Price Floor for Carbon

Michael Grubb of Carbon Trust and a member of the UK Committee talks about the price floors built into the EU carbon markets through the use of auctions with a minimum set price. However, since the EU Emissions Trading System (ETS) allows trading of validated credits from the developing world through Kyoto's Clean Development Mechanism (CDM), and the overall demand for carbon has dropped substantially, the floor may not have the intended effect. In order for the price floor to be effective, the supply of the CDM credits should also be substantially reduced. This does not seem to be an appropriate time for reduction of CDM credits, as the these credits could potentially help the developing world mitigate the negative impact of the global financial crisis.

Carbon Tax vs. Cap and Trade

The carbon tax center, not surprisingly, is in favor of a carbon tax, rather than cap and trade. The cap-and-trade proposals are being discussed in Australia currently, and the mood is clearly against cap-and-trade as well. Even Tom Friedman seems to be against cap-and trade, though for different reasons. However, as MicroEconomics 101 tells us, you go for limits if you are (a) clear as to what the limit should be rather than the price (b) The limit is enforceable. I think both of these factors point to a well-designed cap-and-trade scheme rather than a carbon tax.

An additional factor that has not got much attention is the fact that, in the presence of offsets, (assuming they are allowed after Copenhagen), one could see the emergence of a global carbon price. If the offsets are cheaper than carbon permits in the domestic market, then the demand for carbon offsets would rise, increasing their price, and achieving an equilibrium with the different carbon markets around the world. This could lead to a lower cost of compliance, although this lower cost of compliance will likely benefit the producers rather than the consumers). I haven't seen an analysis of this effect, so I will be scouring the literature to see the effects.

Over the counter vs. Exchange Traded

It appears that the bankers would like carbon trading to be over the counter in addition to being exchange traded. Over-the-counter refers to the trading done through market makers where the buyer and seller are trading directly without an intermediary such as an exchange. The argument is as follows:

"Granville Martin, vice-president for environmental affairs at JP Morgan, said access to OTC contracts was critical for bank financing. “You can’t scale up carbon finance without OTC markets,” he said.

For example, a utility wanting to build a power plant would only get a loan if it could hedge its long-term carbon and fuel risks. In many cases, he said, an appropriate contract is not available and, moreover, the utility would have to tie up a huge chunk of capital with the exchange as collateral.

For such contracts, investment banks would often be the only counterparty, and they could manage the risk by, for instance, taking a second lien in the power plant rather than upfront cash.

Forcing such trades through exchanges would add a significant hurdle to low-carbon development, and would be pointless if the reason was just to ensure transparency, Martin said.

“If the concern is ‘dark corners’ you can come up with solutions. You can have disclosure and preserve OTC,” he said."

I agree that financial innovation is likely to foster the rapid growth of the carbon markets. Unfortunately, the rapid growth of CDS and CDOs, and the pain they brought, as well as the financial innovations of Enron are too fresh in memory to believe that the different players will opt for transparency and full-disclosure. Setting up appropriate regulatory structure is going to be critical in determining not only the growth of the carbon finance industry, but also its ability to withstand systemic shocks.

The Problem with multiple goals

Greenpeace is apparently against inclusion of forest conservation in a market-based mechanism for reducing greenhouse gases (GHGs) on the grounds that industry will continue spewing carbon offset by avoided deforestation carbon credits. I think that if your goal is to reduce overall carbon emitted, you should actually be pleased that industry can find a source that is both cheap and helps preserve the natural habitat. Greenpeace is caught between its twin goals of reducing overall carbon emissions *and* reducing industrial emissions in particular, and it is clear that the two goals are not always aligned.

Becker, Murphy and Topel on economics of climate change

Becker, Murphy and Topel have an interesting take on the economics of climate change. They state here that "the expected benefit from climate change policies is actually more sensitive to a very small probability that global warming results in a catastrophe than to a change in the discount rate". They appear to be in favor of limited action through small broad-based carbon tax that could be ramped up over time.

However, if there is a very small probability of a catastrophic event (essentially tail risk) and if global warming has some positive feedback (in the non-judgemental engineering sense of the word), then there is no way to know this probability*the expected loss, and therefore, the expected value calculations could be off significantly. If the recent financial crisis has highlighted one thing, it is that people are terrible at tail risk assessment. Given that people are unable to appropriately assess tail risk, it seems to me that Pascal's wager arguments would suggest that we should be more actively pursuing climate change mitigation. Taleb makes a similar point here.

Welcome Post

I am interested in learning about the economics and finance of carbon trading. I expect this area is going to attract significant attention in the near future, given the interest in Congress to pass climate change legislation, as well as the Copenhagen conference later this year to discuss the successor to the Kyoto Protocol. Stay tuned for future posts on this topic.