In solving the climate crisis we need to avoid creating the type of large secondary emissions trading market Kyoto did. Large secondary emission markets constitute a whole new sector with strong incentives that conflict with a really large drop in emissions. Maybe carbon traders are so noble and dedicated to saving the planet that financial self-interest won’t influence them. But, if your view of human nature is that incentives matter, then a strong secondary market creates a group of people with the wrong ones. If incentives matter, then a secondary carbon market runs a real risk of becoming the new sub-prime.

For example, it has been noted that the European Emission Trading Scheme and other emission markets tend to be subject to high volatility, something that undercuts long term success. Large price variations for emissions permits discourage long term investment in savings, because it is hard to predict the value of the savings. Volatility can also lead to crashes, where emission prices temporarily drop near zero, which further reduces investment in reductions. The problem is traders tend to profit in the short term from volatility, because prices that vary encourage a larger number of transactions; more transactions produce more profit. While there are regulatory approaches that can discourage such volatility, such as high mandatory minimum emissions prices, financial industries in general tend to resist this type of regulation.

Within finance, the short-term profits the regulations would cost are sharply felt as real. The long-term dangers are dismissed as airy theories, or perhaps dismissed as problems the industry is confident it can handle without government aid. And then the theories turn out not be so airy, and the masters of the universe accepts trillion dollar bailouts. But perhaps the emissions trading industry is too altruistic and noble to act like typical financial institutions, and will support stringent regulation to reduce volatility.

Another problem is that traders will gain from as slow and small an emission phase out as possible. Up to a point profit from rising permit prices can make up for a drop in the number of permits. But if a carbon permit system is part of a process that successfully lowers total emissions, eventually the number of permits will fall faster than the price rises. At some point in a successful process, less-expensive, low-emission alternatives are found, and demand for permits drops. Depending on degree of success this may simply result in prices rising more slowly than the available number of permits drops, or in an actual drop in the price per permit. In either case, significant success will lead to the total dollar value of all permits combined dropping rather than rising. We might speculate that this incentive to keep the volume of permits as high as possible could lead traders to take advantage of loopholes that essentially create new counterfeit permits for them to sell. The bottom line is that once you develop a strong secondary market in permits, any system where there is a lot of reselling of permits after they are bought, you open the door to manipulation that contradicts the goal of actually lowering greenhouse pollution.

Note that this is not a problem with putting a price on greenhouse gas pollution. It is not even a problem with auctioning permits. It is specifically a problem with having a large secondary market in permits where they are sold, resold, and resold again. And potential problems are not limited to volatility and offsets (which are essentially legal counterfeit permits). Let me quote from Liz Bossley’s and Andy Kerr’s book, Climate Change and Emissions Trading: What every business needs to know:

According to the development model for the evolution of commodity markets described in Section Two, the next logical step in the development of the emissions market should be the emergence of a derivative market for swaps and options in emissions allowances. For the reasons described below it is very likely that the emissions market will see an options market develop, but that a market for swaps is more problematic.

In short, unless brought short, any carbon pricing system with a strong secondary market is likely to develop the full wilderness of mirrors that damaged our current broader system. So how do we stop this?

We could try to do without price as means of solving the climate crisis, relying entirely on public investment and standard-based regulation. Public investment and new efficiency standards are actually more critical at the moment than putting a price on emissions. The show stopper is that we will never reduce industrial emissions sufficiently without a priced-based mechanism. Industry is too diverse to allow the design of a “command & control” approach that can cover most emissions without major perverse side effects.

We could rely on a carbon tax. This is gives us a carbon price without any need for trading. Implicitly it provides cap without trade. And if we can get it, that is a good alternative.

James Boyce (of “cap-and-dividend” fame) suggests that in an auctioned permit system we still could have cap without the trade. His suggestion is that, just as we don’t have a secondary market in business licenses, in a 100 percent-auctioned permit system all permits could be bought directly from the government. One problem with this is that since permits are bought in advance permit buyers have to guess how many permits they will need. Many buyers will end up with either more or fewer permits than they need. But the basic idea is right. What needs to be done is limit the amount of reselling that goes on. Give each permit a unique number and limit the total number of times it can resold. Or put a quarter of a percent tax on each resale. No doubt there are other possibilities.

Similarly we need to limit things like options by applying the same sort of limitation to any derivative from emissions permits. And we need to limit leverage by regulating total volume of financial instruments as a ratio of actual outstanding (unused, unexpired) permits. And of course we need to limit the need for this kind of instrument by putting high minimum prices on permits similar to what the charge would be in a carbon tax, thus limiting volatility, and reducing legitimate hedging needs.

Note that this illustrates a weakness in the politics of cap-and-auction. The natural tendency in any system where financial instruments are auctioned, sold for a variable price, is to develop a secondary market in them. To prevent this you need to add a lot features that look wonkish and marginal but are actually critical to avoid disaster. Getting the cap stringent enough is not all that is necessary; preventing a high volume of trading takes a lot of hard-to-explain features. A perfect cap-and-auction system will probably work better than a perfect carbon tax. But a plausibly imperfect cap-and-auction or cap-and-trade system can undercut other solutions to the climate crisis in a way that a plausibly imperfect carbon tax can’t. Yes, on a highly abstract level anything that can go wrong in one can go wrong in the other. But you have to add restraints to minimize volatility and strong secondary markets in cap-and-trade and cap-and-auction. Whereas to suffer the same problems with a carbon tax you would have modify that tax in such a way as to cause
them.