Cap and Trade

An Interview with Richard Schmalensee

Richard Schmalensee '65, PhD '70 is professor of economics and dean of the Sloan School. He is a member of the National Commission on Energy Policy (NCEP), a non-governmental bipartisan group which last week released a set of energy policy recommendations. The recommendations are comprehensive, addressing everything from guidelines for vehicle fuel efficiency to increases in research budgets, to, perhaps most importantly, the creation of a viable national emissions trading scheme. Here Professor Schmalensee talks about some of the issues at stake in controlling emissions, and the challenges that lie ahead for fighting climate change.

The Tech: When did you first realize that climate change would be an important problem?

Richard Schmalensee: In the '88 campaign, then-candidate Bush said that he was going to use the White House effect to deal with the greenhouse effect. Beginning in 1989, I was on the Council of Economic Advisors, and I was assigned the task of directing an inter-agency group on the economics of climate change. What was striking at that point was how much uncertainty there was about everything. The fundamental physics of the greenhouse effect were clear to everybody, but the magnitude of the effect wasn't clear, and the role of the oceans wasn't clear, the role of clouds wasn't clear, and the damages certainly weren't clear … the cost of doing something wasn't clear.

Even now there's a lot of uncertainty, but there's only one planet, and do you really want to roll the dice? Not rolling the dice requires global action at a level that we've never done, however. There's never been anything like "reducing global energy use." So the consequences of not doing something are potentially devastating, [while] the difficulty of doing something is enormous: That's a big problem.

[Sir Nicholas] Stern talks about how "the sting is in the tail." So maybe the median change isn't so bad, but if you look out at that right tail [of the probability distribution], that right tail is really nasty, and there's mass out there.

TT: So what can we do about it?

RS: This has become a very lively issue in Washington. [The NECP] proposes a "cap-and-trade" scheme, with a rising safety valve price, and a substantial increase in spending for research and development on low-carbon energy technologies, and a range of other policies. But the core is a comprehensive, economy-wide, cap and trade system.

TT: How much of a difference will it make without international participation?

RS: The arithmetic is compelling: Any country, even China, acting by itself won't do much. The program that we propose looks like it can be done at a moderate cost to the US economy, but by itself it will have a very small impact on global emissions and certainly on atmospheric concentrations. If fifty years from now, India and China have done nothing, then basically what we and Europe and Japan do won't matter, because total global emissions need to decline substantially, and that's going to require fundamental change not just in our economy, but in everybody's economy.

One thing I think is certain, however: if wealthy countries like ours don't take some action, it becomes very hard for us to get very poor countries to do something. If 1.3 billion people industrialize and use energy at anything like the level that the US or Europe or Japan uses, the CO2 game is over, it's just over. So they cannot become rich the way we became rich.

Their response to that, properly, is, look, you're telling us we can't go down the road you went down because you went down it. You put the carbon dioxide into the air! … and they're right of course, but that's what makes it such a hard problem.

We need fundamental changes in the menu of available technologies. We've never traveled a low-carbon road from poverty to wealth, and we don't have one for them to travel, and we'd better find one, and we'd better help them get on it. Low–carbon, attractive technologies are unlikely to emerge first in very poor countries; they have to emerge in rich countries, when carbon is expensive, when research has been devoted to finding ways to have a energy-rich economy that's not also carbon-rich.

There are lots of things you can do in the short run, like you use energy-efficient lighting, you recycle, and you do all these small things, but fundamentally, in order to solve the problem, we need fundamental changes in technology. Having more people use energy-efficient light bulbs is very good for making us all feel good, but the quantitative impact is tiny.

TT: So the change has to be in technology and not in lifestyle?

RS: Well, they mix. Compare energy use in the US and in Japan: Japan has much lower use per capita, smaller houses, smaller cars. Now suppose we switch to the Japanese lifestyle and continue to grow — then it doesn't matter! It's hard for me to imagine a world in which rich people aren't going to want refrigeration, and the ability to wash their clothes mechanically, and computers and heating and air conditioning … so yes, you could have cities that are more compact so that you drive less, as in Europe and Japan, you could have more public transportation, but what kills you is growth. What kills you is [if] we take emissions down through lifestyle changes by 20 percent over two decades, [and compare it to] how much world energy use will grow just due to economic growth over two decades — it'll swamp that. So at the end of the day, lifestyle changes — unless we all go back to primitive lives, which is not plausible — lifestyle changes won't do it.

Unless we're going to try to say to the bulk of the world's population, stay poor, don't use more energy, we'll cut back a little and we'll all be fine — that's not a viable answer. Or, get rich the way we got rich — that's not a viable answer. We need to find another answer.

TT: Is there a way to separate economic growth from growth in energy consumption?

RS: We've become less energy intensive over time — one way to think about that is that it's the other side of the decline in manufacturing. We've also become less carbon-intensive over time because natural gas has to some extent replaced coal. As natural gas becomes more expensive, and as people build more coal-fired generating plants, that may reverse. But for the last 30-40-50 years, we have with current technology had economic growth with a smaller percentage increase in carbon emissions, and you could imagine zero. You could imagine zero.

But remember we need a decrease … at a time when several billion people in India and China are on a path to take them out of poverty, and that path involves burning a lot of fossil fuels, and that path will warm the earth. So there are ways — a lot of nuclear power — but nuclear power is expensive, we all get nervous about it, and so there's just simply not a quick fix to this.

Burning coal to generate electricity is really cheap … but breathe the air in Beijing or Shanghai on a bad day. The Chinese have raised several hundred million people out of grinding poverty into comfortable lives — it's an extraordinary achievement on any historical scale. But the costs are visible in the air, in other forms of pollution, and in the CO2. The Chinese say, well, you want another SUV, we would like this impoverished family to have a decent life … We do not enter the international negotiations from a strong position — particularly if we do nothing. I think the only way there is a chance that this gets solved and it gets solved over the next century, is if the US takes significant action and again becomes a player in the international negotiations.

TT: What's the time scale for doing something?

RS: My own bet is that nothing happens until after the presidential election. If you think the next administration — almost no matter who wins the election — is going to be more sympathetic to doing something, then you want to spend time now thinking through some of the complexities — this is not a simple thing to do — and get ready so that right after the election, you can pass something.

If you look at the [effort to reduce acid rain by setting up a national cap and trade system for sulfur dioxide emissions], there was so much earlier thinking during the Reagan administration: what do we have to do to monitor for enforcement, where will we get the data, how will we structure it, what are the legal implications of having a tradeable allowance, so that by the time we elected [the first Bush] administration that wanted to do something, it was pretty quick. It was a very successful program, and I think that's the reason we're talking about cap and trade now, and the reason the Europeans have a cap and trade system.

TT: Have some of the complexities of carbon trading been worked out?

RS: Some. The questions of where do you put the regulations, how do you give the allowances out, are under active discussion now. My view has always been that once you have the machinery in place, you can turn the knobs. What's wrong with the European system? They gave out too many allowances. Well guess what, you give out fewer next time.

TT: What would a strong price signal be?

RS: There really isn't anything like that on the table, and it's just not politically viable now. I'm an economist, so I have to be a believer in strong price signals, [but] I don't advocate a strong price signal right now, because unless we can engage the whole world, particularly India and China, we would just be shooting ourselves. They're mining coal like crazy and you're telling me you're going to have Appalachia unemployed?

The cheapest way to reduce carbon emissions, dramatically cheapest, is to reduce them in India and China. It's to improve fuel efficiency there, rather than at unbelievable cost in Japan, and at high cost in Europe, and still pretty high cost in the US. But I think it's essential that we in the US start and look down the road to a regime in which we have a global or something approximately global. It's not clear how we get from here to there, but we need to get something that looks like a high carbon tax, or a very tight cap and trade trading scheme.

The people least able to pay for reducing [emissions] are in developing countries, so there has to be some way across that bridge.

TT: There are systems where you can pay for a reduction there, and have it count here?

RS: We've had [offset] systems like that in the U.S. to deal with air pollution particularly in L.A., since probably the 70's, and they just don't work well. Either you don't get the reductions in carbon because they're so easy to game, or you put in such a heavy regulatory burden that it's just too expensive to transact. There are some interesting experiments going on, to try to come up with kinds of transactions, kinds of offsets, that can be handled in a simple but well-monitored way, so that you can actually have a reasonable market, and that might work.

TT: So do you expect your Commission's recommendations to be followed?

RS: No, it's a very complex process. It's very easy in this political climate to propose amazing cuts in CO2 without actually checking feasibility or cost. The cost of our proposal is not trivial, a quarter percent of GDP — and there are only 100 percents, so it's not nothing. But it's not going to cause a recession or a return to the Stone Age; it's a manageable cost. We think some of the other proposals that are much more aggressive have much higher costs.

TT: How significant are the cuts that you are proposing?

RS: I think we proposed to be down 15 percent by 2030, so it's a reasonably significant cut, given the expectation of substantial economic growth over this period. And also, and this is a very contentious issue, it has a safety valve. It says, if the price of carbon allowances gets above a certain level, the government will issue more allowances.

TT: What about the other way? If they cost too little?

RS: We call for a five-year review, particularly in light of international developments. There are enormous debates about what these things cost. Our solution is, look, those of you who are really pessimistic about technology, rest assured, the cost won't be more than X. Those of you who are really optimistic about technology, hey, then this will be cheap; you'll never see the safety valve price; and everybody will be happy. And most environmentalists are technology optimists.

TT: Are you an optimist?

RS: I go back and forth. I'm not an optimist about the likely payoff from large scale government programs to develop technology; I am an optimist about the response to a strong price signal, and I'm an optimist about the ability of basic research to give us what we need in the long term.

TT: Does MIT have a role to play?

RS: I think MIT could potentially play a critical role, globally. Both in the short term, developing [transitional] technologies that have commercial potential, and, more important, in the longer term, by doing the fundamental research that could lead to the kinds of breakthroughs that the world needs. The question is, it's now 2050, what does the economy look like? It better not look a lot like today's if we're going to solve this problem. Getting from today's economy to a very different energy economy in 50 years is not trivial. We can all bicycle to work, but if we're going to have air-conditioned homes….

Starting out with a relatively weak price signal, aggressive research, and being prepared to take more drastic action — I'm guardedly optimistic.