Cap-and-trade and the transitional gains trap

I'm pleased to present today an op-ed by my colleague, Steve Margolis:

Though much remains unknown regarding U.S. plans to reduce carbon dioxide emissions, Congress is about to ring a bell that will be hard to unring. We are about to be caught in something economists call the transitional gains trap.

The trap arises when a government restricts some activity, often for the specific purpose of increasing prices or otherwise aiding targeted beneficiaries. The limited rights to engage in these activities become valuable as the constraints bind more severely. Owners of these rights become an effective political force for preserving the status quo. Think taxicab medallions, tobacco quotas, land use restrictions and the U.S. sugar program.

First identified by Gordon Tullock in 1975, the transitional gains trap is now commonly taught in introductory economics courses. Tullock’s insight argues strongly for a carbon tax and against cap-and-trade as a means to restrict carbon usage.

Tullock’s main example was New York taxicab medallions, a depression era cartelization of the cab industry. The city issued operating permits—the medallions—in numbers that reduced the number of cabs on the streets.

Medallions can be resold, and in time, as the demand for cab rides grew, so did the price of medallions. The medallion price reflects the benefits to cab operators from restriction on the number of cabs. Those who were in the right place at the right time did well, but today’s cabbies aren’t getting rich. Elevated fares merely pay high the  cost of holding medallions.

Current owners have spent good money on medallions while expecting only a normal return. They are an effective lobby for preserving the status quo. Their case is a good one. They played by the rules and bought medallions in order to participate in the industry, so there is little political will to pull the rug out from under them. And there’s the trap.

There are plenty of other examples. The tobacco program, also started in the 1930s, evolved into a quota system that restricted output of tobacco. Quota owners grew tobacco and benefited from elevated prices, or they leased their quota to others at rates that captured the price premium. Over time, with changing domestic demand for tobacco, the program became an albatross. Quota owners were bought out in 2004 at a cost of $9.6 billion. 

In transitional gains traps, there are initial gains to those who are granted participation rights. Latecomers have to pay a price of entry that captures the scarcity rent. Owners of valuable rights lobby to preserve these programs, so restrictions last long beyond their original purposes. The U.S. sugar program, for example, was created to aid pre-Castro Cuba.

The proposed carbon cap-and-trade system limits economic activity by creating marketable rights to use carbon. Where there are good reasons for restricting an activity, a market for tradable rights does two good things: It sets a readily observable price and it allocates the right to its highest valued use. Accordingly, many economists have supported such approaches. But the particulars of the carbon program combine to create a burdensome trap.

The president’s budget proposed an auction of carbon rights that would raise about two-thirds of a trillion dollars. Although congress will undoubtedly give some of the rights away to favored interests, the budget figure probably captures the values of the carbon rights in play.  So, while we could buy our way out of the tobacco program, undoing this one will not be so easy.

The President’s budget calls for us to spend the proceeds of the auctions about as fast as they come in, $115 billion on green energy projects and the rest on refundable tax credits. Thus, the auction yields no fund for buying back carbon quota if circumstances change. 
 
Furthermore, we are operating in an area of considerable uncertainty. While some of those concerned about global warming shun any discussion of the issue, much of the support for action comes from those who acknowledge some uncertainty but favor taking precautions. One needn’t be a global warming skeptic to entertain the possibility that either our circumstances or our understanding might change over time. And many who accept the forecasts of global warming models nevertheless note that the costs-benefit relationship of CO₂ reduction is unclear. And if other countries do not adopt carbon restrictions, ours may constitute a considerable economic handicap. 

So we may find ourselves quite a trap. Once carbon-use rights are sold, owners will have an interest in preserving their value—two-thirds of a trillion dollars for openers. Carbon cap and trade will set up an alliance between big carbon owners and environmentalists, as both will favor rigid restrictions even in the face of changing circumstances. Big Carbon would likely align with environmental and NIMBY interests to oppose nuclear power, offshore windmills and other alternative energy sources to support the values of carbon rights. 

Carbon cap and trade will establish restrictions on economic activity that will bind future generations. Perhaps that’s what some supporters like about it. But notice who pays. For the most part, it’s not us—not the baby boomers. Sure, we’ll bear some of the cost of these restrictions. But the president’s proposed auction collects the present value of the scarce carbon-use rights from here to eternity, then distributes it in the course of a few years.

Compare the proposed arrangement with an ordinary carbon tax. A carbon tax can limit the use of fossil fuels to the same extent that a cap would—just choose the right tax rate. This year’s taxes are our revenues, available to support our government activities; our children’s taxes are their revenues, available to support their government activities. Under cap and trade, we’ll spend our revenues and our children’s too, thank you very much.

Under the President’s proposal, we capture the transitional gains, but our children live in the trap. Along with our national debt and our Social Security and Medicare obligations, cap and trade is one more way of shifting burdens to our children and their children. This is a heck of a way to start a “new era of responsibility.”