Cap-and-trade regimes do a worse job at stimulating innovative pollution control methods than performance standards, according to a new scholarly article challenging the industry-backed position that emissions trading and market-based programs are inherently superior to so-called “command-and-control” regulation.

Industry generally rails against regulations that set performance standards for emissions reductions, and industry-funded think tanks and academics have successfully turned that opposition into a widely held belief that emissions trading is an inherently superior method of controlling pollution than strict performance standards. That theory is mistaken, argues Center for Progressive Reform member scholar David Driesen in a forthcoming article, in part because the industry position is based on two fundamental flaws:

• It selectively ignores part of the emissions trading equation. In a nutshell, the industry thesis is that emissions trading schemes encourage companies to find ways to reduce their pollution below the allowed cap so that they can sell emissions credits. Although true, the industry argument conveniently ignores the simple fact that there are both sellers and buyers in the emissions market. "While emissions trading encourages sellers to decrease emissions below the levels of a comparable traditional regulation," Driesen points out, "trading encourages buyers to increase their emissions . . ." (emphasis added). He concludes, "It is not clear why a measure that reduces innovation incentives for some facilities and increases them for others will lead to an increase in overall levels of innovation among facilities subject to a regulation."

• It misattributes innovation incentives to the market-based mechanism rather than the stringency of the underlying emissions cap. The industry-backed arguments treat emissions trading and performance standards as stark opposites even though cap-and-trade regimes are ultimately a form of performance standard. The cap in emissions trading schemes establishes an overall performance standard, while the market for trading emissions credits essentially establishes a policy of indifference to the site-by-site geographical distribution of compliance levels. An across-the-board performance standard, alternatively, requires all facilities to comply equally. The stringency of the underlying performance goal creates the cost pressures that induce innovation in both emissions trading and performance standards models. "If the market performs perfectly," Driesen writes, "then an emissions trading program produces precisely the same amount of reductions that a traditional regulation with the same emissions limits would produce, no more and no less."

Driesen’s comparison of performance standards and emissions trading starts with the supposition that traditional regulation can, just like the highly-touted market-based approach of emissions trading, inspire businesses to develop innovative compliance approaches that not only reduce compliance costs well below pre-regulation estimates but also can result in additional cost savings that offset the initial compliance costs. As famously argued by Harvard University's Michael Porter, all pollution is essentially waste and a sign of an inefficient system of production. Strict regulation can force industries to cut waste by discovering more effective ways to manage their resources, resulting in improved efficiencies of operation that save companies money. Porter asserts that companies do not take advantage of potential cost savings of environmental innovations because research into such savings is potentially costly and wrought with uncertainties. Strict regulation gives industries the incentive to invest in such innovations.

Emissions trading discourages this kind of innovation, Driesen argues. Emissions trading fails for several reasons, such as the following:

• It limits the scope of probable innovation by restricting the price range of rational innovation investments. Though emissions trading may provide incentives for some businesses to invest in innovation and cut emissions further, other facilities would be encouraged to buy emissions credits rather than invest in new technologies. Under an emissions trading program, it may be less costly for a facility to buy emissions credits than to invest in costly innovation that may not pay off. Emissions trading would encourage only limited investments in innovation because, Driesen argues, “rational sellers will only generate credits that cost less to produce than 1) the control costs of prospective buyers, and 2) credits with which the seller must compete.”

• The much-touted lower costs of emissions trading will lower incentives for innovation. By lowering the cost of compliance, emissions trading programs may actually discourage innovation. More stringent regulatory standards can induce innovation by providing industries with incentives to invest in innovation. As Driesen puts it, “stringent regulation (with or without trading) raises the cost of routine compliance and creates an incentive to innovate in order to escape the high costs.” Thus, if emissions trading programs are less costly and burdensome for industry, industry will have less incentive to invest in new technologies that may provide greater benefits in the long term but can be expensive and risky in the short term. Driesen concludes, “Trading, by shifting reductions from high-cost to low-cost facilities, may lessen the net incentives for innovation.”

Trading allows companies to comply with regulation without making significant changes that may provide greater benefits in the long-run. Driesen gives the example of a greenhouse gas emissions trading program in the European Union. "If European states imposed strict requirements upon electric utilities, they might have to switch fuels in order to meet the requirements," Driesen explains. "They might need to switch from coal to natural gas to meet fairly stringent reduction targets and very strict standards might drive them toward innovative technologies, such as almost-zero polluting fuel cells and solar energy. But trading may allow them to avoid significant changes."

Thus, traditional emissions regulation -- either performance standards or technology-based standards -- may result in some cost pressures on industry in the short-term but can spur innovation that will provide greater cost savings for industry as well as greater reductions in harmful pollutants than cap-and-trade methods.