07/25/2009 05:12 am ET Updated May 25, 2011

Cap and Trade Part 5: What's With the Add-Ons?

If Waxman-Markey has a cap and trade, why does it need all the other stuff like fuel-economy standards for cars, renewable electricity standards, and building codes?

The Waxman-Markey climate bill is attracting a lot of criticism, from both sides of the aisle. One criticism is not even aimed at Waxman-Markey's main event, the cap and trade. It's leveled at the other stuff, the non-cap-and-trade add-ons or, in the words of the Washington Post editorial board, the "Buried Code." Are these add-ons really necessary?

Here's the way this scientist sees the economics of it all.

In This Series
Part 1: It"s About the Cap, Stupid
Part 2: Walking the International Tightrope
Part 3: You Ask, "What?" I Say, "How Wide?"
Part 4: Forests, Farms, and Offsets
Part 5: What"s With the Add-Ons?

A Cap and Trade Is Designed to Deliver a Market Correction

The purpose of a cap and trade is to correct a flaw in the market. In the case of carbon and greenhouse gases, the glaring defect is that the cost of energy does not include the price society must eventually pay for spewing heat-trapping substances into the atmosphere. (Think health care expenditures, losses in environmental services like drinking water, and the costs of digging out from floods and recovering from droughts. That's a large bill to be offloading onto our children and grandchildren.)

So how do we make a market correction?

  • We start with the technocrats -- in this case the climate scientists; they tell us how much greenhouse gas emissions the atmosphere can take. Admittedly, it's next to impossible to derive a definitive amount, but the scientists can give us something to work with.
  • We then use this amount to set an emissions cap and let the price adjust so that this set limit is not exceeded.
  • By allowing emitters to buy and sell emission allowances, the trade part is used to allow the market to seek out the most efficient, least costly ways of meeting the cap.

End of story, right? Not quite. Even with a cap and trade, there are inevitably aspects of the marketplace that still have the incentives wrong and, in these instances, some further tinkering (or what I call "add-ons") may be appropriate.

Efficiency Standards for Buildings

Efficiency standards and building codes for new construction are good examples where I think an add-on is useful, the Washington Post's take notwithstanding. Consider these extraordinary facts.

  • Emissions from U.S. buildings account for [pdf] almost 40 percent of North America's entire emissions and 10 percent of the world's.
  • By one assessment half of U.S. buildings in 2030 will have been constructed after 2000. 
  • The technologies to increase the energy efficiency of new buildings by 50-70 percent over current designs are already in hand. (See here [pdf], here, and here).
  • In the long run these efficiency measures will save money.

Wow, the third and fourth points make it sound like we got the building thing down cold and we should be seeing huge reductions in carbon emissions from buildings.

Unfortunately, that doesn't seem to be the case; the energy efficiency of new buildings is not increasing at the rate we might have expected. Why? Some economists argue that it's a problem with the market. Constructing more energy-efficient buildings requires up-front investments by the developer, contractor, or, in the case of rental property, the landlord, but the financial benefits go to the occupants. In short, the incentives are not set up correctly.

One approach is to leave things as they are. Eventually, with cap and trade, energy costs will increase and people will begin demanding energy-efficient homes and buildings. Two problems with that:

  1. change will not occur until people feel financial pain; and
  2. buildings hang around for many decades -- if we construct inefficient ones, we're stuck with them for a very long time.

And so Waxman-Markey includes building-code standards to ensure our new buildings don't become energy-hogging balls-and-chains tied to unfortunate tenants and unsuspecting homeowners. Specifically, the bill mandates that:

  • one year after becoming law, new homes and commercial buildings will need to achieve 30 percent energy efficiency over current codes;
  • by 2015 homes will need to be 50 percent more energy efficient (with commercial buildings being 50 percent more efficient by 2016); and
  • every three years following the first efficiency mandate, an additional five percent energy savings will be required through 2030.

Make sense? I think so.

Fuel Economy

What about fuel efficiency in America's cars? Waxman-Markey puts petroleum under the cap, and capping emissions from petroleum will eventually affect the kinds of cars people elect to drive, so why do we need Obama's aggressive fuel-efficiency standards announced in May?

I believe the argument goes like this: the demand for fuel for driving is extremely inelastic -- meaning the price of gasoline must be extremely high before people begin changing their driving habits. (Last year, the cost of gasoline had to get above $4/gallon before people began curtailing their driving.)

In a cap and trade, what will likely happen is that most of the emissions reductions will go to the power sector or to offsets bought by the petroleum sector. In terms of meeting the cap, no problem.

But the cap and trade mechanism does little to encourage the development of new automotive technologies or to lower our dependence on foreign oil, so the administration has added on higher fuel efficiency standards. Make sense? Maybe.

Renewable Electricity Standards

And finally we get to the requirement of a minimum amount of renewable energy on the electric grid. Waxman-Markey calls for a 20 percent mandate for renewable energy with up to five percent from efficiency measures (more details here).

The argument for such standards is that fledgling energy industries like wind, solar, and geothermal need a leg up to reach the economies of scale necessary to compete with the conventional coal, gas, and oil industries. It also would create a more diverse portfolio of low-carbon energy sources.

However, I am not entirely convinced by this one. The cap and trade already provides a competitive advantage to renewables because of the essential absence of greenhouse gas emissions. Adding on a renewable standard smacks a little to me of the government picking winners and losers. Do I have it wrong?

Now with the add-on portion of our series on cap and trade done, we have one more installment to ah add on -- the most controversial: allowances.