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Corn+Soybean Digest

Cap and Trade: Consider the Risks

Whether writing for the Wall Street Journalor testifying before congressional committees, Louisiana State University (LSU) Economist Joseph Mason isn’t shy with his views regarding climate legislation.

In a recent study, Mason suggested a carbon tax should be considered alongside cap and trade. He also warned that a cap and trade system would be incredibly complex and could saddle the U.S. economy with unforeseen consequences.

To see the full study, visit The Economic Policy Risks of Cap and Trade Markets for Carbon Emissions.

Among other titles he holds, Mason is Hermann Moyse Jr./Louisiana Bankers Association endowed professor of banking at LSU. In late September, he spoke with Delta Farm Press about the EU’s experience with cap and trade, misconceptions about market oversight and why a carbon tax should be a part of the congressional debate. Among his comments:

To reset for our readers, could you talk about differences between cap and trade and the carbon tax and how both would theoretically serve to ameliorate climate change?

“The tradeoff between cap and trade and a carbon tax is between ‘benefit certainty’ and ‘cost certainty.’

“With cap and trade, you decide how much less carbon you want emitted and you allow the market, the price, to reduce the emissions. Therefore, you know there will be X amount of tons reduced – but you must let go of the price in order to achieve the X amount of reduction. That would produce ‘benefit certainty’ with price uncertainty.

“Of course, having let go of the price under cap and trade, you don’t know what the price will be to get rid of that X amount of tons. But you’re implicitly valuing that you want X amount of tons gone.

“With a carbon tax, you trade off that ‘benefit certainty’ for a price certainty. With a tax, you’d place a stable price upon the emission of carbon. You don’t know to what extent firms will reduce their emissions given that price signal. But you’d have price stability, price ‘certainty.’”

If those espousing that climate change will be dramatic in coming decades are correct, it would seem the carbon tax would be the easier way to go simply because you could manipulate the price to (achieve emissions goals). You could raise the tax to lower energy usage. If the environment is in such dire straits would it not make sense that environmentalists would want that?

“I think environmentalists do desire action in a workable framework. That’s why some are now rejecting cap and trade. Remember, cap and trade is focused on getting rid of a specific amount, X, of carbon emissions. If we don’t know exactly what X is, then setting a specific amount that is wrong is just like setting a tax at the wrong value.”

Can you talk about the EU’s experience with cap and trade and how it might translate in the United States?

“The trends I see stacking up in Europe seem to be forming a narrative suggesting the EU went backwards. They initiated cap and trade before a carbon tax.”

Since Mason wrote a piece on cap and trade for the Wall Street Journal in August, “France has made moves towards implementing a carbon tax in order to put a sort of base price on carbon no matter what price cap and trade markets may evolve to – and in the case of Europe, that’s essentially zero. France has moved to provide some benefit – even if that benefit is uncertain – on the basis of a minimum existing price.

“As the U.S. develops a carbon policy, it may make sense to, as you suggested earlier, implement some sort of tax. That wouldn’t necessarily be an attempt to price the entire cost of carbon emissions. However, it would put some price on carbon price on carbon emissions above zero. Then, we’d work out the kinks with cap and trade in the longer term later on.”

I understand there have been some things put in the Kerry/Boxer bill (for more, see Senate climate bill: ag unimpressed) to keep a potential carbon market from being manipulated. Do you see anything like that working?

“There are two things to say here.

“When you try to prevent the cap and trade market from working – which is what these provisions do – you no longer get the benefit certainty that’s the hallmark of cap and trade. Markets provide very harsh incentives whether for ill-designed contracts or mispriced goods. And those harsh incentives are what we’re relying upon to give us the benefit certainty of a reduction of X amount of carbon.

“Some of what you see evolving in the (congressional) bills to try and staunch arbitrage plays or other types of what the Hill likes to call ‘market manipulation’ is, to me, a realization that a lot of the cap and trade policy ideas that have shown up are holdovers from how we viewed the central banking 10 years ago – for instance, under Alan Greenspan, who was a great central banker. But we now know he made it look way easier than it really is.

“Engineering and managing a market, whether for central bank reserves or carbon permits, is a tremendously complex task. But 10 years ago, Greenspan made it look simple, like ‘gee, pull this lever and the market reacts. We can just construct this carbon market and it’ll work.’

“Success isn’t a foregone conclusion when you have (numerous) traders critically reading your bill on the details of the market design that are ready to profit off any loopholes or incentive features. The fact of the matter is it’s very difficult to design such markets.

“If we didn’t have to have the central bank operating this market for bank reserves in order to stabilize the value of the U.S. dollar and how that relates to U.S. economic growth, we wouldn’t walk into doing it willingly, today. (Even though) that’s exactly what we’re doing under cap and trade.”

Common misperceptions on this?

“A big one is what I just described: overconfidence in the ability to manage financial markets.

“But the biggest misperception involves the bills, as they mount, keep moving toward using the central banking feature to stabilize the price of carbon. Whether you express this in theoretic economic terms, or in plain common sense, once you stabilize the price of carbon using institutional design and convoluted contracts, you get the same effect as a carbon tax.

“Why not just take the stabilization target price and make that price the tax? Why bother to use the carbon offsets, the institutional framework, the government agencies, the laws, the convoluted market design and the rest?”

So, why not? You mention there are some environmentalists now coming to the carbon tax side. Why didn’t they start there in the first place? Was that mistake from the get-go or was it by design because they know the carbon tax won’t be passed?

“I think it was a mistake made at the beginning when thinking about carbon policy. I think it’s a mistake from which the Greens are gradually retreating, but which Capitol Hill remains wedded to.

“The mistake has to do with the application of cap and trade from an economic perspective. A few months ago, the Wall Street Journal ran a piece quoting the economist who came up with the initial theory of cap and trade. He said, ‘Don’t do it.’ The reason he said that is it comes down not just to the convoluted marketing but the fundamentals.

“The economics of cap and trade – and I said this before the Senate Energy Committee a couple of weeks ago – works for an externality that’s easily identified and quantified. It relies on an ability to say ‘I want 100 million tons of carbon dioxide reduced. And I can identify exactly where those are.’

“If you can do that, you can set the value to be purchased. A price can then evolve.

“Now, in sulfur dioxide emissions, that works pretty well. We know where those emissions are: primarily power generation plants. We can measure the emissions and cut them back. And the effects are relatively local.

“With carbon, the problem is too broad, too big, for a rational application of cap and trade. Everyone is using carbon. Well, if everyone has to look to these carbon contracts then it will open the market to the biggest market test of the contract design.

“Moreover, we learned with sulfur dioxide that if Congress or other policymaking bodies are involved in manipulating the market it can cause tremendously disruptive policy shocks that will have potentially debilitating effects on the price of the externality you’re putting out to market. That happened with a sulfur dioxide court challenge on whether policy could withstand a legal test. Contract prices went wild during that period and almost killed the market notwithstanding the court decision, which supported the market. That’s a window into the effects that policy shocks can have on such markets.

“Having learned these lessons, I think the Greens have rationally retreated from promoting this institutional-designed carbon market. Like I said, France has moved away from relying solely on cap and trade.

“As we speak, I think we are seeing a sea change in thinking on carbon. It’s ill-advised for Congress to ignore that.”

Chances for climate change legislation to pass Congress this year?

“I get the impression nothing will pass this year. Depending on how the Obama administration handles its other big policy problems – healthcare and the financial crisis – we may see something bubble up on climate legislation next year.

“But it seems to me that as time goes on and the debate becomes more complex, the policy risks being lost. And that, perhaps, could be the case for many years hence.

“When we constructed the U.S. Federal Reserve System, Congress undertook an investigation through the National Monetary Commission. That was to study in-depth the applications of central banks around the world. That took a bit over seven years and is still the best study of central bank design features ever performed.

“Before this climate legislation is finished, I could see a similar delay – five, seven, maybe 10 years – before cap and trade passes out of Congress.

“I certainly hope we’ll see some kind of even minor tax placed on carbon in the meantime. I think there are very real concerns about carbon emissions. Whether or not you’re a doom-and-gloomer, I think restrained carbon emissions are good for the environment, for the economy and promote efficient production. There’s nothing wrong with nudging incentives, as a carbon tax could as early as next year.”

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