There has been a lot of talk about a market-based cap and trade system as the ticket to a clean energy future. It’s a good solution. It could work. But it also carries significant risk, risk that a revenue neutral price signal (tax) would not. A recent MIT report highlights the expediency involved in getting climate policy right the first time. This 2009 study projects a median increase of 5.1 C (9.2 F) by 2100, up from a 2003 projection of 2.3 C. This kind of warming will have serious implications on everything from biodiversity to agricultural and forestry production to sea levels on a scale of meters. Any policy the United States seriously puts in place will take years. The EPA for instance has just completed a draft mandatory reporting rule for every producer that emits more than 25,000 pounds of GHGs a year, about 13,000 in the U.S. It has taken years of dialogue to get to this point. The rule still has to be finalized, then a registry set up ands tested, and then the actual cap would have to be developed, and then a tidal wave of litigation resolved. The point is, after all of this is sorted through, the system we get better work. Because of the potential for bubbles, price manipulation and windfall profits in a cap system, there is an elevated risk that it might not. The resultant public pushback and backlash in Washington could very well cause significant modifications if not outright repeal of such a system.
There are three basic issues with a cap system: 1) it’s just a nicer word for a tax because a cap creates scarcity which increases prices 2) even if the permits are auctioned off at the outset if can still result in huge windfall profits that can distort markets and create bubbles and 3) there is an implicit trade-off between price volatility and emissions reductions. This last point is because there is either a price ceiling or there isn’t. Without one, prices can be as high as the market will allow. In the case of the acid rain market, permits got above $1,000/ton and last year showed 75% year over year price volatility. This is far from good for businesses, investors or consumers. And this is in a market where there are readily available technological substitutes. Low sulfur coal is abundant. Scrubbers that capture SO2 and NO2 exist and are cheap. The same is not true for GHG reductions, so there is every reason to think that without a ceiling the price in the GHG market would be higher not lower than the already very high-priced and volatile acid rain market. However, if there is a ceiling, it is maintained in the same way the Federal Reserve targets interest rates, by open market operations with a reserve of credits. In the Fed’s case, reserves in cash, in the GHG market the reserves would be GHG credits. But what happens if you run out of these credits held in reserve? In other words, what happens if it takes more credits than have been set aside to deflate the price to the level prescribed in law? Well then you just create more permits, oh and there goes the whole point of the system – because you’re above the cap, e.g. you’re not reducing emissions which is a primary purpose of the system.
And it is often said that the issue of windfall profits, assigning private rights to a previously non-exclusive public good (like atmospheric emissions) that enriches the recipient of the now newly minted asset class, can be solved with a 100% auction system. Why is this an issue? Say the auction sells credits to the market at $5/ton CO2. The EU and Chicago Climate exchange (the largest U.S. exchange for GHG emissions) have historically traded CO2 at around $4 ton, so in all likelihood $5 is a very high initial assumption and it’ll be more like $2. But even if it’s $5, these permits will be held onto by the market until they appreciate. And the anxiety alone of a new energy scarce world will probably lead to significant appreciation right away. Not to mention that when a firm needs to buy these credits they have few short terms options and so it’s not hard to imagine them being bid up. Now if the price in the market is $20/ton, then there is a 300% windfall, the asset netted 3x what it cost, equivalent to a 75% subsidy. If there was no auction, the windfall would be infinite (something for nothing) – so it’s less windfall than without an auction, but still a windfall. Windfalls are basically strong subsidies, and subsidies distort price signals, create artificial value and expands the size of the market because of the elasticity of demand. So there is value creation absent new productivity, and absent new wealth creation these prices can not be supported indefinitely, they will have to fall. E.g. a classic boom and bust cycle – originating in windfall profits. In short, if firms get assets that trade at $20 for $5 they have a $15 profit margin, which is a good thing for the firm, but that $15 now has to be put somewhere. And because it was created simply by an actuarial identity, because the government said the credits will be sold for that price, and not because of $15 productivity gain, this $15 will contribute towards inflation and asset appreciation that is not sustainable in the mid-run.
Cap and trade can work, it is just that we must be sober about the risk it carries and think hard about getting it right. One approach would be to design a system that is entirely revenue neutral – so all that new money out there is offset by government spending. Another approach might be to smooth out price volatility by creating larger margin calls or position limits. Or, here’s another idea.
There are three basic issues with a cap system: 1) it’s just a nicer word for a tax because a cap creates scarcity which increases prices 2) even if the permits are auctioned off at the outset if can still result in huge windfall profits that can distort markets and create bubbles and 3) there is an implicit trade-off between price volatility and emissions reductions. This last point is because there is either a price ceiling or there isn’t. Without one, prices can be as high as the market will allow. In the case of the acid rain market, permits got above $1,000/ton and last year showed 75% year over year price volatility. This is far from good for businesses, investors or consumers. And this is in a market where there are readily available technological substitutes. Low sulfur coal is abundant. Scrubbers that capture SO2 and NO2 exist and are cheap. The same is not true for GHG reductions, so there is every reason to think that without a ceiling the price in the GHG market would be higher not lower than the already very high-priced and volatile acid rain market. However, if there is a ceiling, it is maintained in the same way the Federal Reserve targets interest rates, by open market operations with a reserve of credits. In the Fed’s case, reserves in cash, in the GHG market the reserves would be GHG credits. But what happens if you run out of these credits held in reserve? In other words, what happens if it takes more credits than have been set aside to deflate the price to the level prescribed in law? Well then you just create more permits, oh and there goes the whole point of the system – because you’re above the cap, e.g. you’re not reducing emissions which is a primary purpose of the system.
And it is often said that the issue of windfall profits, assigning private rights to a previously non-exclusive public good (like atmospheric emissions) that enriches the recipient of the now newly minted asset class, can be solved with a 100% auction system. Why is this an issue? Say the auction sells credits to the market at $5/ton CO2. The EU and Chicago Climate exchange (the largest U.S. exchange for GHG emissions) have historically traded CO2 at around $4 ton, so in all likelihood $5 is a very high initial assumption and it’ll be more like $2. But even if it’s $5, these permits will be held onto by the market until they appreciate. And the anxiety alone of a new energy scarce world will probably lead to significant appreciation right away. Not to mention that when a firm needs to buy these credits they have few short terms options and so it’s not hard to imagine them being bid up. Now if the price in the market is $20/ton, then there is a 300% windfall, the asset netted 3x what it cost, equivalent to a 75% subsidy. If there was no auction, the windfall would be infinite (something for nothing) – so it’s less windfall than without an auction, but still a windfall. Windfalls are basically strong subsidies, and subsidies distort price signals, create artificial value and expands the size of the market because of the elasticity of demand. So there is value creation absent new productivity, and absent new wealth creation these prices can not be supported indefinitely, they will have to fall. E.g. a classic boom and bust cycle – originating in windfall profits. In short, if firms get assets that trade at $20 for $5 they have a $15 profit margin, which is a good thing for the firm, but that $15 now has to be put somewhere. And because it was created simply by an actuarial identity, because the government said the credits will be sold for that price, and not because of $15 productivity gain, this $15 will contribute towards inflation and asset appreciation that is not sustainable in the mid-run.
Cap and trade can work, it is just that we must be sober about the risk it carries and think hard about getting it right. One approach would be to design a system that is entirely revenue neutral – so all that new money out there is offset by government spending. Another approach might be to smooth out price volatility by creating larger margin calls or position limits. Or, here’s another idea.
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