Carbon Markets to Serve the Planet

July 28, 2009

by David L. Levy

Paul Krugman rushed to defend cap-and-trade in his New York Times blog this week against the accusation by Senator Byron Dorgan in the Bismarck Tribune that speculation could make the carbon price as volatile as oil prices have been in recent months. Joe Romm weighed in to support Krugman on his blog, Climate Progress. Krugman argues that:

The solution to climate change must rely to an important extent on market mechanisms — it’s too complex an issue to deal with using command-and-control. That means accepting that some people will make money out of trading — and that yes, sometimes trading will go bad. So? We’ve got a planet at stake; it’s crazy to cut off our future to spite Goldman Sachs’s face.

Yes, Krugman is correct that the planet is at stake – which is precisely why we have to be very smart and very careful about the governance structures we set up to control carbon emissions. We do need to ask very seriously whether we trust investment banks, traders, and financial intermediaries to run a global market that will serve as the central nervous system for global carbon management.

Krugman mocks those who criticize the Waxman-Markey cap-and-trade bill as having a knee-jerk anti-market response: “Eek! Markets! Wall Street! Speculation! Bad!” But Krugman knows all too well that the market devils are in the details. This is, of course, the same Paul Krugman who has spent most of his career writing about market failures, and the last couple of years predicting, then explaining, the current financial crisis. He understands perfectly how asset bubbles, herd behavior, poor regulation, excessive leverage, distorted information, misaligned incentives – not to mention corporate influence over the regulators – all contributed to systemic economic risk and eventual meltdown. It’s also the same Paul Krugman who, back in February 2009, argued for the temporary nationalization of banks in order to give policymakers the tools to steer the economy away from the rocks. If he didn’t trust Wall Street to get us out of the financial crisis, why does he trust them to save us from the climate crisis, in which the stakes are far higher?

Most progressives concerned about climate change, myself included, understand that it’s crucial to set a price on carbon, and right now, cap-and-trade is the only game in town. Most of us are willing to hold our noses and support the W-M bill, or something like it, warts and all (see one of Joe Romm’s blogs on this). First, the US needs some version of cap-and-trade to have a credible presence and exert some leadership at Copenhagen in November. Second, passing a cap-and-trade bill will send a powerful message to business managers that government is now serious about climate change and the time has come to plan for a carbon-constrained future. Third, and most important, the mechanisms and institutions developed for cap-and-trade need some time to debug and fine tune. But once this infrastructure is in place, the carbon cap can be cranked down should the science require it (and if the political will exists). This is exactly what happened with the 1987 Montreal Protocol to control ozone depleting substances (ODS), which was strengthened as the science accumulated to require a faster and more complete phase-out of ODS (here’s a rather dated paper of mine comparing the ozone and climate issues).

One thing W-M style cap-and-trade will not do, however, is set a carbon price that is sufficiently high and predictable to induce fundamental changes in corporate strategy and resource allocation in the next decade. The EPA analysis of W-M (download pdf) states that “Across all scenarios modeled, the allowance price ranges from $13 to $26 per ton CO2 equivalents (tCO2e) in 2015 and from $17 to $33/tCO2 e in 2020”. And W-M will probably have a price cap of $28/ton for the initial years. A price of $30/ton roughly translates into an increase of 30c/gallon of gasoline, and about 2.1c/kWh of electricity (based on the average carbon intensity of power). In his critique of Senator Dorgan, Joe Romm himself observed “it will be so easy to meet the targets for at least the first decade”, primarily by switching power production from coal to natural gas. But this means that the price signal will be too low to trigger more substantial shifts in our transportation infrastructure and low-carbon technological capacities. This was brought home to me in April 2008 at a Sloan Industry Studies Workshop I attended at the University of California, Berkeley, on the impact of climate change on various sectors of industry, including aluminum, paper, steel, electric power, autos, and food. Across the board, there was agreement that a carbon price under $30/tCO2e would not have a major impact on these carbon-intense industries.

If business is to commit large scale resources to long-term investments in carbon reduction, then the carbon price signal has to be strong and reasonably predictable. Oil companies don’t look at the spot price of oil to make decisions about long term exploration. Renewable energy in some European countries has taken off thanks to long-term feed-in tariffs that guarantee prices. Meanwhile, the US wind industry has been hampered in obtaining financing in recent years because the tax credit needs annual Congressional renewal. So the question of carbon price volatility is very important. Yes, W-M addresses fraud and market manipulation, though this is not the core issue (nevertheless, Peter Younger at Interpol has been quoted saying that the carbon market would be irresistible to criminal gangs).

The critical question is whether the particular carbon market structures being developed will in fact deliver the carbon reductions we urgently need. There is often a tendency to trust the “market” as if markets are a natural, magical mechanism to manage all of our society’s concerns. But the carbon case highlights how markets are political and institutional constructions that serve particular purposes. W-M will ensure that prices are low enough to secure the coalition needed for it to pass. And a host of financial institutions are building a carbon market from which they can profit.

What kind of market are the financial companies building? This has recently become a hot topic for academic research. One newly minted Ph.D. from Oxford University, Janelle Knox-Hayes, has spent the last couple of years studying the nascent carbon markets and talking to the people involved. The picture that emerges from her work is that these financial institutions are involved precisely because they (and policymakers) see the opportunity to apply their financial expertise and institutional capacity to a new market. So these actors are creating carbon markets that look a lot like the markets for other financial instruments and commodities, complete with futures, options, and other derivatives.

This is unsurprising, given what we know about how organizations build new institutions by adapting existing templates. These are the very same players who brought us sub-prime mortgages, collateralized debt obligations, credit default swaps, and value-at-risk models. These were attractive because plain-vanilla mortgages had become simple commodities with very low profit margins, while the complexity of new derivatives enabled these companies to charge high fees for specialized products and the associated proprietary expertise and valuation techniques. The financial firms thus have a vested interest in market instruments that are complex, opaque, volatile, and hard to value. So there are legitimate grounds for concern that the carbon market is being cast in the same mould. And it is not looking like a market that will give the clear and simple price signals needed to stimulate a broad transition to a low-carbon economy.

Krugman defends cap-and-trade on the basis that climate is “too complex an issue to deal with using command-and-control.” The irony here is that although cap-and-trade is often viewed as the centerpiece of climate policy, policymakers are relying primarily on command-and-control style policies to reduce greenhouse gas emissions in the next decade. In the US as well as in Europe, the largest impacts are going to come from clean energy mandates to the power sector, subsidies for research and commercialization of low-emission technologies, vehicle efficiency standards in transportation, and building efficiency codes. Krugman is right that we need market mechanisms, but we need to build ones that work to serve the planet.

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