Critiques of cap and trade can be classified in three categories:
One can criticize cap and trade because it is usually connected with carbon offsets, better called rip-offets. Offsets are a big loophole making mockery of the claim that the number of carbon credits is limited. Developing countries need massive aid so that they can embark on green development, but entrepreneurs scouting the landscape for sources of carbon offsets is not the way to do it.
One can also criticize cap and trade because of grandfathering, (cap and giveaway), i.e., allocation of pollutions credits for free to the polluters. This reverses the polluter pays principle and gives windfall profits to the worst polluters, because, even if they get most credits for free, they can and will still raise their prices since their marginal cost has risen (as long as they are not regulated). Besides, experience shows that industry succeeds to get over-allocation.
What is wrong with cap and trade without offsets and without grandfathering? It creates difficult to understand financial instruments which are not flexible enough for regulation (it is not possible to withdraw them once they are issued), and create a distracting drain on the real economy (think hedge funds). They create their own industry of traders who earn commissions, they spark their own derivatives (carbon allowance futures etc.) Here are some examples from the EU-ETS:
(a) recently the carbon price plummeted because the general recession led to less output than anticipated. All cleanup efforts ceased because from the point of view of emission allowances, there is not difference between less output and cleaner output.
(b) the extraordinary successes for renewable energy in Germany did not improve EU pollution because, if there is more renewable energy than anticipated, this did not change the number of offsets issued in the EU-ETS. Each extra windmill farm in Germany freed offsets for more coal-fired power plants in Poland.
(c) firms in desperate need for cash because the banks were not lending resorted to selling their offsets.
(d) extreme price variability.
Once issued, the permits take their own life and lend themselves for rent-seeking behavior. It is a privatization of the atmosphere. There are attempts to counteract this by having frequent auctions and no trading, issuing permits to individuals, etc. Probably the most radical approach never converts the quantity signal into a price signal but issues tradable personal carbon rations to the end consumers.
Hans.
Hans G. Ehrbar http://www.econ.utah.edu/~ehrbar ehrbar at economics.utah.edu Economics Department, University of Utah (801) 581 7797 (my office) 1645 Campus Center Dr., Rm 308 (801) 581 7481 (econ office) Salt Lake City UT 84112-9300 (801) 585 5649 (FAX)