Reporters trip over emissions trading

In the unlikely circumstance that reporters ever grow weary of chasing twitches in the oil markets or interpreting the wanderings of the Dow, they have a new toy to play with: the price of carbon. Which is fine, so far as it goes, except that they keep getting the story so badly wrong:

> The global financial crisis and looming recession might actually make it cheaper to comply with Europe’s increasingly stringent caps on greenhouse gas emissions by pushing down the price of carbon-emissions permits (along with everything else traded on a market). The environmental downside? The economic slowdown and cheaper permits could mean less progress actually cutting emissions.

This is exactly backwards. Permits are cheaper because companies are cutting emissions, and companies are cutting emissions because the economic slowdown is causing them to reduce output. In a cap-and-trade system, expensive permits don’t make companies reduce emissions; the “increasingly stringent” cap does that. Expensive permits are just a sign that companies are having difficulty meeting the cap.

Achieving a specific price for carbon is not a policy goal for a cap-and-trade system: the cap is the policy goal. Supply and demand determine the price of carbon permits. If polluters find that they’re having an easy time cutting emissions (creating low demand for permits), then the price of permits will drop. If the cap is working properly — an important caveat — the price of carbon is somewhat incidental. The cheaper, the better.

> This is not what environmentalists had in mind when they backed cap-and-trade as a way to ratchet down greenhouse-gas emissions.

Yes it is! This is just what everyone had in mind for cap-and-trade. Many have offered thoughtful critiques of this mechanism, but this is exactly how the system is supposed to work.

> For the system to really spur change, the carbon price has to be high enough to give an incentive for polluters to install cleaner technologies or move to cleaner fuels. Capturing carbon emissions from coal plants and sticking them underground, for example, will cut emissions but will be expensive. A carbon price below 40 euros a ton tends to make “clean coal” economically unattractive.

No, for the system to spur change, the cap has to be set at a level that spurs change. Then the price of carbon will adjust based on the available supply of emissions reductions. Clean coal is economically unattractive because of the availability of much cheaper forms of carbon reductions, and that situation won’t change until such alternative supplies are exhausted. At a certain carbon price, clean coal becomes more economically attractive than dirty coal, but that’s not the relevant benchmark. It’s easy to imagine a scenario in which clean coal never becomes economically attractive, because other forms of low-carbon energy such as wind and solar take off (helping to keep down the price of carbon, which, again, is a good thing).

To be fair, it’s easy to confuse means (the price of carbon) and ends (emissions reductions) in this manner. Environmentalists do commonly talk about the carbon price at which various clean technologies become cost competitive with conventional sources of energy. Insofar as we assume certain technologies will play an important role in a post-carbon world, it’s natural to track the price of carbon and watch for certain thresholds to be met.

But this is still the wrong way to think about carbon prices. The price itself is interesting, but the important question is always why the price is at a particular level, which is really a question about supply and demand. Consider the following explanations for a low carbon price:

1. Unseasonably mild weather has led to a drop in fuel usage, and therefore a drop in emissions.
2. The carbon cap has been set at a level that is too high, resulting in oversupply of permits.
3. The McKinsey report claiming that 40% of emissions reductions can be had for free via efficiency improvements turns out to be true. Businesses and individuals are having a field day slashing their energy consumption and saving money.

All three of these explanations are entirely plausible, and they tell wildly different stories. Story 1 is, essentially, boring. Energy usage fluctuates all the time, and the dip in carbon price is temporary. Story 2 indicates a structural flaw in the policy that means it may never work. Environmentalists, to the barricades! Story 3 is a happy tale in which both the environment and the economy benefit in lockstep.

Incidentally, the situation that the Wall Street Journal is writing up is story #1: economic downturn causes temporary dip in emissions. It’s a boring story — which is no excuse for getting it wrong.

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adam

Comments Disabled

  1. ids - October 28, 2008

    Adam,
    The WSJ point is that dirty coal is profiting and surviving, and it has to be stopped cold because market mechanisms do not work! Absent command and control, there’s gaming and dirty coal will benefit. There is no justice in dirty coal, you are missing the WSJ major point. Ultimately, to increase demand for green grid, there will have to be a tax on carbon, or a worldwide bombing raid on coal plants, because some people will never get it. Just because a tax squeezes offsets doesn’t mean it is wrong. Next you’ll be calling for more efficient dirty coal plants.

  2. Adam Stein - October 28, 2008

    Er…I started to respond to this, but I’m not sure what to say. This has nothing to do with gaming, or offsets, or coal. The price of carbon drops when electricity consumption drops. That’s all.

  3. ids - October 28, 2008

    “With more permits sloshing around Europe?s carbon market, other polluters like big utilities who have fewer permits than they need are likely to snap up cheaper permits instead of investing now to clean up their operations.”
    That is the crux of the wsj piece which you ignore. Dirty coal surviving, putting future sustainable expansion at risk. Anyway, if the system works best during a downturn, it is not a sustainable system at all.
    But yea, I see what you’re saying about not being about offsets, tho in my mind cap and trade and offsets go hand in hand, along with the dirty elite gaming the system with their political connections, something the wsj piece does not touch on, either. None of which is to mean, btw, I don’t agree with your “critique” of a cap too low.

  4. Adam Stein - October 28, 2008

    I’m not ignoring that. I’m pointing out that the WSJ is wrong. Those permits are “sloshing” because they’re not needed, because polluters are polluting less. It’s a good thing, not a bad thing.

  5. Marcia - October 29, 2008

    Comment on “Story # 3″…”reductions can be had for free via efficiency improvements.” Since when are efficiency improvements free? Installing more efficient light bulbs costs money, installing higher efficiency appliances, water heaters, and furnaces costs money, installing more or better home insulation costs money. Granted these are all desirable and attractive options for all concerned, but care must be taken in labeling them as “free” reductions in emissions.

  6. Ken - October 29, 2008

    Thanks for this post, let’s see more like it if confusion persists about price vs. actual emissions reductions/cap levels. This seems like better news than when the EU or RGGI in the NE US overallocated permits, resulting in depressed prices. This also demonstrates why cap and trade (which sets a cap, ideally at levels safe for the atmosphere and humanity) is a better policy instrument than a carbon tax (which sets a price, and hopes we get the emissions “right” at that price).

  7. Tony Welsh - October 29, 2008

    I think when some efficiency improvement is called “free” we mean that the improvement is worthwhile on purely economic grounds even without a carbon price. i.e. the discounted savings outweigh the calital cost.
    btw, there is a case to be made for a carbon tax against a cap and trade system, even though the latter is theoretically more appealing. A carbon tax is not subject to market fluctuations like a carbon market, which for example could plummet in response to a recession, so that companies have more certainty about the financial benefit of new capital expenditure to reduce emissions. Also, it does not motivate companies to waste resources on econometric models to predict prices!

  8. Chad - October 29, 2008

    Theoretically, a cap and a tax work out the same. The optimal cap and the optimal tax are equally difficult to calculate (indeed, it is the same cost-benefit calculation), so that is not an issue.
    There are practical reasons that the tax works better. The most important is that because prices fluctuate far faster than emissions can fluctuate, fixing prices rather than emissions is helpful to markets, as it reduces uncertainty. Fixing a tax according to a schedule, with occasional modifications based upon the actual course of emissions, helps businesses plan investments. Caps, on the other hand, result in wildly swinging permit prices, making planning difficult.

  9. Anonymous - October 29, 2008

    “Permits are cheaper because companies are cutting emissions”
    Companies, not including dirty coal, whose finding it cheaper than thought, and able to delay greening the grid.
    “the cap is the policy goal”
    At this time, the cap is a joke, so spurring a green grid should be the policy goal, and the thrust of the wsj piece is the cap and trade is failing the green grid.
    “This is just what everyone had in mind for cap-and-trade”
    WSJ is referring to dirty coal dominating the grid. I know of “enviros” where dirty coal is their goal, and have seen SC praise it, tho not generally is dirty coal a favorite of enviros.
    “for the system to spur change”
    I think you have it backwards. The downward spiral is driving down emissions, it is not that green energy is cheaper or coming to fruition. Anyway, maybe it all will work out for the best.

  10. Tom Harrison - November 4, 2008

    I am not surprised at several comments here; the relationship between mechanism and effect of cap and trade is very poorly understood, as are many aspects of market economics.
    A lot of that misunderstanding is because it has not been clearly explained (or has been summarized badly, as in the WSJ article). It’s also just not that intuitive since it’s so indirect.
    After reading the post, then some of the comments so far, it seems that, for the most part, people are arguing Adam’s point with different words. As long as cap and trade results in lower CO2 emissions, it’s working.
    I think it’s worth pointing out that many of the mechanics of cap and trade are effectively the same as a carbon tax. One major difference is that cap and trade has a built-in, pre-determined, predictable, steady “tax increase” via lowering of the cap. Taxes don’t automatically adjust. Any refinement of a straight tax is likely to converge on being something like cap and trade.
    Taxes, simple carbon caps, legislated mandates and other less nuanced solutions may feel better to those of us who are seriously concerned that we’re not doing enough to solve global warming. But cap and trade is the best method for achieving the objective quickly, for political and financial reasons, as well as environmental.
    Cap and trade has several major political benefits:

    • It has been used before (for ozone) and worked better than many predicted
    • It is what most of the rest of the world are already using (effects will be muted until US and China sign on)
    • 10 US States have very recently begun the RGGI cap and trade program

    In short, we have a lot of experience seeing how to make this kind of thing work, and that dramatically reduces the risk and fear associated with new things.
    It’s not perfect, and it’s not immediate (and therefore not very gratifying), but cap and trade does cause the desired effect to occur, in a politically feasible way, over time — usually a shorter time than expected.
    And certainly in a shorter time than other measures that aren’t nearly as mature!
    Tom

  11. Eddisionklein - November 11, 2008

    Yes…Exactly.Now a days the coal industries cutting down emission because the economic slowdown is causing them to reduce output.This is because the uses of clean coal is very less when compared with the problems raised by it.

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