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Reason Foundation

CO2 Emissions Trading

Creating a market for carbon dioxide emissions

Lynne Kiesling
October 23, 2002

In many ways the jury is still out on the science of climate change, from clouds to carbon sinks to the magnitude and geographic incidence of likely effects. Notwithstanding those uncertainties, the political reality is that controlling greenhouse gases is getting more and more attention, and the possibility of government regulation at several levels looms.

Enter Richard Sandor and his colleagues at Environmental Financial Products in Chicago. Sandor is an economist and a market-creating entrepreneur, who has spearheaded the creation of markets for interest rate derivatives and for sulfur dioxide emissions in the past three decades. In a collaborative effort among many stakeholders, Sandor is leading the creation of a market for carbon dioxide emissions. This market, called the Chicago Climate Exchange, is the product of bringing together firms, consumers, government representatives, and advisors to determine the parameters and rules of the market.

The motivating principle behind creating emissions markets is the Coase Theorem: in the absence of transaction costs, the involved parties can bargain to a mutually beneficial efficient outcome. Problem is, transaction costs are almost never zero, so bargaining to a mutually beneficial outcome could be costly, perhaps so costly that exchange wouldn�t occur at all. This concept is very important for the possibility of market-based environmental policy � reducing transaction costs is a crucial component of enabling people to use markets to manage and optimize pollution.

Creating markets for emissions trading is a powerful way to decrease transaction costs. An important part of reducing transaction costs is the definition and enforcement of property rights, so that a company with a right to emit 50 tons/year can trade away some or all of that right, and will be held accountable for the amount that it does emit. So if it can make more money by selling the right than using it, it can sell it and reduce its emissions. Notice how this trade creates value by putting the emission rights in the hands of people who value them the most (some of whom might retire them so that those emissions will not happen, ever).

Chicago Climate Exchange�s proactive market-based approach to emissions reduction is a watershed in emissions policy, for many reasons. First, it is proactive; the SO2 "cap-and-trade" emissions trading that came out of the Clean Air Act amendments of 1990 followed on decades of command-and-control regulation, which had the possibility of creating vested interests in the existing command-and-control regulatory institutions. Second, and more importantly, the Chicago Climate Exchange involves the stakeholders themselves determining the number of emission credits to have, and the rules. Trading purists (like myself, I admit) have criticized the SO2 emissions trading process on the grounds that determining the cap, the number of emissions credits, is prone to political manipulation and is therefore not a very secure and well-defined property right. The security and definition of the property right is a crucial component of putting the Coase Theorem to work here -- only if the property right is secure and well-defined do the market participants get as much benefit as possible from the exchange.

Chicago Climate Exchange is following a process by which the participants themselves, with all of their diverse interests, incentives and backgrounds, determine the cap. Technically speaking, this collaborative process endogenizes the property right definition process. They will also set rules for changing the cap, which will create security and certainty of the property right. That security reduces transaction costs, leading to increased trade and the creation of value.

Last week's Economist has an article profiling Chicago Climate Exchange.

Lynne Kiesling is director of economic policy at Reason Foundation and senior lecturer in economics at Northwestern University.



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