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On carbon caps and safety valves

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The new compromise bill on global warming has focused renewed attention on the notion of a “safety valve” that some legislators are trying to build into any proposed carbon caps in the U.S. Although sometimes depicted as a sop to the business community, the safety valve issue is actually a bit more complicated than that.

The new bill is a cap and trade scheme, but one which would allow capped entities to purchase additional pollution permits at $12 per ton (a level that will rise annually at 5% over inflation). This is the so-called safety valve, a hard limit on the price of offsets that places a ceiling on how much polluting entities will have to pay.

Safety valves have the effect of turning the proposed legislation into a hybrid between a cap-and-trade and carbon-tax scheme. Below the $12/ton price, the system operates as a carbon market. Above the $12/ton price, the system operates as a straight tax on emissions.

For the economically inclined, this MIT paper (pdf) lays out a readable account of why you might want such a hybrid system. In short, if you are reasonably confident that you know the optimal price for carbon, it could make sense to ensure that a cap and trade system doesn’t spike far beyond that optimal price.

Back in the real world, though, we don’t know the optimal price, but we do know that it’s a lot higher than $12/ton. $12/ton is high enough to motivate a large number of carbon reduction projects, such as methane digesters, but you have to reach prices of roughly $40/ton before technologies like carbon capture and storage on coal-powered electricity generators become feasible. In effect, the safety valve at $12/ton will render any proposed cap meaningless.

A safety valve would also prevent the integration of a U.S. market with the international market, because in an integrated market the U.S. price ceiling would automatically extend to our trading partners.

Finally, a safety valve greatly increases risk for offset project developers. Generating offsets is already a risky enough proposition, given the current legislative and market uncertainty. A safety valve sharply limits the upside value of carbon offsets, creating a further disincentive for project entrepreneurs.

For all of these reasons and probably several others, safety valves are not a good idea. And, of course, carbon markets already have a type of safety valve in the form of offsets, which greatly enhance the available supply of carbon reductions and thereby help to temper excessive spikes in price.

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