Wednesday, June 10, 2009

Why not stabilize prices?

In response to a friendly commenter's request for comment on my cap-and-trade post, Kevin Drum writes:
Jasper: I addressed most of those issues in my print piece on cap-and-trade. It's true that C&T produces price uncertainty, but Rognlie simply asserts without evidence that this is by far the most important consideration in carbon policy. That's a defensible point of view, but you have to do more than just say so. Besides, treating the subject solely from the point of view of finance, as he does, is much too narrow.

Ironically, one way to reduce price uncertainty with C&T is.....derivatives! That's how you reduce price uncertainty with any kind of commodity.

Investors deal with price uncertainty all the time, and in any case I think the price uncertainty associated with C&T is much exaggerated by its critics. It's not a reason to reject it.
Let's spell it out more clearly, then. There are three principal disadvantages of carbon price uncertainty and instability:
  • By making the returns to investors less certain, they discourage investment in green innovations. As Drum mentions, in some cases this can be alleviated by hedging with derivatives.
  • Wild swings in price will make aggressive carbon policy much harder to defend politically. Voters wouldn't have been so angry with $4 gasoline if it had been at that level for years; more than the price itself, it's the sudden pain of a price increase that arouses political opposition. Given how politicians fell over themselves during the recent oil spike with gimmicky proposals to relieve the burden on consumers, you can imagine what will happen when they have the direct ability to bring down a rising carbon price.
  • Most importantly, price swings represent a simple inefficiency. If permit prices are $20 per ton this year and $60 the next, you can make $40 per ton by transferring carbon emissions ahead one year, with minimal impact on climate change. Eliminating these inefficiencies enables us to set more aggressive targets for carbon emissions with no increase in cost.
I'm also unsure what possible reason one could have to oppose simple modifications that alleviate this problem, like allowing investors to borrow and save permits. If there is a good argument, I haven't heard it.

1 comment:

Kevin Drum said...

These are good points. My take is that price swings in absolute terms are likely to be fairly small, and since the permit price will generally be a small fraction of the total inputs, price variation at the end user level will be even smaller. Politically, I don't see this as a big issue, and the efficiency issues are likewise fairly small.

That's not to say they don't exist, of course. It's the main reason for favoring a tax. But it's not the whole story, either. There are other issues, both political and otherwise, that persuade me that C&T is overall a better solution than a tax. Obviously, your mileage may vary.

Oddly, the best argument against C&T, I think , is that it doesn't combine well with other regulatory initiatives. Adopt a local reg to increase building efficiency, for example, and energy use goes down. But that just drives the permit price down, which will drive other carbon emitting activities up. C&T is good at forcing emissions to meet a target, but it also pretty much guarantees that you'll never beat the target. For some reason, though, critics don't often use this argument.

(My own guess is that no policy we adopt will ever be stringent enough to actually beat the targets we should be aiming at, so this isn't a big deal. Still, it would be nice to have policies that all worked together and reinforced each other. A tax does this better than C&T.)

FWIW, I agree about modifying C&T to make it more efficient. I'm not a big fan of offsets, but banking and safety valves are good ideas, as are the use of standard exchange trades derivatives to smooth price swings.