Back when I worked developing large software systems, every now and then we ran into a bug that management decided was too much trouble to fix—“It’s not a bug. It’s a feature!” This is the approach that Kevin Drum seems to be taking when it comes to volatility in cap-and-trade programs.
The short version of the volatility problem is that with a trading system, permit prices vary not only in response to how many permits are issued, but also in response to general economic conditions. As a result permit prices bounce up and down a lot. Kevin, like a number of cap-and-trade supporters argues that this volatility is a good thing, because permit prices drop during bad times when people don’t have money to invest, and they rise during times when they do. In short they argue that counter-cyclicality makes volatility positive rather than negative. But, just as in the software industry, I’m afraid it is still a bug, not a feature.
To the extent that emissions pricing accomplishes anything it drives investment in emission reducing infrastructure. But when emission prices drop too low, firms project long-term prices to be low as well. Managers get a lot more points for increasing or preserving market share than they do for managing environmental risks. Top bosses don’t want to hear that emissions costs are going to rise, and the company needs to invest in reductions to comply with a cap-and-trade system. They want to hear that they can concentrate on their core business and buy low-cost permits from all the other firms reducing emissions. There is always a sound business case to be made for the other guy to reduce his pollution.
This is not a theoretical argument. Volatility leading to underinvestment is not only standard economic theory, but it is also supported by real world experience. Low prices in the RECLAIM district in Southern California led to exactly this result. The 2005-2007 E.U. ETS responded exactly this way. In fact, the over-issuing of permits was strong enough during this period to lead to a rise in emissions among facilities within the trading system while overall E.U. emissions were falling.
In 2008, decreased economic activity due to recession, increased use of nuclear, hydro, and wind generation, and drops in natural gas prices may have finally led to a 3 percent drop in ETS emissions. ETS supporters claim that 40 percent of that drop was due to the trading system, though their analysis does not consider the drop in natural gas prices as one of the factors driving the reduction. Even taking ETS cheerleaders at their word, and attributing a 1.2 percent drop to the ETS, we will note that what their trading system did not drive—in any of the four years it ran—was large-scale capital investments among facilities subject to the system. That means no real preparations have been made among traded facilities that will let them comply if even moderately tight caps are ever agreed to.
Even though I’m a critic of cap-and-trade, today’s critique is a friendly one. I don’t think volatility has to be the deal-killer for trading systems. But for it not to be, cap-and-trade supporters need to move past the denial stage and tackle the problem. One common solution is banking, where speculators can buy cheap permits for use in the future. This does reduce volatility, but not enough to cushion a trading system from major external shocks, or even from major over-issuance of permits. The RECLAIM system allowed banking, which did not prevent collapse.
The only solution I know of that is likely to be effective is to make a permit system more like a carbon tax in one respect. Put a minimum price on it, something close to what you expect the cap to produce. That gives investors a minimum return on emissions reductions, and gives you a chance that some capital investment will go towards such reductions, even in bad times, which in turn helps produce the infrastructure for future reductions.
Top 25 reasons to give a damn about climate change
Comments
View as Flat
Sean Casten Posted 11:15 pm
03 Mar 2009
But to leap from that point to claim that a carbon tax is the fix (or some other regulatory patch - minimum prices, minimum returns, etc.) is a political theory, not an economic one. One may favor top-down, regulator-defined markets for political reasons, but there is no compelling economic reason why that is the right option. Indeed, thousands of markets from orange juice to T-bills have figured out ways to lock in price certainty without a government patch. Historically, the way that this has tended to arise is from a certain critical mass of investor liquidity: the first time a farmer sold a bushel of corn to a wet mill, it was on a spot price. But you get a volume of farmers and a volume of mills and pretty soon you've got the Chicago Board of trade with long-term corn futures, strips, hedges, etc. and all the things that evolve to solve exactly the problem you mention - how to lock-in price certainty in a volatile market.
There is a fertile, largely unexplored area of inquiry as to how you accelerate that liquidity creation. Power markets again, are a good example: a decade into dereg, you still can't lock in long-term prices beyond 10 years (and since the credit crunch, you're lucky to get 5). Some would argue that this is a sign that we don't yet have enough liquidity in that market (and conclude pessimistically that it will take an equivalent time-constant for carbon markets to mature.)
There may be some merit to that argument, but it bears noting that when those markets were set up - and when carbon markets were set up - they were established based on economic theory largely disconnected from economic fact. The theory says spot prices are all you need. The fact says you need some degree of price certainty to spur long-term capital investment. The markets we have basically set the spot price and then presumed that through the magic of economic efficiency, all those sophisticated financial products would appear if demanded. Which is a bullshit argument that doesn't hold water anywhere outside of academia, but it prevailed nonetheless.
Rolling back the clock, one can imagine lots of market-driven ways that longer-term trades could have been facilitated from the get-go, and that's a conversation worth having. But I don't buy the argument that the solution is government interference in market price-setting mechanisms.
Permalink
jestbill Posted 4:19 am
04 Mar 2009
The attitude here seems to be that we need some kind of system that will be perfect in every way from the beginning unto nirvana.
Bah!
This is as much politics as it is science or economics. Change the rules year by year until you get the right answer.
Further, I just don't see why current economic conditions should not be taken into account. Yes, we need change. But, given that this is a political situation, it makes no sense to set goals or policies that will not be implemented.
If companies spend more money when they have it and less when they don't, that's completely understandable.
Where have all the horses gone?
Permalink
Gar Lipow Posted 6:22 am
04 Mar 2009
So "bah" all you want. Just don't be a sheep and settle for less than nothing.
Permalink
Sean Casten Posted 9:38 am
04 Mar 2009
If you'd prefer an environmental angle, take the Clean Air Act which - by mandating only the most expensive approaches to pollution abatement cemented in place the CW that environmental responsibility is incompatible with economic responsibility. We're still paying the price for that, not least in our failure to do anything about CO2 (out of fear that the costs will be too high.)
Both examples show where shoddy methods were confused with bad goals and now make it harder for others to reach the same goal. Yes, you don't need to get it perfect from the get-go - but you shouldn't assume that a crappy system will always be improved. Evidence strongly suggests otherwise.
Permalink
jestbill Posted 7:19 am
05 Mar 2009
If we are SURE that CO2 is a problem and that it will continue to be a problem until we deal with it properly, then my "strategy" of doing something and then modifying it as needed is the only correct way to proceed.
Claiming that some system that might be agreed to will "collapse" is not a complaint about "details" it's a complaint about active corruption and obstructionism.
Agreed, we "know" that deregulation didn't work. Sorry to say, we "knew" it wouldn't work and that, had it been done "right" would have left us even worse off now. We'd still have a bunch of independent producers all claiming that CO2 is not a problem and to leave them alone with all that radical nonsense.
We are not suffering from doing the Clean Air Act wrong but from not updating it as needed. We are suffering from ideological paralysis. Crony Capitalism is the enemy, not abstruse policy details.
Where have all the horses gone?
Permalink
Gar Lipow Posted 8:41 am
05 Mar 2009
And cap=and=trade is actually rather like deregulation. Relying on markets to do stuff they won't do well. At best any price on emissions is supplementary. Old fashioned standards based regulations and public investment is the main means that can reduce emissions. "Pass something that won't work,and then modify it" is seldom a good procuedure. I agree with you that the clean air act worked fine, and just was not updated when needed. And I agree that deregulation could never have worked.
But the thing is we have empirical evidence with cap-and-trade. It worked with acid rain on a small scale, though other nations got better results faster with rules along the line of the old clean air act. But the Reclaim system which tried to implement a larger scale trading system in a much smaller area failed miserably. It collapsded. The ETS over the course of 4 years has raised emissions. Isn't that an indication that any U.S. approach should be different? If the ETS was learning experience shouldn't we fucking learn from it?
Permalink
msandler Posted 11:49 am
05 Mar 2009
Gar is right that the carbon market will have ups and downs. That's why it needs a board of directors who can make adjustments on a quarterly basis, like the Fed does with the interest rate. I don't think Congress will want to have to intervene regularly, so they should set up some rules and institutions to figure it out. They'll only be involved if the whole system crashes, like the financial system currently has. Make sure not to put Madoff or that Merrill Lynch guy in charge.
Volatility in permit prices is a reason to return auction revenues to consumers through a dividend rather than fund programs with it. If you were setting up a solar investment program, you want it to be based on a more stable revenue source, like a tax, not on a fluctuating source like permits.
I hope the cap and traders and the carbon taxers stop fighting and become friends (they're really siblings, one is Quantitative and the other is Pricey) because we'll need both, despite the flaws of each.
Permalink