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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.

Comments to “Putting a collar on carbon prices

  1. What is a way to look at the risk the 6th and 8th graders below pose to the world?

    NASA’s calculations of the sun’s average year-round radiation (called isolation) atop the more than mile high mountain of ice that covers the Antarctic continent is 10,000 BTU’s per square meter per day. That’s enough to melt the glacier 1 / 2 inch a day or 15 feet a year or entirely in 422 years or be 20% melted by 2100.

    A 20% melt corresponds to a 48 foot sea level rise. The only thing keeping that from occurring is surface air convection transporting the sun’s heat away down to the currently cool surrounding southern oceans (Antarctica is a desert with only 6 inches annual precipitation).

    So the risk we face lies in the question: To what extent will the southern ocean’s average temperature rise and leave the glacier at the mercy of the sun’s radiation (as the air convection to a warmer ocean sink in turn loses potency to cool the glacier) once the world’s permafrost reaches tipping point and suddenly melts releasing a projected 12 fold increase in gigatons of atmospheric heat trapping methane and carbon dioxide, which has been stored safely to date in the northern hemisphere and Siberia for these many millions of years ?

    Has this layman (based on cursory readings) characterized the risk correctly, which any 8th grader can prove exists?

  2. An 8th grade adjustment to the 6th grade arithmetic problem: Let’s assume the volume of the earth’s interior plastic flowing mantle does not change, so that while one region of the earth’s crust sinks into the mantle due to increased weight, other areas of the earth’s crust rise as the mantle must flow in beneath them.

    This mthe hydraulic affect of the earth’s mantle. The mantle has a specific gravity of 5. Thus when the ocean depth increases by 302 feet, the mantle beneath the ocean is squeezed out thinner by 302 feet / 5 = 60.4 feet. Assuming constant volume of the mantle, the mantle flows in under Antarctica and Greenland, as the 1.2 to 1.5 mile thick glaciers melt, raising those land areas by 1.2 X 5280 feet / 5 = 1268 feet in the case of Antarctica and 1.5 X 5280 feet / 5 = 1584 feet in the case of Greenland due to mantle inflow (popping those regions up like corks).

    So we must amend our 6th grade arithmetic calculation by accounting that though the ocean water depth is 302 feet deeper, the ocean floor has sunk 60.4 feet relative to the continental land areas it surrounds, not including rising Greenland and rising Antarctica.

    Thus the rise of the sea relative to the continents computes in a more refined calculation now to only 302ft – 60.4ft = 241.6 feet.

  3. But a 10% melt in as short a time period as the next hundred years will result in an approximate 30 ft sea level rise. Good bye South Jersey! Good bye New York City! Good luck Florida!

    Clearly flooding the atmosphere with CO2 is a most risky business. This subtle risk humanity faces is similar to that of the frog placed in a cold pot of water, which is then placed on the stove and slowly brought to a boil. Clearly human kind is not willing to jump clear of a risk, which any 6th grader can document.

  4. Probability of all of that ice melting=0.

    Regarding the carbon tax premise, how is it that the US has managed to come close to meeting the Kyoto protocols, yet has never ratified those protocols? The EU carbon credits are collapsing. They have done nothing to lower emissions from Europe, insignificant would be the word. Besides the truly big problem with pollution and major land use changes is the burgeoning growth in some of the large developing nations. CO2 is not the main driver of the climate of the Earth. Deforestation is a much more severe problem, but overall natural variation is the strongest force out there.

  5. 6th Grade Arithmetic Problem

    Antartica: 5.4 M sq miles with an average glacier
    depth 1.25 miles

    Greenland: .83M sq miles with an average glacier depth
    1.5 miles

    Total cubic miles of glacier on earth:
    5.4M X 1.25 + .83M X 1.5 = 8M cu. Miles

    Total area of the oceans:
    140 M sq miles

    Sea level rise if all ice on earth melts:
    5280 ft X 8M cu mi / 140M sq mi = 302 ft

  6. Absolutely agree about the floor. Just one thought – in Europe is not the fine of €100 per tonne, if sufficient allowances/credits are not surrendered, the price ceiling?

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