Putting a Collar on Carbon Prices

When it was launched in 2005, the EU 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.

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.

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10 Responses to Putting a Collar on Carbon Prices

  1. Lon Peters says:

    Many markets work reasonably well without formal price collars. Rather, derivatives, such as puts, calls, futures and forwards, effectively create collars that help manage risk and create incentives for efficiency. The critical element is probably stability and simplicity in the market rules, to encourage liquidity and a transition toward reliance on standard derivative products. We probably don’t know (and may never know) what the “right” price is for carbon. If we did, then a Pigovian tax would be much simpler to implement. If a formal price collar were adopted, it would have to be re-evaluated periodically, which would introduce regulatory uncertainty, which in turn can discourage market-based solutions.

  2. Mike King says:

    Severin, isn’t this just an argument for a carbon tax instead of a cap and trade system? And Lon, even though we may never know what the “right” price of carbon is, if you believe that stability in the price path is necessary to incentivize “correct” investment in carbon avoidance, isn’t a Pigovian tax superior to a cap and floor system with all of the transaction cost of implementation (and required policing of trading behavior)?

    • Severin Borenstein says:

      @Mike King – A couple thoughts. I think the my post isn’t really an argument for a tax over C&T. Just as we aren’t going to hit the optimal quantity in C&T, we aren’t going to hit the optimal tax. In fact, a tax would probably need similar “guardrails” on the quantity side: lowering the tax if it caused too much abatement by killing more economic activity than anticipated, or raising it if the tax caused too little abatement. All of these are straightforward mechanisms to minimize the deadweight loss of getting the wrong price for the externality given uncertainty about the marginal benefit and marginal cost of abatement. I do agree to some extent the the transaction costs of C&T favor a tax, though the difference isn’t as large as many claim. A tax still requires monitoring emissions and dealing with financial constraints. But there aren’t the issues of market liquidity and market manipulation.

  3. Fred Heutte says:

    The Australian approach of starting with a fixed carbon price (“tax”) and then letting it float is an interesting approach also. However, it seems likely to be trimmed back substantially or perish if the Liberal Party regains power in September.

    More important are two issues. First, a carbon price should not be stand-alone — this is a real problem for the BC carbon tax, which has an exemplary design but is not really connected to complementary policies. As a result, the carbon price has to do all the hard work of emissions reduction by itself. Lacking a cap and relying on what at best are estimates of emissions impact (with the chronically difficult analytical issues of demand elasticity at hand), there is really no direct way to determine how effective it is in that sense.

    The AB 32 framework approach is the way to go, with a hard and declining cap, complementary mitigation and clean energy development policies, and a carbon price mechanism where it is possible to have a flexible “price corridor” as described above.

    But a second problem is now bedeveling California. Carbon price revenues are going to be constantly subject to political raiding, even if the right balance is found for the “three buckets” for the revenue stream — spending on abatement, equitable refund, and general fund. Any politically stable policy will have to provide all three, and even then a determined politician like Jerry Brown can upset the balance. I still think California is heading in the right direction, but getting and holding on to that three-bucket balance right is the place to focus, not on simplistic formulations like “revenue neutrality.”

    A carbon price policy vehicle can support several policy objectives — climate response, tax equity, and capital formation. But only one can be the driver. California made the right choice in AB 32, and as the main posting here indicates, there is enough flexibility to modify and strengthen the framework learning from lessons in state as well as elsewhere..

  4. Nice post, making some very good points. May I just clarify one thing?
    The Phase I price crash came in two stages. First, in May 2006 when the first EU-wide data on emissions showed that almost all governments had issued far more permits than were needed under Business As Usual (which could have been predicted – they were basically printing money when issuing permits), and so there would be an excess supply in Phase I. At that stage, however, I believe the rules allowed individual Member States to decide to allow banking of the permits they had issued, and if one had done so, permits would have been bankable. The price of a Phase I permit in June 2006 was not that far below that of a Phase II permit, consisted with the belief that it could be used in a couple of years’ time.

    In due course, people worked out that banking so many permits into Phase II would also muck up the market in those years, and so banking was eventually banned, as Severin says. I interpret the gradual decline of Phase I permit prices relative to Phase II (eventually reaching zero) as traders placing an ever-lower probability on banking being allowed. Once it was firmly banned, the permits were worthless…

  5. Chris Busch says:

    Severin,

    Always great to read your analysis and thanks for the post.

    Allow me to share an observation.

    I think CARB’s work on a price ceiling is a bit more advanced than the link you provides would suggest. The link to these workshop notices would seem to suggest that there is nothing yet build into the cap-and-trade program, but California’s program includes a strategic allowance reserve that will be released if a price threshold is triggered. As well, additional compliance offsets will be allowed into the system if a price threshold is triggered. These two stepwise design features are more limited than an absolute price ceiling, but do provide a cost containment function. My information is a year old, but I would be surprised if the outlines of the program have changed on these features.

    best regards,

    Chris Busch, Ph.D.
    Research Director, Energy Innovation, LLC

  6. John Parsons says:

    Severin, in explaining the low price of current permits, you really shouldn’t ignore the role of other policies such as the EU’s renewables directive. It is not accurate to treat the EU price as THE cost of reducing emissions. The claim that the cost of reductions has fallen, therefore the EU should do more to reduce emissions does not ring true to the EU economic predicament today. They are actually incurring high costs for what little reductions they are getting. And in the current economy, it is unclear whether more reductions in the EU alone are worth more costs paid by EU residents.
    And your premise seems to be that the quantity has been fixed indefinitely. But that is not true. The EU regularly sets new targets for future years, and these future caps help to determine today’s price. The EU did that in setting post-2012 targets and in recently deciding not to withdraw allowances. That you disagree with their weighing of costs and benefits really has little to do with whether some sort of collared price is an optimal mechanism. In a system like the EU-ETS where (i) there is banking to the indefinite future, and (ii) there is a rolling decision on emission permits allocated in future years, the system always resembles a collar. Your complaint that the price has been allowed to fluctuate too much is really a complaint about how the political bodies have exercised their discretion than it is a case for one mechanism design or another.

  7. Dave Erickson says:

    Regarding: 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.

    Unfortunately, the cost of reducing emissions or not reducing emissions is not set by the market. Ultimately it is set by the irreversible (in human terms) damage being done to the atmosphere. It’s important to have the emissions price accurately reflect this cost, as opposed to abstract market dynamics.

  8. Sy Goldstoine says:

    Severin, As far as creating the necessary long term demand side tncentives for advancing green carbon reducing technology I think you are making some very good arguments. For purposes of realizing long term global carbon reduction goals, incentives have to be thought through very carefully.

    But I wonder if have you given any thought to the fossil fuel carbon supply side?. By that I mean, unless carbon reducing incentives to accelerate carbon reducing technology are very carefully designed won’t they create perverse offsetting incentive on the owners of carbon reserves (coal. oil, etc). If they see the acceleration of green technology won’t the owners of these fossil fuel reserves be motivated , along lines anticipated by Hotelling”s theory, to take their fossil fuel carbon reserves out of the ground today before their value tanks tommorrow?

    If not carefully attended to, coudn’t this offsetting perverse incentives on the carbon supply side also threaten realization of long term global Ghg reduction goals?.

  9. Pingback: California’s Cap-and-Trade Market Still Needs a Price Ceiling | Energy Economics Exchange

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