Carbon Market Conundrum: How To Build a Better Safety Valve

March 26, 2009

It’s not easy being a market advocate these days. With the fate of many Wall Street players far from certain, and disgust from the public over bailouts and bonuses still growing, the notion of creating a new market in an all but invisible commodity would seem to be a political non-starter. But managing a government- created cap-and-trade program for carbon emissions is precisely the issue to be discussed at a House Ways and Means Committee hearing today.

Of all the controversial elements of cap-and-trade policy—there are obviously many—none has proven more difficult to resolve than the debate over “cost containment.” In part, that’s because the term has been used to capture multiple concerns about the performance of the future carbon market, many of which have been exacerbated by the recent financial turmoil.

Some members of Congress, like Rep. John Larson (D-Ct.), have even shunned cap-and-trade altogether, likening it to “an awful lot of Madoff,” and vocally advocated a carbon tax as an alternative.

Unraveling and ultimately resolving the cost containment debate will require cooler heads and an honest discussion about the real potential problems with a future carbon market. Identifying these problems, and the explicit goals to be realized through policy, would seem to be a good place to start.

Broadly speaking, there are two key objectives: The first relates to how overall economic impacts are aligned with our willingness to pay for climate mitigation, and the second relates to how prices are managed to create a stable investment environment for new technology.

Consider the first of these. Even if the market were to perform perfectly, allocating emissions reductions efficiently to yield a stable price signal, the total economic cost of the policy could still exceed current expectations for any number of reasons, including faulty assumptions about technology or baseline emissions growth.

Uncomfortable as it may be, this possibility should be acknowledged and faced squarely from the start. What is our willingness to pay for climate mitigation? Is it 1 percent of GDP, 2 percent of GDP or something else? There is no “right” answer to this question, because it depends critically on how one thinks about climate damages and how the opportunity to avoid them ranks among other national priorities. This is precisely why it must be debated openly in the public sphere, not hidden from further scrutiny.

Once made explicit, this political willingness to pay could be translated into a price ceiling or “safety valve.” Some will argue that this number is so high—that the damages of climate change are so great—that a safety valve would be effectively irrelevant. Perhaps that will turn out to be so, but at this point, it is an open question for policy makers.

Importantly, the higher the safety valve, the more critical it will be to confront the second problem of price volatility. For example, a safety valve at $40 per ton CO2 would do little to smooth prices oscillating between $15 and $30. To mitigate such volatility and the market inefficiency it represents, other mechanisms must be considered.

One creative solution is suggested by the climate system itself. Because the climate response depends on the accumulated stock of carbon emissions (not on the annual trajectory), emissions reductions can be shifted from one year to the next without significantly jeopardizing the environmental outcome. This provides scientific justification for provisions that allow firms to bank and borrow emissions permits in order to realize the economically efficient outcome.

Banking is easy to implement and comes with few drawbacks. Firms that over-comply in one year can use excess permits to meet their targets in a future year. If permits are oversupplied early and undersupplied later, firms will arbitrage in a way that leads to smoother prices over time.

Borrowing is the obvious complement to banking, useful when permits are undersupplied in early years relative to later years. However, the problem with borrowing is obvious; for the mechanism to work well, it must be constrained in some way to mitigate the risk of default.

Some have sought to explicitly constrain the number of permits that could be borrowed, either at the firm level or at the system level. The “reserve auction,” which would draw forward a fixed number of permits from later compliance periods, is an example of the latter.

An even simpler solution would use the ordinary tools of lending – charging interest and requiring collateral.   Requiring firms to pay collateral up front when they borrow permits would greatly reduce the likelihood of default. And in the event of default, the regulator could use the collateral payment to pursue mitigation on its own.

The resemblance between a collateral payment (i.e. a safety deposit) and a safety valve should appeal to the constituency that demands greater price clarity, because this mechanism implies that permits would be available for purchase from the government at a fixed price. Importantly, because borrowed permits (emissions) would be repaid in the future, the long-run emissions integrity of the system would be preserved, thus also satisfying a key demand of the environmental constituency.

Moving ahead, architects of climate policy will need to grapple head-on with these and other difficult issues. If extra attention up front leads to a well-functioning carbon market, success may well go unnoticed. Of course, we know from experience that failure resulting from inattention will be far more conspicuous.