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 / Spring 2009 / Issue 54(originally published by Booz & Company)


Pollution, Prices, and Perception

Unfortunately, energy prices under most proposed cap and trade systems still wouldn’t be high enough to move consumers to take the steps needed to mitigate climate change. And evidence suggests that, no matter how high energy prices might get, they would still be insufficient motivators in themselves. For example, many people still don’t take advantage of home insulation, weatherization (modifying buildings to make them less vulnerable to heat, cold, and moisture), and other opportunities to improve energy efficiency, despite such solutions being economically attractive at current prices. Habit, ignorance, and inconvenience serve as durable barriers to behavior change, regardless of the incentives.

Another shortcoming of cap and trade systems is their reliance on pecuniary incentives — which have a poor track record at influencing certain types of human behavior. Consider the millions of people who choose to donate blood, to volunteer for military service during wartime, to donate time to local community efforts, and to voluntarily sort recyclables from trash every week. Feeling good about oneself or receiving social approbation or blame can work where markets don’t — or where they are viewed as socially inappropriate. The same appears to be true in the case of popular attitudes about climate change. About 80 percent of respondents in the Booz & Company survey said that they would pay a substantial premium for their own renewable solution, but they would not pay even a small percentage of that amount in higher energy prices. For example, most respondents indicated that they would rather in­stall a solar panel on their home than pay even a small increase in their utility bill to reflect the cost of carbon reduction.

Finally, as the turmoil in the financial sector in the last half of 2008 reminded us, free markets don’t always direct people to the op­timal or most appropriate choices. In energy markets in general, the ability of prices to provide useful information is compromised by the lengthy time lags and giant scale of investments typical in this highly capital-intensive industry.

Recent wargame-style simulations conducted by Booz & Company on potential implications of climate regulations for the U.S. electric power sector — with executives from leading utilities and oil and gas companies as the participants — underscored this issue. As in the real world, even experienced players failed to anticipate the consequences of one another’s choices. The result was follow-the-herd waves of underinvestment and then overinvestment in new power generation, with emissions pricing rising to very high levels before crashing to near zero. In the real world, the European Union’s nascent emissions trading scheme has experienced similar volatility. This pattern could easily reappear in a U.S. cap and trade market.

Belts and Suspenders
In the end, the multifaceted nature of climate change, and the requisite shifts in behavior and investment needed to address it, renders problematic any approach that depends solely on a cap and trade program. What then will policymakers do? Rather than placing an undue burden on fragile market institutions, they will supplement the cap and trade system with several other venerable policy instruments.

Several climate change initiatives are already following this kind of diversified, belts-and-suspenders approach. For example, the California Global Warming Solutions Act of 2006 established a landmark climate change abatement program that blends regulatory and market mechanisms with the goal of reducing GHG emissions to only 20 percent of 1990 levels by 2050. Since transportation contributes 39 percent of California’s gross GHG emissions, targeting that sector was a key element. California employs a custom mix of policies, including vehicle efficiency and mileage standards, mandates for lower levels of carbon in transportation fuels, and a transition from gasoline and diesel to alternative and renewable fuels. In addition, the state awards US$120 million annually in grants, revolving loans, loan guarantees, and other measures to develop and deploy innovative fuel and vehicle technologies. California also aims to increase electricity production from renewable resources to 33 percent by 2020, through a combination of standards for buildings and ap­pliances, and programs delivered by utility companies, local governments, community organizations, and the private sector. Climate Action Team subgroups have been formed in sectors such as agriculture, forestry, and energy to identify and analyze measures for reducing emissions. Land use and agricultural policies are also included in this robust portfolio.

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