe should be paid for the right to pollute. In general, a tax ignores the
fundamentals of the market, and would most likely fulfill the President‟s budget gap
coincidentally each year.
Conversely, cap and trade absorbs information quickly and seamlessly adjusts to new
market events. To further illustrate this crucial point, F.J. Convery and L. Redmond write:
One time exogenous events affect prices, such as a long strike in the Finnish pulp and
paper sector, which reduces demand for allowances. It appears that whenever „real‟
information on the long-short balance of allowances is provided…indicating more
„supply‟ relative to „demand‟…the market price immediately adjusts, in this case
downwards (Convery and Redmond, 105).
The ability of the ETS to reflect movements in the market with such immediacy provides a huge
benefit for market-makers to help companies navigate the market and offset risk. In fact, profit
potential for businesses is created by the ability to manage the portfolio of allowances throughout
the long and short term movement of the market. For example, if a business can assess that end
of year prices for carbon will decrease, then a profitable trade will result from taking a short
position in the market: the sale of a futures contract at the beginning of the year and repurchasing
it at a lower price by year end. This opportunity helps offset the cost of investing in clean-
32
technology, and also gives the company great flexibility throughout the year. A tax would be
less effective as trading opportunities to hedge taxes have, unfortunately, not been invented yet.
It is important to fully understand the breadth of opportunity which comes about from a
free-market exchange of allowances in order to make an educated decision as to whether a policy
choice is cost-effective and productive. A tax does not acknowledge the inter-temporality of an
exchange, therefore no future information on emissions is captured. In a tax system, all entities
are buyers hence no profit opportunity exists from the scheme. Without the opportunity to profit,
the cost incurred through taxation becomes highly burdensome as entities have little flexibility
and no options to offset the cost. Due to the stringency of a tax, emitters are encouraged to seek
exemption, and this creates pressure on the program and decreases its coverage (Keohane, 49).
Exemption seeking provoked by the nature of a tax system is counter-productive to any system
attempting to promote environmental safety; a carbon tax is often associated with “creating
pressure to shrink the program, constraining its scope, and thus reducing cost-effectiveness by
limiting gains from trade (Keohane, 44). Cap and trade, on the other hand, generates profit
opportunities and transparent pricing abilities which policy opponents fail to recognize. The
overall capacity of cap and trade, proven by the U.S. Acid Rain Program, is unmatched by other
alternatives and most importantly adds to the argument that reducing the risks of climate change
is an expensive and needless battle.
As members of the United Nations Framework Convention on Climate Change
(UNFCCC) discuss new agreements on environmental policy, some policy makers fear that
carbon can become the next “toxic asset”. According to Bart Chilton of the Commodity Futures
Trading Commission (CFTC), derivatives tied to carbon can potentially form the most important
commodity market ever; the expected notional value of the global carbon market estimated by
33
some economists solidify his claims. As such, the ability for speculators such as Hedge Funds to
affect this market should not be underestimated. Hedge Funds are investment institutions
established with the intentions of generating significant returns for investors through risk-taking
and leveraged investing in large, small and even illiquid markets. Speculation by Wall Street
may cause increased volatility which industry analysts will add to the fear of price uncertainty;
nevertheless, speculators provide a key function to the market which increases the efficiency of
the overall market‟s performance. By providing additional liquidity, Hedge Funds and other
return seeking firms decrease the size of the spread between bid and ask prices16 for carbon
allowances and make it easier for companies to manage carbon exposure. Tighter spreads and
added liquidity decrease the price fluctuations and thus make markets less risky.
Speculators always exist in free-markets, even if a Hedge Fund is not involved. With
speculation comes the chance that the speculator could take the wrong position on a trade and
suffer significant losses; yet, the damages caused by speculators‟ bets are not nearly as
significant as the benefits provided to society by having the market in the first place. The carbon
market provides opportunities for businesses to reduce their emissions of greenhouse gases in
relatively short period of time and in a less-costly manner. It is very easy to substitute the
market for emission permits for that of gold, corn or even wheat futures. All of these
commodities have a market and they should not be addressed differently. Unfortunately the
problems afflicting Main Street, which may or may not have been caused by actions on Wall
Street, have distorted the true power of an efficient market. The market for carbon allowances is
highly responsive to price increases, and thus a speculative bubble would most likely not occur
16
The difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept.
The size of the spread is usually based on the liquidity for that asset—the more available the asset, the tighter the
difference between what the buyer is willing to pay and what the seller will accept (the spread naturally narrows
when more traders are involved since more bids are being placed).
34
unless some unforeseen market fundamental changes over time. Paul Krugman says it best: “It‟s
crazy to cut off our future to spite Goldman Sachs‟s face”17.
Maintaining an incentive to invest in clean-technology
One of the most important determinants of any environmental policy‟s success is whether
it drives families, farmers, companies and investors to invest in low-emissions technology. Most
investment decisions at the corporate and household level are analyzed on a financial basis
through complicated investment return formulas that accountants use to decide whether an
investment‟s is financially attractive. The current cap and trade markets have other methods that
do not require as much mathematical analysis. Within the Kyoto Protocol, three main
mechanisms were established to help entities meet requirements: emissions trading, Joint
Implementation (JI), and the Clean Development Mechanism (CDM) (Act Locally, Trade
Globally: Emissions Trading for Climate Policy, 29-30). It is important to reemphasize the
purpose of JI and CDM in order to elaborate on factors affecting investment.
The two mechanisms allow entities to acquire emission reduction units (ERUs) available
in the JI program, or certified emission reductions (CERs) in the CDM program for
environmentally sustainable projects. Both credits equate to a ton of carbon, just as a tradable
allowance does, and are fully fungible with emission trading schemes. The credits are obtained
through greenhouse gas reduction projects that receive approval from the executive board of the
respective mechanism applied to. Once issued, both ERUs and CERs can be traded through
emission trading platforms. These credits have substantial economic value to companies,
farmers and traders involved in this market because the market produces a liquid price realizable
through exchange. Since credits can be exchanged through trading, these credits add to the
scheme‟s liquidity and create another profit opportunity for savvy businesses.
17
Krugman, Paul. “Is the threat of speculation a reason to shun cap and trade”. The New York Times. Jul 21, 2009.
35
Both the CDM and JI mechanisms encourage entities to invest in low-emissions
technology in order to reap the financial benefits from the value of the credits generated.
Investing in low-emissions technology reduces an entity‟s future emissions but also generates
CERs and ERUs with substantial market value. Managers would be more likely to undertake
such credit producing projects since they would lower “carbon costs” and generate positive cash
flow. On the other hand, entities will be less likely to invest capital in a project if the economic
value is not quickly realized. Without the free-markets, entities would not realize the economic
and environmental benefit of green investment projects for years.
With these tradable credits from the CO2 offset programs, businesses can drastically
reduce the cost implied with reducing GHG emissions and potentially generate a profit. For
example, Blue Source is a company which helps large emission sources throughout the “going
green” process. In 2003, Blue Source began working with Blue Lake by evaluating the activities
undertaken by the energy company, and advised the company to invest $10 million in clean-
technology. The investment connected the carbon dioxide stack from the gas processing plant
(source of emissions) to a pipeline that travels 16 miles to the “Sheep Mountain CO2 Pipeline”.
The carbon dioxide is transferred to a location for use in Enhanced Oil Recovery (EOR) instead
of being emitted into the atmosphere. Approximately 30 million cubic feet per day of CO2 was
vented into the air before Blue Lake made this investment; now this project eliminates 350,000
tons of carbon each year through carbon capture18. If the US ETS was already in commission,
Blue Lake would receive credit for 350,000 tons of carbon; with a market price of $15/ton, that
is a market value of $5.25 million. By selling the excess permits and offset credits, Blue Lake
would add several millions of dollars to its balance sheet, all due to the cost-effectiveness and
productive power of cap and trade.

18
http://www.ghgworks.com/4b-bluelake.html
36
Even though not all companies necessarily benefit as Blue Lake did from green-
investments, other companies should still be a part of the global climate change effort. In some
cases, corporate management faces opposition to green investments by shareholders who are
ultimately concerned with stock prices and earnings. World-renowned economist Milton
Friedman once argued that a business‟ primary task is to improve shareholder wealth. Friedman
would likely disagree with a corporate executive who decides to invest large amounts of capital
for corporate social responsibility. Capital investment in a sector regulated by cap and trade with
CDM and JI mechanisms in place, on the other hand, would have a positive effect on a
company‟s profits and thus increase shareholder wealth. This type of corporate social
responsibility would certainly appeal to Milton Freidman‟s dedication to profit seeking.
Foremost in the energy sector where energy efficiency projects are vitally important to
any substantial move towards becoming “green”, CERs and ERUs can help promote projects
with “upstream” impact. Energy installations can invest in large projects with high CER value to
assist in reengineering the energy generation process (Act Locally, Trade Globally: Emissions
Trading for Climate Policy, 60). Although both the CDM and JI markets require strict
application and approval processes with administrative costs or professional fees, offset credits
provide a phenomenal amount of flexibility to industry participants. This flexibility allows
installations to reengineer old business, effectively monitor and register emissions, account for
costs and project future profit opportunities. More important, the mechanisms add liquidity to a
new market, create cash flows that lower investment costs, and require that emissions be strictly
reduced. Thus, the mechanisms bring to light the cost-effectiveness and productive capabilities
garnished by cap and trade.
37
Establishing the commitment period
Other factors which affect the investment decision process are investor expectations
about future carbon prices and stringent legislative policy. Much of recent international dialogue
regarding the carbon market has been geared towards providing more certainty in the market
since uncertainty can tend to delay investments. A high level of certainty can be achieved with
the establishment of specific commitment periods that last throughout the entire cap and trade
program.
In general, commitment periods define a specific time period during which regulated
emission entities must meet a predetermined reduction obligation. There are different elements
of commitment periods that increase effectiveness when implemented in a cap and trade strategy.
For example, the length and stringency of targets for each period are two of the most important
factors when creating a commitment period. Medium-length periods, such as periods of five to
ten years in length, increase predictability and certainty for businesses and offset the short-term
fluctuations of carbon prices and emission levels. If a period is too long compliance becomes
difficult and the incentives to invest in clean technology are deferred too far into the future or are
eliminated all together. On the other hand, a shorter period of about one year in length does not
provide sufficient certainty and makes long-term decision making very difficult. Shorter periods
allow better adjustment to scientific data, economic fluctuations and political interventions. As
such, the best period for cap and trade is a medium-term period which incorporates the benefits
of both a short and long period. (Buchner, IEA, 6-22).
The key benefits of a medium-term commitment period improve management of carbon
exposure, maximize profit seeking ability, and structure development of emission reduction
projects. First among the benefits is the ability to set a long-term horizon for reduction goals.
38
Second, the short-term monitoring and regulation helps ensure that these long-term goals are
satisfied. Third, the medium length period makes periodic reviews of the long-term schedule
possible and helps communicate short-term progress among participants. Last, strong
monitoring and compliance rules promote international compliance and enable bi-lateral
integration (Buchner, IEA, 6-22). The implementation of medium-term commitment periods
addresses the problems of business cycles and the irregularity of weather patterns. For example,
the price of carbon is correlated to the price of commodities which rapidly fluctuate at times;
such price volatility risk would need to be monitored. The increase of oil prices in 2008 which
caused the price of carbon to increase as well is an illustration of this point. The medium-term
period absorbs some of the shock of these events, and works very well with inter-temporal
design. Price absorption and smoothing of medium-term commitment periods decreases the
frequency of unusual price spikes and thus supports the cost-effectiveness argument.
In 2005 the EU ETS began its operations and a medium-term commitment period was
implemented. In the current version of the Waxman-Markey bill19 which has passed through the
U.S. House of Representatives, preference is in favor of similar medium-term periods. The first
commitment for the EU ETS was a (3) three year period from January 1, 2005 until the last day
of 2007, and its second phase lasts from 2008 until 201220. The medium-term periods allow
policy makers to establish realistic long-term goals, for example a fifty year reduction schedule,
and then several two to five year plans aimed at helping businesses and countries accomplish
smaller goals once at a time.
A one year plan would be much too short and would require entities to buy or sell
allowances based on information provided from multiple standard deviation events which are not
19 Waxman-Markey bill is the American Energy Bill which includes a cap and trade system for reducing carbon
emissions.
20 Phases post-2012 are expected to last 5 years.
39
a significant representation of the true demand for carbon. Longer commitment periods would
reduce the impact of outlier events. For example, an unusual winter freeze and consequent
increase in the demand for fossil fuels used in heating would cause the market price for carbon to
increase; the price would then decrease back to normal levels once the winter cold subsides. If
this event were to occur in the middle of a five year term, the price effect would be less
significant than if it were a one year term. On the other hand, a fifty year period would not
stimulate near-term investment. Managers could too easily defer any action since satisfying the
long-term requirements could be imposed on a future manager. With a medium-term period,
businesses can periodically moderate the success or failure of the plan and make adjustments
when necessary.
Costs and expectations are developed over a five year period that enables managers to
effectively plan for investment and to capitalize on the use of valuable resources from companies
like Blue Source. As opposed to engaging in climate panics caused by the threat of yearly taxes,
cap and trade portfolio managers can utilize the additional flexibility to carefully make
investment decisions.
Socially responsible action and capital investment
Businesses would obey the law established by a cap and trade program if they are
covered by regulations; however, beyond regulations, there still remains a responsibility for
unregulated businesses to commit resources that benefit environmental programs. Despite
arguments that corporate social responsibility is akin to theft, many people believe that the
obligation exists (Reinhardt, Stavins and Vietor, 221). The relationship between corporate social
responsibility and cap and trade is mutual and corporate social responsibility can actually be used
as a selling point for many firms. The profit opportunities which exist in cap and trade make
40
corporate social responsibility much more attractive and corporate social responsibility augments
the productive capacity of cap and trade.
Many businesses view emission reduction projects as a tax on their operations because
returns on investment are usually accrued over long periods. As shareholders are mainly
interested in short-term gains on quarterly statements, environmental investments are not usually
considered feasible for firms as such investments require capital expenditure. However, cap and
trade can provide shareholders with opportunities that will make quarterly statements improve
long into the sustainable future. Making smart investments develops new processes for
businesses that replace old equipment and processes which may be threatened by future stringent
regulations (Reinhardt, Stavins and Vietor, 225). Socially beneficial investment can increase the
goodwill21 of a business and make the company more valuable to its shareholders.
In addition, unregulated firms may choose to enter the CDM and JI markets to prepare for
future stringent regulatory conditions that may be imposed. Early investment will create a
competitive advantage for a business in the future through first mover advantages. Trading
opportunity stimulates great profit potential for businesses which invest in clean-technology and
reduce the carbon footprint of their operations. Profitability not only stems from the actual
credits issued and traded, but also from the long-term competitive advantage an early-entrant
would receive from the technological “know-how” that other businesses which were slow in the
decision making process missed out on (Reinhardt, Stavins and Vietor, 225). A business which
was a “net-buyer” in the market can reap even more profits by becoming a “net-seller” by
deciding to employ green investments.
21
Goodwill=Acquisition cost of company (minus) fair market value of net identifiable assets.
41
Economics of international cap and trade
In the international landscape for climate change, the cap and trade system has a key
advantage over other alternatives which explains why it is the most cost-effective policy: cap and
trade aligns domestic policies with international interests and fosters wide scale coordination
(Keohane, 50). Given the wide variety of abatement options available in the international carbon
markets, the convergence of emissions trading schemes into a single globe-wide system would
be tremendously beneficial to its participants. This benefit drastically lowers costs and enhances
productivity, silencing those who fear that costs can stifle the success of environmental policy.
Marginal costs are reduced and equalized by increasing the scope of coverage and
through the harmonization of one trading scheme with other trading schemes. In harmonizing the
global trading schemes, sovereign nations would establish domestic markets and then a linking
directive would allow regulated firms to purchase foreign allowances for compliance with
domestic requirements. Linking the world‟s largest cap and trade programs would achieve cost-
effective reductions in the price of carbon because it allows regional areas, such as the U.S., E.U.,
Asia and Australia—just to name a few—to set up and maintain their own individual allowance
markets but also to receive the benefits of having global information embedded in their prices.
The speed at which information is transferred through computers today would ensure that all
international prices and events would be incorporated into one country‟s domestic prices.
Although it is unlikely for all international prices to equate perfectly, the trading of allowances
on a global basis would equalize the prices22 of all allowances available for sale in the market
and thus, equate the marginal cost of abatement (Keohane, 50). “Maximizing cost-effectiveness
requires that all agents face the same price on emissions. The stronger condition of maximizing
the efficiency gains from policy intervention implies a particular level for this price: namely, the
22
As long as transaction costs within various countries are relatively stable.
42
one that equates the marginal costs of emissions reductions” (Goulder et al, 154). In reality,
environmental regulations would not likely be comprehensive enough to provide one price to all
entities around the world, yet obtaining a common price on these entities is only possible through
an ETS.
Common prices and similar costs create a more equal playing field and provide for a
greater certainty in a new international market. International coordination is highly practical and
should be favored by regulated businesses with the goal of maximizing gains and minimizing
uncertainties. Any carbon system with the goal of obtaining an accurate price must cover as
much territory as possible; not just emitting sources or the total number of participants, but also
in the variation of opportunities to abate emissions as well. “The broader the program, the
greater are the gains from trade, and the lower are the total costs of meeting a given target”
(Keohane, 49). The basis of a cap and trade system naturally supports international
harmonization because the price for allowances—the cost for firms to meet requirements—is
evidently based on the scope of the policy.
As allowances from various cap and trade schemes would thusly be accepted elsewhere
(not just in the region which issues the particular allowance), the price of carbon will reflect
market actions from several carbon trading schemes, not just one. For example, if an allowance
issued in a developing nation is acceptable in the United States, the price for carbon in both
systems will include information about the carbon market from both international regions. This
can help lower the cost associated with carbon because the market price would then indicate the
level of abatement opportunities available in both regions, in the U.S. where they are in scarcity
and in the developing nation where they are in surplus. In the absence of high transaction costs,
43
international coordination will equalize prices and thus marginal costs throughout much of the
global carbon market.
Consider a relatively inelastic good, such as gasoline. Suppose a buyer has only one
station from which to purchase gasoline. In this scenario, no competition exists and the gasoline
station has the ability to charge a higher price than one would actually be willing to pay. The
gasoline operator does not need to account for the supply and demand of other markets or the
prices other stations are charging because there is only one place to go for gasoline and drivers in
this area must buy from this station in order to operate machinery. In the context of a
harmonized carbon market, various abatement opportunities can compete with one another, thus
driving down the cost of abatement. This downward pressure on abatement costs is reflected in
the price of carbon just as in a competitive market for gasoline. For the gas station, once the
market opens up to competition with other stations, the prices will need to reflect all of the
opportunities available to buy gasoline. As a result, firms which are regulated by a carbon
market with international authority have an incentive to include more firms and additional
regions into the program “since their inclusion can create gains from trade and lessen the burden
on the covered sectors” (Keohane, 49). As more regions are included into the market chemistry,
more information is embedded into the price and cheaper abatement opportunities in surplus
markets will lower the average prices for all trading schemes.
International cooperation of carbon markets is improved by the ability to use offsets from
the CDM and JI mechanisms across borders. Nathanial Keohane writes in a recent edition of the
Oxford Journal Review of Environmental Economics and Policy that:
By expanding the scope of abatement opportunities, a well-designed offset program
lowers the overall cost of meeting emissions targets and enhances efficiency. At the
44
same time, a cap and trade program creates a natural constituency that supports offsets:
polluting firms that expect to be net buyers of allowances, who will benefit from lower
allowance prices (49).
The CDM and JI markets are prime examples, as they are orchestrated by the United Nations and
furnish credits which are available to candidates that pass a rigorous test on the proposed
emission reduction project. A cap and trade system is, by virtue of such mechanisms, the best
system to provide these opportunities to engage in environmentally friendly investing23 as the
credits would not have value if they cannot be exchanged between counterparties.
Avoiding more frequent occurrences of the natural disasters mentioned in Part II of this
paper requires a serious reduction in greenhouse gas (GHG) emissions around the world in a
relatively short period of time. The article Cap and Trade, Rehabilitated clearly indicates that a
cap and trade system furthers the GHG reduction goal by promoting cost-effective reductions
through broad participation of international systems. Over time, as additional countries enter the
market for carbon, new and less-costly opportunities will lower the international price for carbon,
and increase the potential for price stabilization. Price stability also helps businesses navigate
the markets and control their exposure to several international ETS markets. As many large
companies have operations all over the globe, international harmony of carbon trading would
provide for the consistency needed to accurately hedge all carbon-related risks the firm must
account for. If a company operates in the U.S. and China, which is very common, cross region
harmonization would prove to be very beneficial24.
23
There are some reasons preventing complete coordination between one nation‟s cap and trade scheme with
another‟s such as banking and borrowing policies, however a discussion on these differences is not relevant to this
paper.
24
Granted that both countries enact legislation.
45
Even though a tax system may seem to be an adequate solution when regarding
consistency, this is highly theoretical and not very practical. A tax does not adapt to changes in
the market and therefore does not equate costs over a period of time. If a tax change is proposed,
it would take months for it to pass into legislation. As such, even if a domestic tax based system
prevails, international coordination is completely neglected. Only through free-markets and
trade can international cooperation be realized. Trading promotes international cohesiveness and
offers a great deal of flexibility, ultimately increasing the plan‟s political feasibility and its
worldwide success in reducing greenhouse gas concentrations.
Stimulating the employment markets
The advancement of technology needed to meet the requirements of environmental policy
brings the potential for major job growth in the economy. Since the 1990s, there has been
renewed interest in alternative energy sources such as geothermal, nuclear, solar and natural gas.
Naysayers of environmental reform, such as Warren Buffet and George Sokol, declare that
offsetting climate change would harm employment markets and cause prices for consumer goods
to increase in ways that more realistically threaten families than some of climate change‟s
greatest risks. In the article published by New Scientist We Can Afford to Go Green, it is argued
that if the U.S. were to cut emissions by 50%, prices of most consumer goods would increase by
less than 5 per cent (Giles, Dec 5, 2009). When compared to the annual rate of inflation in the
U.S. of approximately two to four percent, a five percent increase in prices during a period in
which fifty percent of emissions were eliminated is statistically insignificant and certainly not
substantial enough to halt climate change efforts. Moreover the potential exists for prices to
decrease in the periods following emission cuts as green technology and clean investments
reduce or even remove America‟s burdensome reliance on foreign resources.
46
Environmental safety programs that utilize the capacity of capital markets, such as the
Clean Air Act, have proven that goals can be achieved in a cost-efficient way that creates new
and sustainable jobs. The American Recovery and Reinvestment Act of 2009 included more
than $80billion in clean energy investments that create “clean” jobs for the future. This bill
includes $11 billion for the creation of bigger, better and smarter grids for solar energy; $4.5
billion to make federal buildings around the country environmentally friendly; $6.3billion for
local renewable energy programs; and, $600million in green job training programs25. According
to Boston.com, Massachusetts workers will benefit from a $5million grant to the Utility Workers
Union of America to provide safety, technical and green skills training. States and local
municipalities continue to bolster their economies with green investment, and green jobs are the
new sustainable jobs that will support many American families for many years.
In the private sector as well, companies like Chesapeake Energy, Solarfun Power,
SunPower Corp., LDK Solar and JA Solar lead the industry in clean-technology investments and
green jobs. Investment banks such as Goldman Sachs and Deutsche Bank have entered into this
market place to develop investment banking relationships. Goldman Sachs launched its “GS
SUSTAIN” research business to educate its banking partners on the best companies which are
truly sustainable and which can maintain profits while navigating climate change legislation.
Hybrid car manufacturers, such as Ford and Lexus, have weathered the recession far better than
many other car companies like GM and Chrysler which needed government assistance. In a
capitalist economy, the most successful industries and companies are those which provide a great
product or service at the most affordable price. Although green-technology like hybrid cars are
more expensive than non-energy efficient items, continued investment and commitment in this
area will make sustainability a less-expensive alternative. As companies begin to reengineer

25
http://www.whitehouse.gov/issues/energy-and-environment
47
their products to meet the requirements of legislation and consumer-demands, sustainable growth
will lead the international community to a new level of wealth and prosperity while reducing the
risk of cataclysmic natural disasters.
Possibilities for Investment

Presently, a wave of cap and trade program proposals is appearing around the world.
Delegates from over 190 nations are meeting at the Danish capital of Copenhagen to discuss
potential ideas for combating global warming pressures and to develop the workings of a plan to
guide environmental investment for the next century. Economists and bankers from around the
world expect the market for carbon allowances to be massive, with estimates for the U.S. market
ranging around US$2 trillion (according to Bloomberg magazine26). As the U.S. represents
about 20% of the world‟s CO2 emissions, second only to China, its decisions on the environment
will be very important to the actions of other nations. According to the “Safe Climate Act”, if
enacted by Congress, the U.S. will undergo emission reductions of about 17%-20% from 2005
levels by the year 2020. If the rest of the world also decides to reduce emissions by an equal or
greater amount, approximately 6 billion metric tons of carbon will need to be eliminated in
roughly ten years. As the global economy is recovering from an international recession, the
decline in economic output (production) has likely ended. This means that reductions in carbon
emissions will need to come from investment in new cleaner technologies at every stage of the
product and service life cycle. From lithium-ion batters to wind-farm energy, clean-technology
must be utilized as efficiently as possible. This process can be costly during initial
implementation phases, but long-term profitability is likely due to efficiency gains. As the
demand for green products continues to strengthen, the benefits become more apparent to both
26
Kassenaar, Lisa. “Carbon Capitalists”. Bloomberg Markets. Jan 2010.
48
businesses and consumers. Expectations for return on investment in this area are extremely high,
especially if one bases expectations on the results from the companies which have already begun
the process such as General Electric.
Developing clean-technology products and reengineering production facilities is certainly
not the easiest aspect of managing a company; yet, it has proved to be “greener” for some
companies that have already begun the process. General Electric (GE), for example, launched its
Ecomagination initiative in 2005. This project includes everything from developing wind
turbines to business solutions for internal sustainability. According to the TIME.com news
article “COP-15: Climate Change Conference”, written by Bryan Walsh, the Ecomagination line,
generated US$17billion in revenues in 2008, a 21% improvement from 2007. Not only did this
project bring in large revenues, but it also reduced GE‟s carbon footprint by 13% from its 2004
benchmark. Walsh quotes from Steve Fludder, GE‟s Vice-President: “Ecomagination shows that
green is truly, green”.
Even as some great companies like GE prove the potential for profitability in going green,
uncertainty remains. Investment managers view uncertainty as a major risk to a portfolio and
avoid uncertainty risk entirely by leaving the market or hedge the risk through diversification.
An article in the Journal of Management Studies entitled Regulatory Uncertainty: A Reason to
Postpone Investments? Not Necessarily, argues that portfolio decision makers do not necessarily
postpone investment decisions in the light of uncertainty and can even benefit from investments
if they gain a first-mover advantage (Hoffman, Trautmann and Hamprecht). Several
observations have been made through analysis in regards to investments to secure first-mover
advantages.
49
Companies are investing in a strategy called carbon capture and storage, or also known as
carbon sequestration. The first-mover advantage provides the early entrant an advantage in
technological “know-how” and general experience in manufacturing and usage. The successful
implementation of new technology like carbon capture and storage could make a power plant
independent of cap and trade regulations as the carbon emitted would be immediately captured
and stored. If a power company were to successfully develop this innovation, the first-mover
advantage would allow the company to reduce its own carbon footprint to near zero levels and
profit from trading in the ETS, but also to profit from manufacturing and selling the equipment
for a carbon sequestering unit.
In contrast, normative pressures are conflicting with many businesses around the world.
These pressures come from shareholders who have a right to the firm‟s profits; they are
suggesting ways to boost the company‟s image through reducing its carbon footprint in areas
other than revenue divisions. For example, a company‟s image can be improved through the
construction of LEED Certified buildings, replacing old heavy footprint buildings in crowded
cities like New York. Unfortunately, due to the risk of regulatory uncertainty, shareholders are
not emphatically suggesting reengineering the production processes that are the main engine
behind the firm‟s stream of profit. As a result, most companies are applying the “wait-and-see”
strategy and can potentially miss out on sizeable first-mover advantages. The GEs of the world
will eventually be emulated by others in an effort to move towards sustainability. Doing so can
help companies secure competitive assets, leverage complementary resources and alleviate some
of the numbing institutional pressure.
50
Conclusion
The threat posed to human safety by climate change has made environmental policy one
of the most important issues of the new millennium. Carbon dioxide concentrations have clearly
risen during the modern age at the hand of mankind, and these findings are well-documented.
The large scale emission trends are frightening and confirm the necessity of action to move away
from old-world energy and into a new sustainable future. In 2008, a financial meltdown took
the world by storm. Since it can be argued that financial derivatives and unregulated financial
instruments led to or exacerbated the economic recession, emissions trading may not be the
universal remedy to bolster the global effort against climate change. Emissions trading, if
precisely implemented, has the power to trigger the needed international and local action that can
bring this world back to a natural level of carbon concentrations through stimulating a new
economic paradigm of sustainable development.
It has been demonstrated in this paper how cap and trade is superior to other alternatives
through a comparison of a tax based system and a careful illustration of its cost-effectiveness and
productivity. Reflecting upon some of the most essential elements of emissions trading provides
one with an understanding that trading the right to pollute generates an efficient market price and
equates marginal costs across several opportunities for abatement and millions of installations.
A hybrid allocation method of permits allows governments and politicians to accurately control
the program, raise revenue, and remain politically favorable for their actions. Financial products
allow managers to effectively hedge their risk and their exposure to the carbon market. There
are various elements of cap and trade which display its efficacy; yet, there still remain important
leaders in society who deny the need to employ environmental reform and believe so mainly for
the wrong reasons. The two most popular reasons are disbelief that Earth‟s climate is changing
51
warming and distrust in the fact that such a program is not nearly as expensive as some argue.
The U.S. Acid Rain program is an illustrative example where U.S. companies were able to
reduce emissions of sulfur dioxide to astounding levels at only a fraction of the cost which
economists had expected. These governments did not achieve this milestone through
government taxation or professional standard programs; they achieved this goal with the help of
free-markets and competition. Cap and trade allows companies to be aware of competitive
resources and alternative measures being taken to cut carbon emissions, but more important, it
enables managers to find new ways to provide a better service or to make a more-efficient
product. A carbon tax and other alternatives add to institutional pressure that tie manager‟s
hands behind their backs and asks them to achieve the same result. Emissions trading unleashes
their potential to be creative, to come up with new innovative ideas and to do so more affordably.
Cap and trade harnesses the market power needed to achieve environmental safety goals
cost-effectively. Markets can deliver by giving businesses the flexibility and financial incentive
needed to find fast and innovative solutions. Cap and trade enables those who can reduce
emissions cheaply to earn a return on their investment which lures others to the market in a rapid
progression towards global cooperation. It gives all emitters an incentive to innovate and find a
solution for pollution control. Throughout this essay, the efficacy of cap and trade is revealed to
prove a point. It does not intend to force readers into believing that the world must change
before a tidal wave flattens New York City, but it seeks to compel the readers away from the
falsely extolled reliance on media and political jargon which cry against policy and argue that
environmental reform is not possible. This paper does not attempt to link one-time events like
Hurricane Katrina directly to human‟s actions, but it hopes to show that these multiple standard
deviation events will become less deviated should no action be taken. The time has come for
52
humanity to realize that the grass on the other side of the fence is both literally and figuratively,
greener.
Cap and trade is the embodiment of environmental capitalism, capitalism at its finest.
The United States became the premier business center of the world because free markets allowed
pioneers to display their creativity and hone in on consumer demands. There have been so many
instances when the future had been uncertain; so many times when innovators were not positive
if their idea would be fruitful. Once again, the future is unclear. The doors to creativity need to
be dusted off and reopened for the world‟s pioneers to walk through. The opportunity to reap
major social benefits is before America and its counterparts once and for all. Individual
avariciousness ought not to dissuade the new world movement towards sustainability for it‟s the
very same personal motivation that led America to its wealthiest times. The plight of millions
around the world can be answered and solved through vast economic expansion in this new
millennium, just as economic expansion has cured the pains and sicknesses of millions many
decades ago. Environmental capitalism is the key to sustainable development, the key to
unlocking the future.
53
Annotated Bibliography
Buchner, Barbara. “Policy Uncertainty, Investment and Commitment Periods.” International
Energy Agency. Dec 2007
This paper was prepared by the OECD and IEA secretariats in 2007 in response to the
Annex I Expert Group on the United Nations Framework Convention on Climate Change.
This article explained the advantages and disadvantages of both a long commitment
period and a short commitment period, and how both periods affect the consistency of
environmental policy (cap and trade). Most importantly this article illustrated how
commitment periods are a major source of political flexibility for governments pressed
with creating environmental reform.
Convery, Frank and Luke Redmond. “Market and Price Developments in the European Union
Emissions Trading Scheme.” Oxford Review on Environmental Economics and Policy
1.1 (2007): 88-111.
Learning to understand how carbon is priced through cap and trade is crucial to any thesis
which wishes to illustrate the cost-effectiveness of such a program. As such, this
document served very well in explaining how carbon markets effectively price the right
to emit carbon into the air. In addition, this article summarizes and notes some important
events that occurred in the EU ETS experience, including unforeseen price volatility. A
major concern about cap and trade is the inability for businesses to manage the volatility
of carbon prices. This article teaches the reader by discussing legal and institutional
framework exactly how such volatility can be a healthy sign for a market. In addition,
this document clearly details how linking various exchange schemes can improve the
overall price efficiency.
Ellerman, A. Denny and Barbara Buchner. “The European Union Emissions Trading Scheme:
Origins, Allocation and Early Results.” Oxford Review on Environmental Economics and
Policy 1.1 (2007): 66-87.
This document helped in gaining an understanding of how the first major cap and trade
program came into existence. Beginning with an analysis on the Kyoto Protocol and the
EU Directive, this paper effectively notes the amount of compliance measures required to
run such a program. For example, the article mentions the importance of monitoring
installation emissions data and the potential problems that can arise. The authors also
include a discussion on the different techniques available for issuing allowances, such as
free-allocation and auctioning, and the methods used in the EU ETS.
Field, Christopher and Michael Raupach. The Global Carbon Cycle. Washington, DC: Island
Press, 2004.
This book illustrates the natural carbon cycle which takes place on Earth and integrates
humans into the model, demonstrating how we effect Earth‟s natural processes.
54
Goulder, Lawrence and Ian W. H. Parry. “Instrument Choice in Environmental Policy.” Oxford
Review on Environmental Economics and Policy 2.2 (2008): 152-174
This paper examines the extent to which various environmental policy options meet
major criteria such as cost-effectiveness, political feasibility, distributional equity and the
ability to address uncertainties. The paper includes discussion on tax programs, cap and
trade, subsidy programs, and performance standards. The paper effectively considers
externalities and potential market failures associated with efforts to employ emission
reduction schemes.
Griffiths, Peter. “Arctic to be Ice Free in Summer in 20 Years.” Thomson Reuters. 15 Oct.
2009
This article explains some of the current action being taken by scientists to highlight the
harm being caused at the Earth‟s North and South poles by man-made greenhouse gases.
The article specifically sites the work of scientists and professors who have conducted
research in order to help expand upon previous findings.
Hansjurgens, Bernd. Emissions Trading for Climate Policy. New York: Cambridge University
Press, 2005.
This book begins by discussing the various instruments available for climate change
mitigation. The book then focuses more on technological investment and innovation with
regards to the cap and trade design, highlighting the importance of combating global
warming through a cost-benefit analysis. One of the most important portions of the book
is its discussion on the U.S. attempts to reduce emissions and comparing these attempts to
global attempts which were either market-oriented or command-control. The book
concludes by highlighting some of the legal issues involved in environmental policy,
especially in regards to the linking of several cap and trade schemes.
Hoffmann, Volker, Thomas Trautmann and Jens Hamprecht. “Regulatory Uncertainty: A

Reason to Postpone Investments? Not Necessarily.” Journal of Management Studies.
46.7 (2009): 1227-1253.
This paper discusses the polarity in literature as to whether or not companies postpone
investment decisions in the light of regulatory uncertainty. The authors make their
argument based on competition, leveraging complementary resources and institutional
pressures. Most importantly, the authors base their research on a case study covering 80%
of the German power generation industry which faces regulatory uncertainty from the
European Union ETS.
International Energy Agency. Act Locally, Trade Globally: Emissions Trading for Climate
Policy. Paris: OECD/IEA, 2005.
55
This book provides a comprehensive analysis on the existing emission trading schemes
around the world, illustrating their strengths and weaknesses and identifying their threats.
It shows how trading schemes can be used in sectors other than heavy industry where
emissions are the highest, and in countries other than those which are already considered
to be developed nations. The book importantly demonstrates that, if implemented
accurately, a cap and trade program has the power to trigger many local actions which
will be needed to curb the trend of carbon dioxide emissions.
Keohane, Nathaniel. “Cap and Trade, Rehabilitated: Using Tradable Permits to Control U.S.
Greenhouse Gases.” Oxford Review on Environmental Economics and Policy 3.1 (2009):
42-62.
This article examines the design of both a cap and trade system and a tax based system in
environmental policy and economics. Beginning with an explanation on the basics of
both systems, the author continues with an in-depth analysis on several aspects of both
systems such as: allocation methods, revenue opportunities, government involvement,
economic efficiency and political acceptability, program scope and coverage, flexibility,
pricing development, and international harmonization.
Kleiner, Kurt. “Climate Science in 2009.” Nature Reports Climate Change. N.p., 17 Dec. 2009.
http://www.nature.com/climate/2010/1001/full/climate.2010.134.html. 31 Dec. 2009.
This article cites some very important scientific research which occurred throughout the
year 2009. The article‟s main argument is to show that the scientific facts from 2009
support the claim that the Arctic is warming. Most of the data is in regards to
temperature trends and other data pulled from research assignments at major universities.
Metcalf, Gilbert. “Designing a Carbon Tax to Reduce U.S. Greenhouse Gas Emissions.”
Oxford Review on Environmental Economics and Policy 3.1 (2009): 63-83.
As the public sentiment begins to favor action against global warming, the author of this
article writes on one of the popular alternatives—taxation. The paper lays out the basics
of a carbon tax, and also provides in-depth research about the benefits and disadvantages
of a tax system. Most importantly this article provided information on how the tax would
be levied, and the affect each would have on the prices for consumer goods.
Murray, Brian, Richard Newell and William Pizer. “Balancing Cost and Emissions Certainty:
An Allowance Reserve for Cap-and-Trade.” Oxford Review on Environmental
Economics and Policy 3.1 (2009): 84-103.
The trade-off between a tax and cap and trade is between the difference in the level of
certainty for emission levels and costs. This article analyzes the affect of an allowance
reserve can have on the market, and how it adds to the certainty level. The article
addresses the reserve as a type of “safety valve” that releases some of the pressure when
market prices reach levels which would cause damages to businesses‟ profits. The
reserve for emission allowances act similarly to a central bank‟s reserve of cash.
56
PriceWaterhouseCoopers. “Carbon Taxes vs. Carbon Trading.” N.p March, 2009.
PwC, a big-four accounting firm, has a very large interest in the carbon markets and is
one of the only big-four firms to have done a large amount of research in this area. Its
article, “Carbon Taxes vs. Carbon Trading” defines both a carbon tax and carbon trading,
accurately explaining some of the key functions of each. Also, PwC interestingly makes
a case for a “hybrid” approach, combining some of the elements of each into one
dynamic plan. Although this approach was not completely relevant to my paper, it was
the only attempt I read which makes such a case for environmental policy and therefore
educates me about other current policy analysis that is being conducted.
Reinaud, Julia and Cedric Philibert. “Emissions Trading: Trends and Prospects.” Paris:
OECD/IEA, 2007.
This paper documents the design features of emissions trading schemes and main
proposals, most especially coming out of the United States. The document begins will a
discussion on existing trading schemes, announcing trading schemes, and newly-
proposed trading schemes. The document then follows with an explanation on the design
features of an ETS, including offset programs, allocation options, control measures and
new entrant provisions.
Reinhardt, Forest, Robert Stavins and Richard Vietor. “Corporate Social Responsibility through
an Economic Lens.” Oxford Review on Environmental Economics and Policy 2.2 (2008):
219-239.
This article discusses corporate social responsibility and whether or not firms ought to
invest profits for a social benefit. The paper does a great job at leaning towards the
middle on the subject in order to accurately present both sides of the story. The paper
cites some court cases which illustrate the progression businesses have experienced over
the last 20 years or so in order to demonstrate that businesses are friendlier towards social
responsibility then they had been before.
Strassel, Kimberley. “The Climate Change Climate Change.” The Wall Street Journal. 26 Jun.
2009.
This article highlights some of the most important figures which have spoken out against
environmental policy, including some leaders of the House of Representatives and the
U.S. Congress.
Walsh, Bryan. “COP-15: Climate Change Conference.” Time Magazine. 14 Dec. 2009.
Bryan Walsh‟s article on the Copenhagen conference provides some important

information about international corporations‟ participation at this year‟s conference as
compared to previous conferences. The author argues that businesses this year did not
speak out against the talks as they may have in prior conferences on climate change.
57

Environmental Capitalism: The Power of Cap and Trade

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Environmental Capitalism: The Power of Cap and Trade

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Seton Hall University

UNIVERSITY HONORS PROGRAM

 Scientific Case for Environmental Change

 Factors in Arriving at the Instrument of Choice

 Current Environmental Policy Analysis

 The Opposition to Climate Change

 Taxation: A Necessary Comparison

 Cost-Effectiveness and Productivity

 Capital Investment Decision Factors

A special thanks to Dr. Ahr and the Honors Program

for providing me with an excellent education, and also to Colin, Sean,

Dominick and James for their help in making this a success.

naturally sustainable levels. A change in human‟s perception of the environment is a necessary

large-scale attempts at reducing emissions of anthropogenic gases as too costly on their

effective and productively efficient solution for today‟s globalized economy.

scientifically arrive at convincing evidence for change.

Scientific Case for Environmental Change

hydro-fluorocarbons and per-fluorocarbons1. During Earth‟s natural carbon cycle, carbon

underground. An example of this process is photosynthesis, a process by which carbon dioxide

consequences of the greenhouse effect—the artificial warming of the Earth‟s surface.

consequences of sea level rise.

Antarctica‟s warming trends:

In January, climatologist Eric Steig of the University of Washington in Seattle and

West Antarctica had increased 0.1°C per year.

over the last 50 years.

would certainly cause inland businesses to reconsider the externalities of emissions.

current upward trend of greenhouse gas emissions.

Factors in Arriving at the Instrument of Choice

of future generations. At the Massachusetts Institute of Technology, U.S. President Barack

burden on a particular sector in the economy.

commoditization process involved in a cap-and-trade system and highlights its superiority to a

emissions and abatement opportunities available. Consequently, the more comprehensive a

amount of people—a truly utilitarian technique.

Current Environmental Policy Analysis

goals in its attempt at creating an effective plan.

targets for the EU ETS.

multilateral trading system. Equally as important, the EU ETS establishes a community of

implementing a similar scheme.

incentives to the private sector as it begins to implement the use of clean-technologies.

sectors even exceeded requirements by twenty percent (Environmental Defense Fund).

executed and both the allowances and funds are transferred.

discussions. One option is free-allocation of allowances and the other is auctioning of

allowances. Free-allocation distributes allowances without payment in proportion to a source‟s

allocation. The authors write:

Auctions are first and foremost a distributional mechanism—they redistribute at

government can recycle revenues in the form of lower taxes to businesses

impacted by the ETS, or use the funds to invest in clean-technology (24).

on carbon by apportioning firms a valuable asset without payment.

skeptics of environmental reform who, based on a string of misconceptions, falsely worship

The Opposition to Climate Change

remain dissatisfied at the lack of America‟s commitment to climate change efforts.

perception of an average individual, especially since bone-chilling temperatures during the

adjustments that pass regulations8.

political campaigns and philanthropic foundations.

to defend its opposition by highlighting mysterious cost expectations. Republican

in employment or in capital reinvestment. The argument linking economic disaster to

outweigh the initial expenses.

leaders who do not support it on the basis of high cost expectations.

businesses which choose to embrace sustainability in their production lines.

Taxation: A Necessary Comparison

emissions. Uncertainty surrounds both alternatives, but it is important to consider which

other non-friendly taxes or in subsidizing investment in green technology. Although a clear

in gradually accomplishing its goal of significant reductions.

levied “upstream”. Consequently, consumers would be justified in expecting increases in energy