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Cap and Trade; Good for Environment, Good or Bad for Business?

Posted by Stacy Richter on April 30 at 10:15 PM Like most, I found myself increasingly interested in how the “Cap and Trade” system actually works and what effect it would have on overall business. To provide a little perspective, the EPA issued a memo on Apr 23 on how the Agency will meet its “heightened commitment to transparency.” (EPA, 2009)

The theme was protecting the environment and supporting economic recovery. The first two priorities of the published EPA guidelines should be of particular interest to the energy industry.

Priority 1: Reducing Greenhouse Gas Emissions

“Transitioning to a lower-carbon economy will protect public health, create jobs and open up opportunities for investment in existing and cutting-edge technologies, creating a foundation for future growth.” (EPA, 2009)

Priority Number 2: Improving Air Quality

“Improving air quality is a critical national goal. The US continues to face serious air pollution challenges, with large areas of the country that still cannot meet federal air quality standards and many communities still facing health threat from exposure to toxics..” (EPA, 2009)

Enter the “Cap and Trade” system. In short, the goal is to reduce GHG emissions economy wide. According to the Center for American Progress (2008), the ‘Cap’ is administered by the federal government and will issue a specific number of permits for every ton of CO2 a firm releases into the atmosphere.

The ‘Trade’ assumes that some companies will be better positioned to make reductions and emit less than their permits. The credits can be sold to firms unable to adequately reduce emissions. The overall system ensures a specific level of emissions which can be reduced to meet federally committed targets.

The “Cap and Trade” system should be a large blip on the radar of resource companies in the U.S. and Canada as well as the service companies who supply them. GHG’s are a large by-product from producing and burning hydrocarbons. The permits issued through this system will require these companies to innovate in order to reduce emissions or to buy the necessary credits to meet the regulations.

The benefit of such a system is that it will create a tangible economic benefit that directly affects the bottom line; either through financial penalties or incremental revenue. The innovative firms will flourish while stagnant firms will suffer. Environmental organizational policies are no longer a budget line for stakeholders to feel good about and for executives to cut to improve the financial statements.

Topics: energy, strategy, sustainability        SHARE:  Share with Delicious Share with Stumble Upon Share with Furl Share with Digg Share with Reddit

8 Comments so far...

At what level do you implement the cap? How do you assign permits, do you cap it at current production levels, what about new players into the industry, this creates barriers to entry and therefore will affect competition...Too many questions still for this system before you can say if it's good or bad...

Posted by C becker on May 7 at 4:51 PM

Thanks for the comments Colin. All of your questions represent excellent opportunities with the cap and trade system.

As it is right now, the federal governments would issue the permits which would be based on the total amount of emissions the government would like to achieve. For example, if the limit for Canada was to be 1mil Tonnes of CO2, only those permits would be issued. The following year, the government could issue permits for only 900,000 tonnes thereby resulting in an emissions reduction. This is oversimplified of course but demonstrates the idea.

I am interested in your ideas of how such a system creates a barrier to entry. Will you please expand on this a bit? I am also curious about how you would suggest that a company could overcome these barriers.

Posted by Stacy Richter on May 8 at 7:35 PM

Well that's just it, if there are pre-defined limits and therefor amounts to said 'permits' you essentially create somewhat of a monopoly or oligopoly situation, as the business that exist already have an advantage over a business trying to get into the industry. With this type of business situation a new company would have somehow purchase these permits from existing companies that were grandfathered in if that's how they are distributed. This is an additional sunk cost that any new entry into the industry would have to pay, thus decreasing the return on investment. These situations are great for existing companies as they are likely to have less competition and firms will set prices at quantity levels that are closer to marginal costs but charge prices on size of demand allowing them to make greater than economic profits.

The problem is that likely companies won't overcome this, and consumers will pay the price with less competition. The resulting deadweight loss and smaller consumer suprlus, is to the favour of the existing companies, and the detriment of the market from a consumer point of view and any firms wishing to enter the market.

Posted by Colin on May 21 at 10:52 AM

With a Cap and Trade system, the government will set a ceiling of the amount of emissions; governed by industry. I would agree with all of your statements provided we assume that the government will issue 100% of the available permits, kind of like a province will only issue so many of one type of hunting license. The debate is still open on how a Cap and Trade system will be administered and I am sure several methods, including the methods we have mentioned here, are being considered.

However, I'd like to suggest that the Cap and Trade system may have an opposite effect on entry barriers. The best way I can explain it is by an example from the airline industry.

Airlines such as Air Canada and United have grown to be very large and encompassing. They have been able to achieve significant economies of scale that provide significant barriers to entry for new airlines. However, the state of the industry was changing faster than either airline was able or willing to match. An opportunity arose for cheaper and higher performing airlines to enter the industry and outperform either airline. West Jet is one that comes to mind. One of the reasons West Jet has been so successful in tearing down entry barriers is because they are a new (relatively) and nimble company not burdened by legacy systems and old school thinking.

I believe the same will happen when a Cap and Trade system is put in place. The older companies will have difficulty adapting their old systems and traditional way of doing business than a new company will overcoming barriers to entry. The new company will not be burdened with the cost 'changing over'. They get to start afresh which is considerably less expensive the converting.

Thanks for the great discussion.

S.

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