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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adam

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  1. Dan - July 17, 2007

    A safety valve is totally inconsistent with the premise of cap-and-trade programs that the cap provides assured reductions of carbon dioxide emissions. One the safety-valve price level is reached, the cap is breached. Curious, since cap-and-trade proponents argue that a cap provides certain carbon dioxide reductions with an uncertain price, while a carbon tax provides a certain price without certain reductions. The problem is that many cap-and-trade proponents accept the need for a safety valve in order to avoid the price volatility that is inevitable since the price of carbon allowances will fluctuate as weather and economic factors affect the demand for energy.

    Cap-and-trade proponents have to choose between assured carbon dioxide reductions or an assurance through the safety valve that volatile prices won\’t cause serious harm to the economy. They can\’t have both. The hybrid isn\’t an answer; it undercuts the purpose of cap-and-trade, ends up relying upon an effective carbon tax, but unnecessarily foists all the costs of cap-and-trade on the public.

    Why not just rely on a carbon tax? With carbon taxes ramped up through a multi-year phase-in, future energy and power prices can be predicted with a reasonable degree of confidence well ahead of time. This will make it possible for literally millions of energy-critical decisions — from the design of new electricity generating plants to the purchase of the family car to the materials used in commercial airframes — to be made in full recognition of carbon-appropriate price signals. If necessary, the carbon tax can be adjusted as necessary to increase or decrease carbon dioxide reductions. For more on the relative merits of cap-and-trade and carbon taxes, take a look at the Carbon Tax Center\’s issue paper on the subject at http://www.carbontax.org.

  2. Adam Stein - July 17, 2007

    Well, we pretty much agree on the merit of a safety valve. I don’t particularly share your belief that cap-and-trade proponents need to make up their minds on this one, though. Is anyone in the policy community really conflicted over this issue? Politicians like safety valves for reasons of political expediency. It’s not pretty, but it’s not necessarily evidence of sloppy thinking.
    Speaking of political expediency, I find the notion that we can simply adjust a carbon tax up or down as needed to be pretty dubious. Can we really trust politicians to responsibly manage a tax scheme to achieve the optimum environmental outcome? This seems about as probable as a well-managed safety valve.
    Unfortunately, in the real world, both cap-and-trade and carbon tax proposals are going to get pretty well mangled before becoming law. We’ll have to take what we can get and hope that the big picture looks good.

  3. Greg - July 18, 2007

    I don’t think dismissing the value of a safety valve out of hand is a good idea. There are many merits to having a safety valve. However, I agree with you that a safety valve so low is going to be ineffective – a veritable carbon tax.
    Imagine a system where politicians actually create a cap and trade scheme where the cap is close to the perceived optimal level of emissions (I’m not holding my breath that they’ll try to do this, but let’s pretend). Since these things are hard to judge, it wouldn’t be unreasonable to think that we could be wrong and we should guard against unintended consequences – such as huge spikes in the price of permits. Thus, setting a safety valve above the expected price of permits would make some sense – we could still have a cap when we can afford it and when it becomes unaffordable, we simply switch to a guaranteed price ceiling on permits. Just look at the SO2 market… prices have spiked by huge amounts, sending shockwaves through the system.
    Safety valves make a lot of sense – but not if we set them lower than the expected price of permits or so much lower than the perceived marginal social damages. It is possible to get the best of both worlds though – a cap and trade system guards against steep environmental damage while a Pigouvian tax guards against steep economic costs. By setting a safety valve sufficiently high enough – we can guard against both.

  4. Rob - July 21, 2007

    Quoth NYT: “The money from the permits would be widely spread to … compensate farmers for higher fuel costs and help low-income families pay their heating and gasoline bills.” That sounds worryingly like they might refund farmers amounts proportional to their energy costs, which would undermine any incentive to improve efficiency. I guess if you provided refunds based on crop-area-grown or normalized for some kind of “efficient” amount of energy the incentive might stay, but since they’re all getting credits to sell in the first place this seems really dubious.
    Also, the fact that it sounds like the bill doesn’t cover gasoline etc. at all (except emissions produced during extraction and refinement) seems pretty lame.
    -Rob

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