If Congress doesn't pass a climate bill this year, then, as I've mentioned before, individual states are likely to pick up the slack, either through their own efforts to promote clean energy or through regional carbon-trading systems. But an obvious pitfall of a regional system is that participation is totally voluntary, and a state can always leave for any reason. Arizona is announcing today that it's pulling out of the Western Climate Initiative, which plans to set up a cap-and-trade system for seven states and four Canadian provinces starting in 2012. Berkeley economist Matthew Kahn ponders the consequences:

1. Will Arizona's decision trigger a domino effect such that the regional pact unravels? Why? Fear of leakage of jobs. Will Nevada now say to itself; "If we remain in the pact; our electricity rates will be higher (reflecting carbon pricing) but Arizona's won't be; footloose electricity intensive consumers such as a Google may move to Arizona rather than here." If Nevada believes that this story is true, then their probability of staying in the pact declines. Erin Mansur and I have been studying this job migration issue as a function of local electricity prices and will report some results soon.

2. If other West Coast states drop out, how does this affect California's AB32 initiative? In particular, do issues of thin markets arise as there are not enough buyers and sellers in the carbon market to have a competitive market?

3. If all of the West Coast States remain in the cap & trade initiative, will there be more R&D innovation because there are a larger number of potential buyers of "green energy" low carbon? Hopefully California is a large enough market to create a "home market" effect so that innovative nerds keep tinkering away even if Nevada and Arizona drop out.

Kahn also points out that the "guinea pig" states that go first on cap-and-trade are providing a real benefit to the rest of the country—they're testing out a brand-new policy, seeing what works, what doesn't. That info is a positive externality, and there's a case for finding some way to compensate these states. Under the House climate bill, states don't get penalized for acting early (they're allowed to trade in their existing pollution permits for federal permits), but they don't get rewarded, either.

(Flickr photo credit: Al_HikesAZ)