Cap and Trade: Creating a winning policy coalition?

August 13, 2009

This is a guest contribution by Dr. Matthew Paterson, School for Political Science, University of Ottawa, Ontario. He is also co-editor, of the journal Global Environmental Politics.

David Levy raises many questions in his post Carbon Markets to Serve the Planet, on Krugman’s defence defence of cap-and-trade. I want to pick up on two here, and then add another into the pot which seems to me crucial to whether carbon markets can help in the fight against climate change.

First, a central premise in David’s intervention is that carbon markets could encourage speculation which will produce carbon price volatility. It is clearly the case that this would undermine the ability of such markets to help achieve carbon emission reductions in a predictable way, since investors and manufacturers rely on a stable and increasing carbon price to give them the signals to direct investment.

But let’s look at the main cap-and-trade market in existence, the EU Emissions Trading System. The two figures below give carbon prices in the EU ETS. The first one goes from December 2004 (just before the official start of the system) to April 2007. It shows the prices for the Phase I (2005-7) allowances and the Phase II (2008-2012) allowances. These are forward prices – precisely those prices on the derivative markets that make people squeamish about speculation. The second one shows just Phase II allowances but goes up to January 2009. These are also forward prices.

ETS price1

ETS price2

Two major episodes of volatility can be seen in these graphs. One is the collapse of the Phase I price in April 2006 (the blue line on the left). The other is the steep decline from July 2008. My point here is that neither of these have anything to do with speculation. In the former case, it was because new information came out from the European Commission, which showed that companies had been over-allocated with allowances, causing the price to crash to virtually zero. This might cause us to worry about the regulatory capacity of governing institutions, but not to prevent speculation. The forward price for the Phase II allowances, after a little panic, recovered and was pretty stable throughout the period before the Phase II period started (January 2008).

The second decline followed the onset of recession and the decline in oil prices (since January 09, it has recovered somewhat, again along with oil prices). Here, the point is that because the main demand for allowances is among electricity producers, as demand for electricity fell, two things happened. First, anticipated demand for allowances also fell, and their prices fell accordingly. But second, demand for natural gas fell, since natural gas is the swing producer in European electricity supply. And gas prices correlate strongly with oil prices, since they are often produced together, thus putting further downward pressure on electricity prices and thus carbon prices.

So it is hard to find evidence that speculation is a huge problem in those carbon markets which already exist. One or two of the smaller short-term spikes (e.g. the one in June 2005) were possibly attributable to speculation, but there isn’t systematic and wide fluctuations in prices which would suggest there is volatility produced by widespread speculation. In fact, the prices overall look relatively stable. To be sure, they are young markets, but they are nevertheless the sort of derivative markets – with forwards, options, swaps, and the like – which current worries about finance emphasise as the reason why we should be wary of finance-driven solutions to climate change.

David raises a second question about price – that it is too low. This is clearly another question, and it is indeed clear that the prices being envisaged in the Waxman-Markey bill are way too low. Again, a comparison with the EU ETS is instructive. As to a price cap, in Phase II the EU ETS has an official price cap (the fine you would pay per tonne of CO2 for non-compliance) of €100 (around US$140). As the figures above show, carbon prices have never gone above €30 (US$43), way below the fine price. The EU envisages prices rising considerably again in Phase III (2012-2020). Again, two things are worth noting here.

The first is that EU officials deliberately decided to aim for a low-ish price in the first period, to get the system up and working, rather than aim too high too quickly and risk the credibility of the system if huge number of firms were not able to meet their obligations. American officials and policy-makers are presumably making a similar judgement. Of course the converse risk is that the targets may not be ratcheted up later, but the experience of the EU isn’t too bad on that front either.

The second leads me to what is probably the biggest regulatory dilemma for carbon market design, which David doesn’t mention. This is the question of offsets, which are crucial to whether cap-and-trade has a chance of delivering emissions reductions. Waxman-Markey allows companies to use offsets (see sections 731-743), but doesn’t specify a limit to their use. In the EU ETS, offsets are the de facto principal cost containment strategy in the EU ETS, not the fine price. In most member countries, there are limits as to how much of a company’s obligation can be met by purchasing offsets.

Much of the carbon market industry argues forcefully that maximum access to offsets is required, both for regulated firms to contain costs, and to sustain interest in carbon markets by investors. But there are two questions (at least) here. On the one hand, the regulation of the carbon offset market – what types of offsets to allow, what percentage of firms’ obligations can be dealt with by offsetting, how to measure additionality, and so on – is much more problematic than for cap-and-trade markets, since they involve stages and processes which are much more prone to flexible accounting if not outright scams. There have been huge numbers of exposés of carbon offset projects, both of the UN’s Clean Development Mechanism and the voluntary carbon market, well-publicised in particular by Carbon Trade Watch.

Perhaps these can be addressed with good political campaigning to close loopholes. But there is a deeper problem, which is that if you allow offsets the cap is no longer a fixed cap. This is a more basic question, and here it is even clearer than with cap and trade that we are in a ‘Faustian bargain’, and this is perhaps the core of Krugman’s problem. Even though he is critical of many of the dodgy practices of financiers, he is so precisely in order to recuperate the ‘good’ side of finance.

As I see it, the kernel of the problem of dealing with climate change within capitalist society is this. Capitalism needs growth in order to keep going. Historically, business, or specific sectors, has worked with other forces (unions, nationalists, social movements) to provide legitimacy and a broader appeal for ways of managing the economy that suit business interests. With other environmental problems, you could deal with them by isolating specific parts of business and limiting their activities, assuming that growth would go on elsewhere; with climate change this is not possible, however. Energy is simply too central to the whole of capitalist development. To sustain any project for decarbonisation, it is unimaginable to do so without gaining the support of wide sectors of business.

This is the basic brilliance of cap-and-trade. Economists will tell us it is all about efficiency, but in practice it is all about (a) parcelling up the climate so as to concentrate the benefits of climate change action on particular economic groups (financiers and clean energy), and (b) as a consequence building a political coalition that can sustain climate policy in the face of the rustbelt and SUV onslaught. No other policy can do that. Famous NASA climate scientist James Hansen came out in favour of carbon taxes recently, and organisations like Carbon Trade Watch opposing carbon markets supported his claim. But a carbon tax is no more certain to create a shift to decarbonisation, certainly not at the speed Hansen along with many others now argue is necessary. To believe so requires extraordinary belief in neoclassical economic principles – principally concerning how much demand for energy responds to price changes (what economists call price-elasticity). We know these principles don’t function in most energy markets, where demand is in fact rather insensitive to price changes. At least with cap and trade, there is a cap. But more importantly, carbon taxes create no winners, and will thus get massacred, as the Canadian Liberals recently experienced in their 2008 election campaign.

David raises the point that most of the policies that will help us get to decarbonisation may well be good old-fashioned ‘command and control’. We do indeed need to mandate levels of renewable energy use, housing standards for low-carbon futures, city planning that eliminates sprawl and favours transit and bikes over cars, and so on. Most of these will be achieved through such command and control policies. And most outcomes they would achieve could not be done simply via carbon markets.  But the political point here is that cap and trade could get buy-in from powerful actors. They may then see the opportunities in investing in rail, wind, solar, fuel cells, etc., given increasing carbon prices. But they will have realised their goals of money making in carbon markets (even if, as David says, the rest of us have to hold our noses), letting us get on with the business of other policies which either work on their own, or more likely, work in tandem with carbon markets.

Some critics of carbon markets suggest that it is a distraction from the ‘real’ action which is needed. This may be true. But the question is: Whose attention gets deflected? Does cap and trade deflect the attention of policymakers from command and control, or does it rather deflect the attention of the anti-climate change nutters from the command and control policies that actually deliver results?

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