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Putting a collar on carbon prices

Severin Borenstein, professor of business | June 4, 2013

When it was launched in 2005, the European Union cap and trade program for greenhouse gases (known as the Emissions Trading System or EU-ETS) was a bold and important step in addressing climate change.  But from the beginning, the EU-ETS has often been a painful learning experience, much of the learning by politicians:

–  A high probability of a price collapse in the first compliance period (2005-2007) was completely foreseeable, because the permits for that period couldn’t be carried over for use in later years (“banked”), so they had no residual value.  That collapse began in 2006 and drove the price to virtually zero by the end of 2007.

–  The “shocking’’ (to some regulators) fact that companies raised their prices to reflect the cost of associated emissions permits — even though they’d received most permits for free — was just basic economics: the permits had an opportunity cost to the firm since they could sell them at the market price.  That cost of using a permit was reflected in the production costs, and thus their prices.

NASA photo of Earth

NASA photo

And the most recent disappointment — the extremely low prices of current permits — while not completely predictable, were a clear risk when the program was launched.  Unlike California’s cap and trade program, the EU-ETS has no price floor.  As a result, when lower-than-expected emissions occurred – due primarily to the anemic EU economy – the price was likely to crash.  With prices now around 3 euros (equivalent to about a 5 cent per gallon tax on gasoline), the EU-ETS is providing very little incentive to take actions that reduce emissions.

But if the emissions targets are being met at that price, what’s the problem?  Why is the market being called a failure or irrelevant?  Because nearly all observers recognize that it makes no sense to stick to a rigid quantity target for EU greenhouse gas mitigation when the real goal must be long-run development of alternatives to fossil fuels and other GHG emission sources. In particular, alternatives that are economic enough that the developing world might be enticed to adopt them.

The EU reductions alone aren’t going to shift the path of earth’s warming, so pretending there is a fixed target simply ignores the science of climate change.  Instead, we should recognize that the market (remember, this is a market-based approach to emissions control) needs some stability in price signals to make investment plans.  That’s the role of a price floor.

If the EU-ETS had a floor at, say, 10 euros, then if demand for permits went soft, as it now has, the cap and trade program would transition smoothly to be essentially a carbon tax.  Investors would know that even if the economy tanks, or breakthroughs in natural gas technology allow it to crowd out some coal and accelerate emissions reductions, the value of reducing GHGs would never drop below 10 euros.

Such a constraint on the permit price recognizes that pollution policy is always a tradeoff of costs and benefits.  If the costs of further GHG reductions have dropped to near zero — as reflected in the low price of permits — then we should do more of it, since we know in reality that the benefits of further reduction don’t suddenly drop to zero when we hit some target number.  A price floor supports doing more when the cost is low.

So far, a lot of environmentalists are probably nodding vigorously.  Here’s the part they may not like: the  same logic supports a price ceiling. Again, there isn’t a magic target emissions number that will “solve” the climate change challenge.  Again, it’s a matter of costs and benefits.  If the cost of further reducing emissions is currently enormous – as reflected in skyrocketing permit prices – then we should do less of it, at least in the near term.  Failing to set a price ceiling risks both forcing GHG reductions for which the costs are greater than the benefits and, more importantly, setting off political blowback and emergency policies that undermine or destroy the program (such as suspending the program or granting waivers to politically powerful emitters).

California has already gotten this lesson half right with a price floor, and the California Air Resources Board is in the process of developing a policy on “cost containment” that will act as a price ceiling.  Some say that with low California permit prices today – just a couple dollars above the price floor — a price ceiling isn’t necessary.  I’ll bet there were people who said the same about a price floor in the EU-ETS when the price was around 30 euros in 2008.  The fact is that it’s a lot easier to pass good policy when the potential emergency isn’t imminent rather than after it has already begun.

Meanwhile, the EU-ETS continues to offer lessons from which later programs can learn.  Instead of a price floor that would be a reasoned policy response, the European Parliament just considered, and rejected, an ad hoc delay in releasing some permits in the short run.  That may have raised the price, but it would not have provided policy stability or credibility.  Instead, the EU-ETS should now follow California and adopt a price floor, and then a price ceiling.

Cross-posted from Energy Economics Exchange (tag line: Research that Informs Business and Social Policy), a blog of the Energy Institute at Haas.