Prices vs. contracts: Why good CO2 policy needs complex financial markets
Economic theory is predicated on the thesis that if supply and demand are allowed to freely set the price for a given item, rational capital allocation (and a host of other social benefits) will follow. Much of public policy is predicated on the truth of that thsis. But there’s a problem with the thesis: price alone isn’t sufficient.
A market that provides nothing more than a spot price for a given commodity is only a market in name. To have a real market of the kind that brings about all the good things that economic theory describes, we need a much richer, more complex suite of transactions. In particular — and especially for capital-intensive industries — the length of a contract can be as or more important than the price. Tell me that widgets are selling for 15 cents each 10 minutes from now and the only decision I can make is whether to buy, sell or hold my stock of widgets. Tell me on the other hand that I can execute a 30 year contract for widgets at 10 cents each and I might just build a widget factory. Between those two extremes lies a tremendous amount of financial sophistication that policy makers too often fail to appreciate.
Of African food and california power markets
Perhaps the best evidence that price alone isn’t sufficient comes from places where that argument has spectacularly failed. In Roger Thurow and Scott Kilman’s excellent book “Enough,” they outline how the wholesale replacement of government subsidies with price-only markets led to the waves of mass starvation in Africa in the 1980s. Closer to home, the deregulation of California power markets begat the California power crisis. In both instances, the creation of a price signal was followed shortly thereafter by a shortage of supply. A spot price is a necessary precondition for a functioning market, but clearly it is not sufficient.
The common cause in Africa and California was the absence of liquid, sophisticated capital markets. The Chicago Board of Trade did not magically appear, fully formed the first day a Wisconsin wheat farmer pulled his barge down Lake Michigan. Similarly, when African farmers suddenly had to sell grain at a market rate come harvest time, they didn’t have the benefit of futures contracts, swaps and puts to hedge their risk. Rather, they had a commodity to sell at the same time that all their competitors had the same commodity to sell. Supply shot up, price collapsed and the next season the farmers responded (perfectly rationally) by growing less food. In California, generators realized that they earned a lot more for their power on hot days, to the extent that it was in their economic interest to hoard fuel and withhold power supplies in advance of a heat wave.
In both cases, the presence of a price signal led to “economically-rational” behavior, and yet that behavior ran exactly contrary to the social benefits that economically-informed policy makers predicted. The common cause was the immaturity of capital markets, which were not deep enough to get beyond the immediate short term buy/sell decision. In a more sophisticated market, Africans have granaries, silos, and futures contracts, and Californians have short-sellers and other financial arbitrageurs to limit the market power of a small number of generators. But that sophistication does not come overnight.
Lessons for the U.S. power market
When U.S. power markets deregulated in the late 1990s, there was a temporary construction boom in natural gas power plants by a number of companies who grossly misjudged the pace of further deregulation. Most of those companies ended up in bankruptcy. Since then, virtually no new power assets have been built in response to wholesale electricity market signals — for the simple reason that wholesale markets haven’t provided a power price or contract tenure sufficient to attract capital.
Some say we shouldn’t doubt market omniscience, and that the failure to build new power plants proves that we don’t need them. The problem with that argument is that we have seen new generation built during that period external to deregulated markets. Regulated utilities have continued to make investments subject to utility commission approval. That approval effectively provides (very) long-dated contract for any power they produce at prices that are guaranteed to be high enough to recover all operating costs and capital. There has been a concurrent boom in wind turbine construction, driven by a combination of wind-specific tax subsidies and wind-specific RPS contracts, both of which combine to provide long-dated contracts for power, provided that it comes from wind. In both cases, these assets are procuring long-term contracts at prices that are well above clearing prices in wholesale power markets, distorting markets even as they are bypassed.
Again, Africa offers a parallel. U.S. food aid has depressed prices in African food markets, slowing the maturation of the very markets that are required to make Africa self-sufficient, and increasing the continent’s dependence on further food aid. The deployment of extra-market generation in U.S. power markets is comparably slowing the maturation of U.S. power markets, making it ever harder to break free of our antiquated, top-down regulatory paradigm.
Lessons for CO2 markets
So is market efficiency predicated on a 20-year wait for sophisticated markets? Not necessarily — and Kyoto-compliant CO2 markets are a noteworthy exception. They are about as old as U.S. electric markets, but are vastly more sophisticated. I can lock in a 15 year strip for CO2 sales in a CDM-compliant country today that gives me price certainty, and even gives me a buyer who is willing to take the post-2012 regulatory risk after Kyoto expires. On just about all relevant measures, these markets are deeper, more robust and more sophisticated than U.S. electric markets. How come?
My guess is that it has something to do with the fact that these markets were created from whole cloth. There is no equivalent to the commission-sanctioned power plant in Kyoto that gets built outside of the market but affects prices within the market. Regulated parties have to meet in a single market and that single market became the magnet for capital. While far from perfect, good things have largely followed.
Meanwhile in the U.S., we are in the midst of a large and understandable backlash against complex financial markets. Without question, there is a need for greater regulation and oversight of financial instruments. However, we cross a line when we ban their use — and we should be very careful about efforts mooted to do so in current CO2 policy proposals. That ban makes for a good populist sound-bite, but only amongst those who don’t understand what those “complex financial instruments” do. If we want people to invest in capital to reduce CO2, we need to give them a way to enter into long-dated contracts for CO2 reduction at firm prices. A spot market for CO2 doesn’t provide that financial product — but a vibrant participation in that market by financially-sophisticated players will. That means hedges, swaps, collars, puts, and — dare I say it? — derivatives. Some financial institutions will make a lot of money on those transactions and others will lose. Such is the nature of a functioning financial market that prices and allocates risk through the system. And while we absolutely need a regulator to ensure that those booms and busts don’t put the functioning of the market at risk, we cannot forget that the purpose of a CO2 market is, first and foremost, to reduce CO2 emissions. That in turn will require capital investments and the long-dated contracts necessary to bring that investment forward. Price alone won’t cut it.