Carbon Emission: Regulatory Controls vs. Market Based Solutions

Many of you have been asking what the difference is between regulatory approaches and market based solutions to carbon emissions.  The answer is fairly simply but depends on what you want the outcome to be.  The whole question can be boiled down to: Tax or Trade?

A carbon tax is a pure price instrument that establishes a certain price on pollution.  While the price is guaranteed, the final emissions reduction is not.  For example, a $5 tax/ ton on CO2 emissions for a firm that pollutes 100 tons of CO2/ year would cost the firm $500.  This policy creates certainty for businesses and governments, but leaves uncertain the amount of emissions reduction. 

On the other hand, a cap-and-trade system (or quantity instrument) determines the final output of allowed emissions, but leaves the price uncertain.  In a certain year where polluters find it hard or costly to reduce emissions, the price of each credit would rise as companies bid up the price of the allowance.  In a different year, the price of the credits might fall as many industries would have a surplus of their pollution credits available on the market.  As companies find it harder to meet the required pollution allowances, the price of each credit would increase with demand.  Every so often credits would be removed from the market in order to achieve the desired level of emissions.

So which one is better?  Depends.  It all depends on what the predicted damage costs are.  If the marginal damage costs are high, then it is better to use a quantity mechanism because you know the level of pollution output.  The market will set the rate.  If the marginal damage costs are low, and policy makers are worried about the high costs of transition to a low-carbon economy, then a price mechanism would be the better option because it would provide more clarity to the business community when making future investment decision.  Hit me back and let me know your thoughts.

China’s Green Tech Innovation

For years the West has relied on an old premise that innovation in technology will create new jobs, if not new industries, to keep our economy rolling. This belief softened the fallout from the off-shoring of our manufacturing base. We figured as long as we can keep inventing new products, we can outsource the production to a low cost area, and still maintain a high tech economy. As I said earlier, when you give up production of a product, you also give up the opportunity for innovation on that product, or at least the opportunity to innovate on the process of producing that product where small innovations can bring further efficiencies and even new products to market. Right now, energy is the problem in China and the government has committed all efforts to solving this problem by building coal, wind, nuclear, hydro, and solar power plants to address their energy needs. The might of the state is enormous – every week a new coal power plant opens in China! China is now the largest emitter of GHG’s in the world, but they are also the largest market for clean tech energies as well.
China’s twelfth five-year plan calls on the National Energy Administration (NEA) and the Ministry of Science and Technology (MOST) to research, develop, and finance clean technologies not only for domestic use, but also for export. It is estimated that the government funnels over $50 billion for R&D through these organizations alone.
This state-backed plan seems to be good news. First, the US and China are the two biggest polluters, accounting for 40% of emissions and 40% of energy consumption, so any plan to lessen the emissions in either country is a score for the earth and her citizens. Second, many large businesses will benefit through the partnerships formed with their Chinese counterparts. However, this creates a reversal from the prior paradigm of Western innovation being sold to emerging markets. It now would be the US clamoring for Eastern technology. This would have enormous monetary policy impacts as well as lead to a dramatic increase in the trade gap. While the US is in deadlock, with republicans refusing to touch defense spending and democrats refusing to cut entitlements, the only area of the budget that suffers is the discretionary spending side. Take a guess where the funding for education, technology, and research and development come from? In any case, as people live longer the global population is going to grow. As more and more countries develop, energy supply is going have to expand dramatically in order to keep up with the demand. Not only do we have to find new sources of energy, but we need to make products that use energy more efficiently. Now is the time for all of us to act – and this begins with innovation to the current technologies.

Trade Wars

Forbidden City A long time ago in a galaxy far, far away…. no wait, that was Star Wars, what did I want to write about?  Oh yeah, Trade Wars!   Let’s try this again . . .Not so long ago, in a city just as dysfunctional as the late stages of the Galactic Republic, but centered in the US and called Washington D.C., a bill passed the Senate . . .

There is wide consensus that the Chinese yuan is considerably undervalued with some economists citing ranges between 20-40%.  While the renminbi is officially classified as a “managed floating exchange rate” whereby it is allowed to appreciate or depreciate within a narrow band against a basket of currencies, it sure feels like it is pegged to the dollar at a steep discount, dramatically lowering the cost of Chinese goods for export.  This also has the effect of a tax on US imports to China, making foreign goods seem more expensive on the Chinese market.  This has been a constant thorn in politicians’ sides over the past few years, especially those whose constituents reside in hard hit areas of the economy such as manufacturing that saw many jobs go overseas.  It is an old and familiar dance much like the hustle – politicians make noise about the undervalued currency, China reminds us that they want to get off the dollar as a reserve currency, a few months pass and just when it seems that the politicians want to implement protectionist policies, the value of the yuan magically increases and the calls for action fade.
Why this time is different
Unfortunately, this time seems different because just as the US is preparing for an election in 2012, China is ready for a political transition as well, and leaders on both sides of the Pacific want to look strong for their populace.  In this atmosphere, even minor disputes run the risk of being hyped-up.  Does anyone really want to see a trade war break out between the two largest economies in the world?  That spells doomsday for the global economy as a whole.
Mr. Greenbacks goes to Tiananmen SquareI had the pleasure of traveling to China earlier this year and one of the major lessons learned in dealing with Chinese is the concept of “face”.  I can hardly do this concept justice in just a few sentences, but hear me out.  “Face” is your reputation, but it is much more than that, it is your code of conduct in forming relationships – from new acquaintances to family elders.  I take it back, this is almost IMPOSSIBLE to explain in words.  Basically, it means not humiliating anyone in public – ever.  In the Chinese culture, it is acceptable to lie to a person in order to save face.  “No” is a very hurtful word and damaging to any relationship.  An example of this would be a street vendor selling souvenirs – while you might not want anything to do with this, you cannot simply say “No, get this crap out of my face” as we would here in New York.  In Beijing, you have to say, “It is very nice, but too expensive.”, or some form of lie to let the retailer “save face”.  This includes avoiding backing someone into a corner in an argument, you must always leave them a way out in order to preserve face.  Often the Chinese will lie directly to you, but their body language will tell you the real answer.  This is all done for the concept of “face” and to preserve the relationship.  It cannot be stressed how important this is in dealing with the Chinese culture.
Saber Rattling
So now the Senate passes this bill and calls China’s leaders out to the whole world, completely ignoring this concept of face.  Response – China lets the value of the yuan fall even further.  Now we have hard line politics being met with hard line resistance.  The problem with currency accusations is that they eventually morph into trade wars, add more fuel to the fire and trade wars become real wars.  As economist Frederic Bastiat once said, “When goods don’t cross borders, soldiers will.”  History tells us that China has never been an imperialist country, but they have, over the past few years, developed a blue water navy and began to exert their influence over an expanding area, from coastal protection to patrolling international waters that the US maintains shipping routes through.  Could more serious confrontation lie ahead?
Yuan Appreciation
The problem with the bill in the Senate is that it was a very public spectacle over a problem that has been solving itself.  From 2009 to early 2011, the analysis found, the yuan appreciated by just 4% in nominal terms, but by 17% in real terms, after accounting for inflation.  Other studies put the yuan appreciation at 30% between 2005 and today.  It should come as no surprise to China that they need to rebalance their economy from exports to domestic consumption in order to keep growing.  A floating yuan would give the government more flexibility in their domestic policies such as battling inflation as well as prove to other nations that China is committed to a level playing field.  Due to rising labor costs in the Middle Kingdom, manufacturers are already coming back to the US or moving their shops to other low cost Asian nations such as Vietnam.
Is the Measure Warranted?
Most economists will tell you that capitalism combined with free trade is the single biggest creator of wealth in history.  You will not find argument here, billions of people are now being lifted out of poverty due to the developed world’s appetite for cheap goods.  Even if one country is great at producing many goods, the concept of comparative advantage allows other countries to enter into the fray and begin to trade.  But while free trade is great for developing nations, what about America and other developed nations?  What we get in return is cheaper goods and soaring company profits, good for investors, bad for workers.  America has always been the creator, the inventor, and the producer.  We would then manufacture these new innovations on our shores (south and mid-west actually) for domestic consumption as well as export.  Now however, we have given up our manufacturing base.  We have outsourced and outsourced until the only possible play we have left is the service industries.  As education improves in developing nations, this advantage will become less and less.  New generations will have to compete with globally connected, highly skilled, low-wage workers.  So what is the answer for America?  How do we put America back to work?  That will have to be another post, so stay tuned.  One thing is sure, though, this bill is the wrong way to get results.  Not only would this bill fall apart in front of the WTO, but it also runs the risk of retaliation from other countries possibly convinced that the rounds of quantitative easing were a ploy to keep the value of the dollar low.  When countries stop trading, we all lose.  So instead of figuring out ways to build walls (pun intended . . . see photo below) to prevent trade, shouldn’t Congress worry more about optimizing the conditions for the next growth industry such as improved infrastructure, broadband or clean tech that will pull our country out of this funk?  After all, isn’t there an American jobs bill somewhere on their desks?Fordham MBA's on the Great Wall of China