Senators Kerry and Lieberman have introduced their “compromise” climate change legislation that relies largely on a “cap and trade” scheme to reduce carbon emissions.

Even assuming there was a need for carbon limits, the Kerry-Lieberman bill gets the mechanism all wrong, apparently because the Senators either don’t understand or don’t trust markets.  Kerry and Lieberman propose that the government manage a carbon market because controlling pollution is really important.  This will work about as well as the government running grocery stores because everyone needs food.

The insight underlying the use of market mechanisms to achieve public goods (such as reducing pollution) is the Coase Theorem , developed by Nobel Economics laureate Ronald Coase.  The theory holds that private actors will find optimal uses and costs so long as property rights are transferable and transaction costs are eliminated.

In other words, to make it work, the government has to define property rights and then get out of the way and trust the market.

Kerry and Lieberman begin by attempting to vest a sort of property right in existing energy-generating uses of carbon fuels, but then they do everything else wrong.  The bill does not make the rights freely transferable, but limits the market to existing utilities.  And rather than reducing transaction costs, the bill increases them by limiting trading to a government-managed exchange.

Under the bill the Treasury Department will decide who gets to be a “market maker” on the exchange and how much they can charge.  “Market makers would be in this business not to make vast sums of money,” explained one Senate staffer.  Sorry to burst your bubble Anonymous Staffer, but market makers are in business to make money: vast sums if possible.  The way to limit those profits is not through limiting the market participation and prices controls but through vigorous competition.

Come to think of it, we do have some recent experience with government-approved market makers.  Remember what a great job Fannie Mae and Freddie Mac did in the housing market?

It is hard to predict whether a Treasury-managed carbon market would get the price too high (and thus kill trading) or too low (like Fannie and Freddie), but it is certain that they would get the price wrong.  In the real world, a license from the Treasury Department to extract fees from a captive trading pool is far more likely to result in excessive profits than it is to lower costs.  And, if you screw up, taxpayers will always be there to bail you out.  (Can anyone imagine the Treasury Department letting the government-mandated carbon market fail?)

The magic of the market is that everyone who wants to play can participate on the terms they choose (assuming anyone else likes those terms).  The government can’t limit who gets to be in a market, how they can trade, and how much they can make and expect the market to work.

Rather than encouraging the private sector to make optimal use of carbon the Kerry-Lieberman bill establishes a series of fees to pay and hoops to navigate. That’s why the bill is really a cap and tax scheme.

There is one last irony.  There is actually an operating carbon exchange in Europe, with trading on the London Stock Exchange and a futures market managed by a US-based company.  There is even a US market ready to start trading.  If there really is a need for a carbon market, Congress just needs to define the property rights involved and get out of the way.  (And under the Coase Theorem, it doesn’t even need to get the property rights assigned perfectly.)  Trying to micromanage the market from Capitol Hill is a sure way to failure.