Yes, we Kahn

Carbon trading: Worthy of Feinstein’s ire? 18

“Deregulation shifts the major burden of consumer protection to the competitive market, and therefore, in important measure, to the enforcement of antitrust laws.” -  Alfred E. Kahn, Lessons for Deregulation: Telecommunications and Airlines after the Crunch.

I’ve always found the above to be one of the wiser quotes about deregulation. (Kahn, for those who don’t know him, was at the helm of the Civil Aviation Board when airlines were deregulated, and has since written some of the more   insightful pieces on deregulatory processes in multiple industries.)

What does this have to do with commodities and Senator Feinstein? Recently, she announced a proposed amendment to the Senate climate bill, one that would commence federal oversight of CO2 markets “to prevent Enron-like fraud, manipulation and excessive speculation in the new federal, state and regional carbon markets that will be established by [a cap and trade] system.”

That sounds perfectly noble,  part and parcel of the broader political backlash against commodity market speculators. Recall a few years back, when speculators were being blamed for driving the price of oil and gas to artificial highs. Economists argued that such trading had no effect, but was a part of a healthy market that allowed informed people to make bets and hedge risks. Populists argued that energy is too important a commodity to be exposed to such volatility, especially for folks living paycheck to paycheck. Both points are valid, and with the political turnover in DC, the general mood is shifting from one favoring laissez-faire, let-‘em-speculate approaches to one favoring market regulations and speculator constrainment. (See here for the NYT‘s recent take.)

Speculation pros and cons

Discussions of regulation, populism, and economic theory inevitably take a political turn, so let’s state a few obvious, apolitical truths:

  1. Unless you’re an energy producer, high energy prices stink.
  2. No matter who you are, volatile energy prices stink.
  3. Not withstanding points (1) and (2), high and/or volatile energy prices encourage greater energy efficiency.

To argue that energy price volatility and/or perpetually high energy costs are categorically good or bad is false, and unnecessarily polemical, even if it does make for a good political soundbite. As we now start to contemplate the creation of entirely new markets for entirely new commodities (namely, CO2 emissions rights), it’s not at all surprising to hear the battle joined on familiar sides. Nor is it surprising to hear the e-word word (Enron!) thrown around, which calls for a brief digression.

What Enron did and didn’t do

Enron undoubtedly engaged in a host of amoral transactions, not to mention lots of illegal transactions. But not everything   that was amoral was also illegal. This latter point is particularly true with respect to California electricity markets, and it’s worth reviewing some history—especially when Enron-as-metaphor comes to have a meaning so distinct from Enron-in-reality.

When the California Power Exchange, or CalPX, was first created in 1998, it was essentially the first time that electricity could be bought and sold external to a regulated transaction. After a cautious year learning the rules, the gloves came off once electric generators, buyers, and speculators came to appreciate the magnitude of potential market swings (and how much money could be made therein). Enron’s Star Wars-inspired ploys were the most famous example, making them the poster child for rapacious speculation. So far, so fair.

The awkward wrinkle to this story is that some of those transactions weren’t technically illegal. If you’re an avocado farmer and you can get $2 an avocado at Kroger and $2.50 at Safeway, no one calls you amoral for selling to Safeway. And if that then causes Kroger to raise their avocado prices to draw you back into their supply chain, no one is likely to take out their ire on the greedy avocado broker.

But watch what happens if you replace the word “avocado” with electricity. If your power plant will earn more money tomorrow (given the hot weather forecast) than it will today, and you therefore curtail production today to horde your fuel, are you breaking the law? If you then notice that the price today starts to rise when you curtail, such that you can independently affect price, are you amoral for using that knowledge to your economic advantage?

To be clear, I don’t in any way mean to suggest that Enron wasn’t amoral, nor that society’s access to electricity is no more important than society’s access to avocados. However, when the regulatory rules are set up such that the electricity broker’s regulatory constraints are broadly similar to those of an avocado broker, a fair portion of the blame for whatever next ensues is rightly laid at the foot of the regulator. Every time we simplify the California power crisis to “Enron-type manipulation,” we give the regulator an undeserved free pass.

Why Kahn matters

In a regulated enterprise, the role of the regulator is essentially to set price. That’s how consumers get protected. In an unregulated enterprise, the role of the regulator is to make sure that the market sets the price, but that no individual actor (or collection of actors, acting in concert) can affect that price. That’s why he says that the regulatory function shifts from price setting to anti-trust enforcement. The fact that Enron was allowed to exist in California is all the evidence that you need that antitrust enforcement was absent.

Which brings us back to Senator Feinstein’s efforts to regulate emerging CO2 markets. Should we be leery of amoral market speculators? Yes. Should we guard against market dominance that can affect the price and supply of CO2 credits? Yes. But should we define success by a stable, not-too-high price for CO2 emissions credits? Absolutely not. A healthy market is incompatible with price controls. What’s more, a regulator focused on price controls is often blind to precisely those antitrust-busting games that smart, amoral speculators like to play.

For now, I’m cautiously encouraged by Feinstein’s efforts. Encouraged, that is, to the extent that her invocation of Enron meant that we need to adopt greater regulatory discipline to ensure we don’t repeat our prior regulatory mistakes. But cautious, also, because too often, that invocation turns a blind eye to the culpability of regulatory agencies whenever we have a regulatory failure.

Sean Casten is President & CEO of Recycled Energy Development, LLC, a company devoted to profitably reducing greenhouse emissions.

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  1. Ken Ward's avatar

    Ken Ward Posted 3:56 pm
    09 Jul 2009

    Sean, You've left out the key piece of the story, which is that it was Enron that mounted the national campaign to win state deregulation and it was Enron that spearheaded the idea of cap & trade as climate policy, having reaped immense profits in the sulfur market. Enron's utility deregulation drive included significant payouts to state environmentalists, which may or may not have been illegal, depends on the state law, but was certainly unethical (for all parties). 

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  2. Sean Casten's avatar

    Sean Casten Posted 4:47 pm
    09 Jul 2009

    Completely agree, Ken.  But that's kind of my point.  If you are a rapacious speculator, your wet dream is to have a regulator in a deregulated market who believes that their primary purpose is cost control (since by definition, that means that they DO NOT see their primary purpose as anti-trust enforcement).  Like I said in the post, I don't set out to absolve Enron in any way, but rather to hope that among the lessons we learn from that debacle is that the regulator was also asleep at the switch.  Smart businesses will always figure out how to convince regulators that they are doing the right thing by regulating this bit, but not that bit.  A smart regulator ought to know when they're getting their chain pulled.Deregulation is not a bad thing, even though Enron-style deregulation with a sleepy regulator was bad.  Similarly, the fact that Enron was pushing for cap & trade doesn't mean that all flavors of cap & trade ought to be painted with a negative brush.  A C&T market with proper oversight to ensure that there is no market dominance by single entities (to the degree that no single entity can independently affect price) is a good thing, and decidedly not what Enron-as-metaphor would have wanted.  But in the blowback against speculators and the populist push towards cost control, let's be careful that we don't end up right back where Enron-as-metaphor wants us.

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  3. Ken Johnson's avatar

    Ken Johnson Posted 5:59 pm
    09 Jul 2009

    Sean - Re "A healthy market is incompatible with price controls.": How do you define "healthy"?Let's apply your standard of "health" to the acid rain trading program. According to EDF, "The expected market price for SO2 allowances was in the range of $650-$850 (in 2000 dollars). The actual market has been between $100 and $200 for most of the program." According to the EPA, the benefits of SO2 reduction exceeded costs by 40-to-1, and the benefits of further reductions beyond the 1990 CAA limits would exceed costs by 25-to-1. Costs were a fraction of what Congress expected in 1990; benefits of further reductions would have exceeded costs by over an order of magnitude; and yet the SO2 trading created no incentive for further reductions. In what sense is this "healthy"?On the other hand, suppose the EPA had set the allowance price at, say $650 -- at the bottom of the projected range. There would be no cap, just a fixed-price sale. The revenue could be distributed according the exact same proportionate allocation formula that was used for allowance allocation (or any other preferred formula). SO2 scrubbers would be a lot more attractive at $650/ton than they would at $200/ton, so the objectives of EPA's CAIR program could have been achieved -- or exceeded -- years ago without further regulatory intervention. In what sense would a fixed-price allowance sale have been "unhealthy"?The implications of the SO2 trading program for GHG regulation should be plainly obvious, but how do you explain the obvious to people who have their ears plugged, their eyes shut, and their minds firmly closed?- KenJ 

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  4. Ken Johnson's avatar

    Ken Johnson Posted 6:08 pm
    09 Jul 2009

    (That last link is broke - try this.)

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  5. Ken Johnson's avatar

    Ken Johnson Posted 6:11 pm
    09 Jul 2009

    Still broke ...http://www.grist.org/article/fred-krupps-response#c97523

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  6. Sean Casten's avatar

    Sean Casten Posted 6:41 pm
    09 Jul 2009

    Ken,It's a logic I never understand when we assume that a market doesn't work because the price isn't high enough.  Do you get upset when your shoes don't cost enough?  Or when the price you pay for home insulation doesn't approach the value that the insulation creates?  Of course not - so why does the low cost of SO2 permits suggest a failure of that market?The SO2 markets had plenty of problems, most notably that all the allowances were given away for free, putting the compliance burden disproportionately on new sources rather than the grandfathered ones.  But the fact that SO2 traded way below the price that everyone thought it would AND lowered the emissions means that society got more bang for it's buck.  I fail to see why that's a bad thing!  We should all be hoping for CO2 costs that are as low as possible, unless our goal is simply to penalize CO2 emitters.  Personally, I'd much rather see a goal to lower CO2.Re: your question about a healthy market and price controls, it's fairly straightforward.  If government sets the price, it's not a market.  Might be socialism, might be a tax, but it ain't a market.  CA showed this quite dramatically, when they allowed markets to set wholesale rates, but then capped retail prices, and we briefly had the somewhat surreal situation where regulated utilities were forced to buy power at one price and sell it at a lower one.  Next thing we know, PG&E is bankrupt and the state is out of power (and pretty soon, CA taxpayers are out some $17 billion bailing out PG&E so that ratepayers wouldn't have to.)  If the sums weren't so large, it would be funny.  Anyway, that's my point.  If we want a market, let the market set the price.  That's not to say the regulator doens't have a role; quite the contrary.  Per Kahn, the regulator has a critical role to make sure that the market functions and no market players can exert anti-competitive power.  But that's not price setting - it's simply ensuring that the market behaves like a proper - and healthy - market.

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  7. Ken Johnson's avatar

    Ken Johnson Posted 9:44 pm
    09 Jul 2009

    Sean -Re "why does the low cost of SO2 permits suggest a failure of that market?": There is no market failure. It is a failure of regulatory policy to create regulatory incentives sufficient to achieve sustainability objectives.Re "But the fact that SO2 traded way below the price that everyone thought
    it would AND lowered the emissions means that society got more bang for
    it's buck.  I fail to see why that's a bad thing!" It's a bad thing because SO2 emissions were not reduced to ecologically sustainable levels, even though they probably could have been within limits of cost acceptability. It is also a bad thing because tens of thousands of premature human deaths could have been avoided if we had a rational regulatory policy.Imagine that the Pentagon had set a "cap" of 10,000 lives lost to terrorism per year. Would you say that the program was a success in 2001 because it was well within the cap -- only 3,000 fatalities -- and because the cap was achieved much more cheaply than anyone had anticipated? Seriously. This is frickin' insanity.

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  8. David Roberts's avatar

    David Roberts Posted 10:43 pm
    09 Jul 2009

    I agree with Ken here, and as it happens the output-based standards beloved by Sean precisely avoid this trap -- they award those "above average" in perpetuity. If the cap ends up artificially limiting emission reductions (they turn out to be cheap and the weak-ass 2020 target is reached too easily) rather than let all cost-effective reductions be undertaken, it is needlessly trading lives for extra profit.

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  9. Sean Casten's avatar

    Sean Casten Posted 6:12 am
    10 Jul 2009

    Ken & David:I don't follow your objection. If you think the cap wasn't tight enough, then lets talk about tightening the cap.  What I don't follow is the logic that says that the price wasn't high enough.  The cap sets supply, the market sets the price.  I'd draw the analogy to RECs; when utilities are mandated to procure 5% of their power from renewable sources and the price of renewables subsequently assumes a $30/MWh premium to meet that regulation-enforced supply, what ought we do to bring more RECs forward?  Raise the price or raise the utility requirement?  Since the price is set by a market, the obvious answer is to raise the utility requirement.  Your objection to SO2 cap & trade seems to be framed on the same logic, except that you conclude that somehow the problem is the price.  We agree that the regulation could have been done better; my point is simply that failures due to regulation should not be blamed on market pricing mechanisms.As I noted above, there are certainly big problems with the SO2 cap, and the most notable one was the grandfathering of pollution permits.  The biggest sources (those pernicious coal plants) got to emit for free while new, much lower sulfur sources had to come into full compliance under the cap.  That clearly led to higher SO2 emissions than we otherwise would have had, and lowered the price of SO2 by reducing the number of credits that had to be bought.  But again, that's not a failure of the market, but one of the regulatory construct around the market.Put it another way: if we raised the price of sulfur through some mechanism, but kept the cap unchanged and kept the grandfathering in place, do any of your objections go away?  Unless I'm missing something in your logic, it doesn't appear that they would.  Which suggests that the failure is not the market pricing mechanism, but the failure of the regulations that defined the rules of engagement within that market.  Which brings me back full circle to the start of this thread: when markets fail, it doesn't necessarily imply that dastardly speculators foiled an infallible regulator. 

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  10. Ken Ward's avatar

    Ken Ward Posted 6:48 am
    10 Jul 2009

    First Ken (Ward) speaking here...My point about Enron's role was more general than cap & trade, that is, regulation, enforcement and law are always subjected to constant pressure by those regulated looking for loopholes, laxity, or to reshape the playing field. In my view, to guarantee an outcome, and we have no choice with carbon, then we have to look at more draconian measures then cap & trade. If and when we do so, by mandating cap & phase-out on extractions or feedstock, then and only then is price parity for renewables achieved (and price stability for fossil fuels). 

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  11. Ken Johnson's avatar

    Ken Johnson Posted 9:00 am
    10 Jul 2009

    Sean -Re "lets talk about tightening the cap": How tight? What policy criteria determine the cap? If the scientists can tell you what the sustainable emission level is, and you are willing to impose a cap at that level even at $1000/ton, then just set the cap at that level and let the market figure out the cheapest way to achieve it. That's the ivory-tower theory behind cap-and-trade, but the real world doesn't work that way. We either don't know what the sustainable emission level, or are unwilling to pay what we think it will cost to achieve that level. So the cap is set through a political horse-trading process that is driven more by cost expectations than by science-based sustainability requirements. Costs turn out to be much lower than expected, but the cap does not automatically adjust to lower costs, so the result is that cap-and-trade does not even motivate us to spend what we are ready and willing to spend on emission reduction, much less what science says we need.Re "if we raised the price of sulfur through some mechanism, but kept the
    cap unchanged and kept the grandfathering in place, do any of your
    objections go away?" That "mechanism" could be a price floor, e.g. $650/ton-SO2, which is so far above the $200/ton unconstrained market price that the cap would become irrelevant. Emissions would be reduced far below the cap.W-M imposes a price floor of $10/ton-CO2, increasing 5% annually. What do you think the policy rationale for the price floor is, and how do you think they determined the floor level? 

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  12. Sean Casten's avatar

    Sean Casten Posted 11:24 am
    10 Jul 2009

    Ken J,I fully accept that the precise cap level is unknowable, for the same reason I don't get my palm read - I'm dubious of anyone who claims an ability to predict the future.  (And don't even get me started on economic forecasters!)  I also agree that the policy is inevitably politicized to a degree that is suboptimal.But having accepted those points, I don't see how either of those are unique to cap & trade, or how either of those are fixed with some market-neutering mechanism like a price floor/price cap.  (And yes, I think it's no less of a bad idea in W-M than it was in CA when they set retail price caps.)  More often than not, those price caps work against the policy goal - witness Massachusetts, where for years the utilities never had to fully meet their REC obligations because the price was above the circuit breaker, so they just got to pay $ into a fund that went to R&D instead of renewable energy deployment. Which proves only that you can't set a price such that you eliminate the actions of a market - which is, after all, nothing more than the way that the collective populace responds to that price.  You can get unintended consequences no less readily if you impose a price floor than a price ceiling, but the larger point is that a price per se is not sufficient ot ensure volume certainty.  A cap is, subject to your (well-taken) concerns about the politics.  But under no political environment is a pricing structure sufficient to create volume certainty.

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  13. Ken Johnson's avatar

    Ken Johnson Posted 12:33 pm
    10 Jul 2009

    Sean,Re "under no political environment is a pricing structure sufficient to create volume certainty." SO WHAT!! Why do you care about "volume certainty" if the "volume" is wholly inadequate to avert climate catastrophe?The "unintended consequences" that you get with a price floor are more emission reductions than you anticipated. So??Going back to SO2, the basic issue is plain and simple: If the emission price is $200/ton then industry will be motivated to spend up to $200 to avoid emitting a ton of SO2. If it is $650/ton, then they will be motivated to spend up to $650. Never mind whether the price is set by the market or by regulators, a $650/ton price will motivate more emission reductions than $200/ton. 

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  14. Sean Casten's avatar

    Sean Casten Posted 1:14 pm
    10 Jul 2009

    Ken,Perhaps we just suffer from different political philosophies.  To my way of thinking, if the government chooses to place a price on an environmental externality that was previously given away for free, they have ample regulatory apparatus to set  the rules of supply and demand for that commodity, and in so doing, can take advantage of a vibrant set of market actors who can independently find paths to meet both at a market-set price.  But as soon as government tries to create path- or price-certainty, no shortage of bad things happen.  (Indeed, setting too high a price can also lead to too little pollutant reduction, since no one has infininte resources.) Put another way: environmental regulation can get one of the three: path, price, or volume certainty.  I've yet to see a policy that successfully get more than one of those, although most do try.You may simply have more confidence than I that regulators can insert price- and path-certainty without unintended consequences.  I've yet to see it.  Price floors in CA gave us blackouts.  Price ceilings in MA REC markets (coupled with a highly-constrained set of eligible technologies) gave us less clean energy.  BACT/MACT rules in environmental regs that sought path certainty have greatly penalized energy efficiency and driven up the cost of pollution compliance, creating near-permanent hostility between environment and business communities, both of whom are convinced that the other is not to be trusted.  None of those outcomes was preordained, and all were avoidable - but all resulted directly from a regulatory model that sought price- and/or path-certainty. We are both in violent agreement about the urgent need to act on climate, and about the inadequacy of our current political discussion to face up to the magnitude of the challenge.  From that point, I suppose it is simply a case of pick-your-poison.  Do we think we are better off pushing to move the politics in line with the policy or do we think we are better off imposing top-down controls on a market and hoping the market will respond in a predictable way without unintended consequences.  Neither is easy, and neither is without risk.  But all my experience tells me that the first path has a much higher probability of success.

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  15. Ken Johnson's avatar

    Ken Johnson Posted 4:41 pm
    10 Jul 2009

    Sean -Here's another example of "unintended consequences": Sweden enacted legislation in 1990 to reduce stationary-source NOx emissions, with the intent of reducing emissions by 35% within five years. There were no caps, no standards, no timetables -- just price controls. Consequently, they missed their target. By 1995 specific emissions had dropped by 60% (and total emissions, with demand growth, had dropped by 50%). Oops.

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  16. Sean Casten's avatar

    Sean Casten Posted 6:36 am
    11 Jul 2009

    In hindsight, sounds like the failures of that one were pretty predictable, eh?

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  17. Ken Johnson's avatar

    Ken Johnson Posted 7:56 am
    11 Jul 2009

    No, their failure to hit the 35% target were not predicted. If they
    had employed cap-and-trade, they would have achieved the 35% target --
    no more, no less: "Environmental certainty." As a consequence of price
    controls, they overshot the emission reduction target by a wide margin.If a similar approach had been used with the U.S. SO2 program, market forces could have been harnessed to achieve dramatic, unanticipated reductions in emissions similar to the unanticipated cost reductions that resulted from emission trading.

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  18. ids's avatar

    ids Posted 4:14 pm
    12 Jul 2009

    obvious, apolitical truths:Unless you’re an energy producer, high energy prices stink. No matter who you are, volatile energy prices stink. Not withstanding points (1) and (2), high and/or volatile energy prices encourage greater energy efficiency. 1.  Not necessarily.  If the price comes without externalities included that affect you, high price can be good.2.   Not necessarily.  Many don't give a shit what the price is, especially within the boundaries of current politics, just the way they like it.3.  Not necessarily, see 2.  Also, efficiency doesn't decrease demand or externalities in real terms. You might want to re-examine your truths.

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