A Simple, Yet Powerful Explanation of Cap-and-Trade

by: Greg Steele

Cap-and-trade is a new solution to a long standing problem called “the Tragedy of

the Commons” a good explanation can be found on wikipedia. The article’s
introduction nicely sums it up:

"The Tragedy of the Commons" is an influential article written

by Garrett Hardin and first published in the journal Science in 1968. The
article describes a dilemma in which multiple individuals acting
independently in their own self-interest can ultimately destroy a shared
limited resource even when it is clear that it is not in anyone's long term
interest for this to happen.

Central to Hardin's article is a metaphor of herders sharing a common

parcel of land (the commons), on which they are all entitled to let their
cows graze. In Hardin's view, it is in each herder's interest to put as many
cows as possible onto the land, even if the commons are damaged as a
result. The herder receives all of the benefits from the additional cows,
while the damage to the commons is shared by the entire group. If all
herders make this individually rational decision, however, the commons
are destroyed and all herders suffer

This peer-reviewed and tested model and has frequently been used in the context of
environmental issues, providing a strong foundation on which to build an
explanation of cap-and-trade.

Two diametrically opposing views have been proposed to address “the Tragedy.”
One is regulation, the other is private ownership - fence up the commons into lots
and sell them off. The Tragedy of the Commons runs counter to Adam Smith’s
fundamental tenet of capitalism that states, individuals acting in their own best
interests also serve the collective best interest, illustrating a weakness in capitalism –
unaccounted externalities.

Cap-and-trade combines the best of both systems and has the potential to become a
new economic system that addresses the inherent problems with capitalism while
still working within a market system. The significance of this cannot be overstated.
This is not just about CO2 emissions. It is a whole new way to organize distribution
of resources that accounts for externalities. It could be used to manage resources like
ocean fish stocks and potable water; while controversial it could even be used to
address immigration and population growth.
The model part 1 Part one applies carbon caps to the Tragedy of the Commons
model, it assumes that all energy production results in the same level of CO2 by-
product. Part 2 farther extends the model to include the existence of alternative fuels.

Step 1. Determine the sustainable carrying capacity of the commons, or how many
cows can indefinitely graze on the commons without destroying it. For the model
let’s assume a target of one-hundred cows as been agreed upon.

As there is controversy over an appropriate target in regard to real world global

carbon emissions, cap-and-trade proposes modest reduction over an undermined
time frame.

Step 2. Determine the number of herders who wish to use the commons for grazing.
Let’s say that the town puts a “cap” of ten cows per herder and charges each the
same fee, which is given to the town’s people as an increase in public services and/or
tax abatement.

Optional. Rather than 10 cows per herder, let’s say there are ninety non-
herders (teachers, doctors, millers, tailors, blacksmiths, etc) who live in
the town which owns the commons. In the traditional Tragedy model
these people who, by being citizens of the town, own the commons are
cut out completely as the herders are the only ones who use the resource.
A fair and just arrangement would allow each citizen the right to graze
one cow in the commons. However, most of the townspeople do not want
to herd cows and it would not be practical for everyone to be a herder.
Therefore, each citizen is given one “cow credit” which they sell to the
herders. In the real world this is the carbon auctioning process which
allows larger and smaller CO2 emitters to enter the system at their
current levels.

This, in effect, is the same thing as the proposed privatization solution to the Tragedy
of the Commons problem. Essentially, the town is selling the commons to the
herders without dividing it into lots.

Therefore, a herder with 5 cows can sell his/her 5 unused shares of usage to another
herder with 15 cows. Each herder is free to grow their business as much as they
would like as long as the sum remains under the cap. If more want to increase their
herd size the value of a cow credit will go up, enticing the sale of more credits until
an equilibrium is reached.

Much of the discussion about cap-and-trade stops at this point, understanding it as

only a system of appropriating costs associated with production. This still is a good
thing as it assigns the cost of externalities, requiring them to be subtracted from
gross revenue rather than be passed off to the general public in the form of expensive
measures to clean up environmental issues. These clean up projects are of course
funded through tax dollars and this should be a point argued from the right in favor
of cap-and-trade. However, arguments are made that this will be a tax passed on to
the public, while it is assigning a real cost of production to the parties profiting from
the production. It’s a question of good accounting verses bad accounting. However,
this is a zero-sum game prospective, the existence of renewal energy means that this
is not a zero-sum game.

The model part 2

Let’s add to the model an imaginary super cow. This new type of cow produces the
same amount of milk/meat as a normal cow but eats half as much grass.

This represents a renewable energy source which produces the same energy, but does
not produce as much, or any CO2 - some CO2 may be generated from the
manufacturing process. However, these super cows cost twice as much to breed. This
models the reality that it is cheaper to generate energy from fossil fuels. However, as
demand for renewables increases, economies of scale will bring prices down.
Therefore, in the model, as demand increases more people will breed the super cows
and the costs will decrease as a function of demand.

Since the super cows eat only half as much grass the commons can sustainable
support 200 of these cows. Therefore, they only coast a half cow credit to graze in
the commons. So a herder with 20 super cows will be within the ten cow credit cap.
A herder with 15 cows who coverts his/her herd to super cows is only charged for
7.5 cows meaning he/she can maintain the same herd size while being able to sell 2.5
shares to another herder with more than 10 cows. This new source of revenue,
therefore, offsets the cost of purchasing the super cows. The system is self
reinforcing as the incentive to own the new cows encourages breeders to breed for
lower and lower grass consuming cows. It also creates the potential for more herders
to enter the market as the carrying capacity of the commons has doubled.

This has been working for much of the industrialized world (excluding the United
States) since the Kyoto Protocol was agreed upon. It has created a new market in
carbon trading that is based in reality. Natural resources are monetized adding
significant value to the global economy. Some say, this will be ten times bigger than
the dot com boom.