The new Waxman-Markey bill gives away 80% of permits for the first five years. Because I’m confident others will write about climate justice issues in this bill, I thought I’d discuss how giving away large numbers of permits weakens cap-and-trade effectiveness.

Cap-and-trade, to the extent that it works, drives behavior through price.  Polluters decide on whether to make capital investments to reduce greenhouse gas pollution based on what they expect the price of permits to be in the future.  And given the short term horizon used by most managers, and required by stock markets, such decision makers are eager to project future prices as low, so they can invest in their core business rather than pollution control.  As a result volatility (that is prices that tend to fluctuate) and especially extreme dips in permit prices lead to underinvestment in emission reductions.  The RECLAIM failure in Southern California is one example of how low prices and volatility can undermine a cap-and-trade system. The ETS actually increased emissions from 2005 through 2007.  This happened in a period when total EU emissions were falling.  (Traded emissions under ETS did fall in 2008. But this was in the face of the beginng of a depression. The total drop was much less than for the EU as a whole.) Cap-and-trade on a large scale tends towards volatility.

Unfortunately, Waxman-Markey gives away permits to utilities and other entities who would otherwise be steady customers. It removes a steady demand from the artificial carbon market it creates, and the removal of equal supply does not eliminate the destabilizing effect. An example follows:

Example: issue permits for six years – 3% below a baseline, dropping by 3% per year. In the first case we imagine them being 100% auctioned. But we break them down into permits that will be kept in the second example. No price is predicted, but instead a ratio of demand in the absence of such a price is given. Thus we can see a ratio of demand to supply, which in turn predicts whether the price of permits must rise or fall in order to bring demand into line with supply. Note that because we are in recession, this example assumes demand falls a few years before rising.    

 

Permits

(as % of baseline

emissions)

% of baseline giving away 80% of permits removes from market. (note this is very conservative.)

Rest of permit demand as percent of baseline.

Total demand as percent of baseline.

Ratio of demand to supply. Indication of direction and degree prices must move to bring demand into line with supply. (Note: elasticity is not considered here – because this numbers still indicative whether elasticity is high or low.)

97.00

25.00

75.00

100.00

1.03

94.09

25.00

66.00

91.00

0.97

91.27

25.00

54.00

79.00

0.87

88.53

25.00

76.00

101.00

1.14

85.87

25.00

77.00

102.00

1.19

83.30

25.00

77.50

102.50

1.23

 

The second table is the same baseline as the first but with 25% of demand supplied by permits that are given away and not resold. That is I’m making an assumption that would result in a comparatively small effect on volatility – that more than 2/3rds of permits given away are then sold, and that less the 1/3rd are kept. If a higher percent of permits given away are used by those to whom they are issued then the effect on volatility is worse.

 

Permits issued (as a % of baseline) less  25% given away and used rather than sold.

Market demand for permits

Ratio of market demand to supply.

72.00

75

1.04

69.09

66

0.96

66.27

54

0.81

63.53

76

1.20

60.87

77

1.26

58.30

77.5

1.33

 

The spread between ratios is greater in the 2nd than in the first case. The smallest ratio is also lower in the second case than the first.  In short even if only a comparatively small percent of permits given away displace steady demand, volatility is increased, and price dips due to volatility are more extreme.  Specifically, permit price crashes in response to temporary demand drops for permits are exacerbated.