Back when I worked developing large software systems, every now and then we ran into a bug that management decided was too much trouble to fix — “It’s not a bug. It’s a feature!” This is the approach that Kevin Drum seems to be taking when it comes to volatility in cap-and-trade programs.

The short version of the volatility problem is that with a trading system, permit prices vary not only in response to how many permits are issued, but also in response to general economic conditions. As a result permit prices bounce up and down a lot. Kevin, like a number of cap-and-trade supporters argues that this volatility is a good thing, because permit prices drop during bad times when people don’t have money to invest, and they rise during times when they do. In short they argue that counter-cyclicality makes volatility positive rather than negative. But, just as in the software industry, I’m afraid it is still a bug, not a feature.

To the extent that emissions pricing accomplishes anything it drives investment in emission reducing infrastructure. But when emission prices drop too low, firms project long-term prices to be low as well. Managers get a lot more points for increasing or preserving market share than they do for managing environmental risks. Top bosses don’t want to hear that emissions costs are going to rise, and the company needs to invest in reductions to comply with a cap-and-trade system. They want to hear that they can concentrate on their core business and buy low-cost permits from all the other firms reducing emissions. There is always a sound business case to be made for the other guy to reduce his pollution.

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This is not a theoretical argument. Volatility leading to underinvestment is not only standard economic theory, but it is also supported by real world experience. Low prices in the RECLAIM district in Southern California led to exactly this result. The 2005-2007 E.U. ETS responded exactly this way. In fact, the over-issuing of permits was strong enough during this period to lead to a rise in emissions among facilities within the trading system while overall E.U. emissions were falling.

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In 2008, decreased economic activity due to recession, increased use of nuclear, hydro, and wind generation, and drops in natural gas prices may have finally led to a 3 percent drop in ETS emissions. ETS supporters claim that 40 percent of that drop was due to the trading system, though their analysis does not consider the drop in natural gas prices as one of the factors driving the reduction. Even taking ETS cheerleaders at their word, and attributing a 1.2 percent drop to the ETS, we will note that what their trading system did not drive — in any of the four years it ran — was large-scale capital investments among facilities subject to the system. That means no real preparations have been made among traded facilities that will let them comply if even moderately tight caps are ever agreed to.

Even though I’m a critic of cap-and-trade, today’s critique is a friendly one. I don’t think volatility has to be the deal-killer for trading systems. But for it not to be, cap-and-trade supporters need to move past the denial stage and tackle the problem. One common solution is banking, where speculators can buy cheap permits for use in the future. This does reduce volatility, but not enough to cushion a trading system from major external shocks, or even from major over-issuance of permits. The RECLAIM system allowed banking, which did not prevent collapse.

The only solution I know of that is likely to be effective is to make a permit system more like a carbon tax in one respect. Put a minimum price on it, something close to what you expect the cap to produce. That gives investors a minimum return on emissions reductions, and gives you a chance that some capital investment will go towards such reductions, even in bad times, which in turn helps produce the infrastructure for future reductions.

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