Environmental Economics

Editorializing Europe's carbon market

NY Times:

The European Union became a pioneer in tackling climate change by starting the first major cap-and-trade system designed to reduce carbon-dioxide emissions by putting a price on them. But analysts are increasingly worried that technical mistakes, Europe’s prolonged recession and the failure of policy makers to strengthen the system is undermining its effectiveness.

Like all such systems, Europe’s program caps the overall emissions that power plants, steel mills and other industries can put into atmosphere. The cap, which is regulated through permits, declines every year, forcing businesses to become more efficient or buy permits from another firm or on the open market.

Recently, the price of permits has collapsed to less than 4 euros (around $5.25) per ton of carbon, down from nearly 30 euros in 2008. This is troubling because the low price discourages emitters investing in climate-friendly technologies and fuels. ...

In addition to its trading scheme, Europe has made real progress in dealing with climate change through policies encouraging energy efficiency and renewable sources of power like wind and solar. But nothing would do more to drive down emissions than putting a meaningful price on them, either through a carbon tax or through a cap-and-trade system. Europe’s job is to put that system on a sounder footing to make sure it doesn’t undo the real progress it has made.

I like the way the editorial ends, with a carbon tax and cap-and-trade as substitutes with plusses and minuses. And actually, a quick review of the regulating prices vs. quantities literature suggests that hybrid approaches might be preferred (e.g., cap-and-trade with a trigger price). It is only the naive who think a carbon tax would magically avoid implementation problems. And note, permit auctions can generate government revenue. 

Negative space

Some economists might see this as a failure of cap and trade:

Europe’s carbon market, a pioneering effort to use markets to regulate greenhouse gases, is having a hard time staying upright. This year has been stomach-churning for the people who make their living in the arcane world of trading emissions permits. The most recent volatility comes on top of years of uncertainty during which prices have fluctuated from $40 to nearly zero for the right to emit one ton of carbon dioxide.

More important, though, than lost jobs and diminished payouts for traders and bankers, the penny ante price of carbon credits means the market is not doing its job: pushing polluters to reduce carbon emissions, which most climate scientists believe contribute to global warming. 

The market for these credits, officially called European Union Allowances, or E.U.A.’s, has been both unstable and under sharp downward pressure this year because of a huge oversupply and a stream of bad political and economic news. On April 16, for instance, after the European Parliament voted down the proposed reduction in the number of credits, prices dropped about 50 percent, to 2.63 euros from nearly 5, in 10 minutes. ...

Europe’s troubled experience with carbon trading has also discouraged efforts to establish large-scale carbon trading systems in other countries, including the United States, although California and a group of Northeastern states have set up smaller regional markets.

Traders do not mind big price swings in any market — in fact, they can make a lot of money if they play them right.

But over time, the declining prices for the credits have sapped the European market of value, legitimacy and liquidity — the ease with which the allowances can be traded — making it less attractive for financial professionals. ...

Until the end of 2012, these credits were given to companies free according to their estimated output of greenhouse gases. Policy makers wanted to jump-start the trading market and avoid higher costs for consumers.

Beginning this year, energy companies must buy an increasing proportion of their credits in national auctions. Industrial companies like steel plants will follow later this decade. ...

Over time the number of credits is meant to fall gradually, theoretically raising prices and cutting pollution.

The reality has been far different because of serious flaws in the design of the system. To win over companies and skeptical countries like Poland, which burn a lot of coal, far too many credits have been handed out.

At the same time, Europe’s debilitating economic slowdown has sharply curtailed industrial activity and reduced the Continent’s overall carbon emissions.

Steel making in Europe, for instance, has fallen about 30 percent since 2007, while new car registrations were at their lowest level last year since 1995.

Big investments in renewable energy sources like wind and solar also reduced carbon emissions, which have fallen about 10 percent in Europe since 2007.

As a result, there is a vast surplus of permits — about 800 million tons’ worth, according to Point Carbon. That has caused prices to plunge. ...

via www.nytimes.com

Me? It looks like government failure. Any market is going to have price fall to zero if the supply is handed out like candy at a parade. To prove my point ask yourself this: when was the last time I went to the candy store after a parade? Q.E.D.

A more useful response to the observations about Europe's carbon market is to consider what is wrong with it and how can it be fixed. Carbon taxes are prone to government failure too.

Veconlab gets (really) environmental

So, last weekend I'm looking for an experiment on Veconlab for my introductory environmental economics class to work on while I was at the CNREP conference last week. I like the emissions permit experiment that illustrates the equivalence of buying or gifting pollution permits. It is a bit hard to find (turns out it is called "production cost" ... I finally found it and will present the results in a week or so) and I stumble across the emissions permits experiment:

Bidders in these auctions acquire "permits," e.g. emissions allowances or other licenses. Bidding takes place in "rounds," with a cutoff price that is either clock driven or bid driven, and with prices that either increase or decrease (Dutch). Single-round sealed bid procedures and continuous-time formats are also available, with either uniform or "discriminatory" prices. The "shot clock" hybrid starts as an ascending price clock and ends with a single-round first-price "shootout" among those bidders that are still active in the auction when the number of permits requested reaches a target cutoff. Other setup options include asymmetries in costs and permit needs, the presence of permit banking, secondary "spot" markets, a chat room for collusive disucssions, free "grandfathered" permit allocations, and the amount of inforrmation that is revealed after each round of bidding.

... This program was used to design auctions for the Regional Greenhouse Gas Initiative (RGGI).

I'm thinking this would be great for my class! So I keep reading and try to figure out the rules. Bad idea as it is the most complicated Veconlab experiment that I've ever tried to understand. I'm like, dang, this is designed for an experimental economist, not a vanilla economist to use for their classes (like most of Veconlab). 

Then, last night the Easter bunny delivered my RePEc "New Economics Papers: Environmental Economics" email from Francisco S. Ramos that included this paper: 

Investigation of the Effects of Emission Market Design on the Market-Based Compliance Mechanism of the California Cap on Greenhouse Gas Emissions

Date:	2013-02-18
By:	Charles A. Holt (University of Virginia) William M. Shobe (University of Virginia)
URL:	http://d.repec.org/n?u=RePEc:vac:report:rpt13-01&r=env
The state of California has implemented an economy-wide program to regulate its greenhouse gas emissions. A significant share of the emission reductions will be obtained via a cap and trade program with a mix of auctioning and free allocation of allowances. This program has a number of novel design features including, among other things, a price containment reserve, a limit on ownership of allowances, and the forced consignment to auction of some of the share of freely allocated allowances. We use a series of laboratory experiments to test the influence of two of these design features on the performance of the emissions market. We test the effect of holding limits and of the new three-tier price containment sale mechanism. We find that tight holding limits used to prevent market dominance reduce liquidity and appear to harm market efficiency and price discovery. The price containment sale mechanism reduces price spikes during per
Keywords:	Emission markets; experiments; cap and trade; greenhouse gas emissions; market design

Now I get it (2+2), Charles Holt, of Veconlab, and Bill Shobe are designing these regional permit markets. I should have known this since I saw Shobe present a paper at the Appstate Experimental Economics conference awhile back. And here is a Holt/Shobe/RFF paper from 2007 describing the RGGI auctions. 

Anyway, I'm a fan of lab experiments (the research and using simple ones for teaching) but this is way beyond me. On the other hand having the RGGI experiment online seems like too much of an opportunity for me to pass up. Any suggestions? My first thought is to spend half the summer trying to understand it and then run it with my senior seminar class in the fall. 

Daily demand and supply: ethanol (i.e., theory of 17th best)

Don't be frightened when you get to the parts where it says "Congress set out to create" and "lawmakers assumed." This stuff happens all the time and we need to just get accustomed to it:

Nearly 10 percent of the nation’s ethanol plants have stopped production over the past year, in part because the drought that has ravaged much of the nation’s crops pushed commodity prices so high that ethanol has become too expensive to produce.

A dip in gasoline consumption has compounded the industry’s problem by reducing the demand for ethanol.

The situation has left the fate of dozens of ethanol plants hanging in the balance and has unsettled communities that once prospered from this biofuel. ...

Congress set out to create an ethanol industry that would produce enough to make up 10 percent of every gallon of gas pumped into a car, but the lawmakers assumed that demand for fuel would grow. Instead, it has shrunk to 8.7 million barrels a day from 9.7 million in 2007, said Larry Goldstein, an economist and a director of the Energy Policy Research Foundation. And with corporate average fuel economy rules now in place to double the number of miles that the average car gets per gallon by 2025, “you know we’re on a trend,” he added.

via www.nytimes.com

A single policy that would provide incentives for ethanol production AND increased fuel economy would be a carbon tax (or cap-and-trade).

An overview of potential climate policies

The beginning and end:

GREEN jobs have long had a whiff of exaggeration to them. The alternative-energy sector may ultimately employ millions of people. But raising the cost of the energy that households and businesses use every day — a necessary effect of helping the climate — is not exactly a recipe for an economic boom.

The stronger argument for a major government response to climate change is the more obvious argument: climate change. ...

The two sides in the climate debate have spent recent years offering dueling — and dubious — economic claims. Switching to more expensive, cleaner energy does not promise a free lunch of more prosperity and a healthier planet. But it also does not need to result in stagnation. A federal climate response brings a mix of costs and benefits, and the specific policies that Mr. Obama and Congress pursue will help determine the balance.

In the end, the strongest economic argument for an aggressive response to climate change is not the much trumpeted windfall of green jobs. It’s the fact that the economy won’t function very well in a world full of droughts, hurricanes and heat waves.

The middle of the article is a summary of the available climate policy options, and their relative efficiencies, over the next 4 (3? 2? 1?) years. 

Remember that day when we got all worried that they were going to raise the RGGI cap? And we drank all that beer and we went over to the McWeenie's place and turned over their trash cans?

Yeah, that was great. Well, it appears that the op-ed guys either (a) turned the tide with their well written piece or (b) overreacted to something harmless that they heard around town (psst, didja hear they're raising the RGGI cap?). It seems that the RGGI cap is going to be tightened:

Five years ago the RGGI states demonstrated leadership in addressing CO2 pollution and accelerating the region’s transition to a clean energy economy by conducting the first ever regional auction for CO2 allowances in the nation. The changes outlined in today’s Updated Model Rule and Program Review Recommendations Summary build upon RGGI’s success and strengthen the program moving forward.

Improvements include:

• A reduction of the 2014 regional CO2 budget, “RGGI cap”, from 165 million to 91 million tons – a reduction of 45 percent. The cap would decline 2.5 percent each year from 2015 to 2020. 

Standards over incentives in the inaugural address

Dang:

Mr. Obama’s path on global warming is a case study in his evolving sense of the limits of his power and his increased willingness to work around intense conservative opposition rather than seek compromise. After coming to office four years ago on a pledge to heal the planet and turn back the rise of the seas, he is proceeding cautiously this time, Democrats said, intent on making sure his approach is vetted politically, economically and technologically so as not to risk missing what many environmental advocates say could be the last best chance for years to address the problem.

The centerpiece will be action by the Environmental Protection Agency to clamp down further on emissions from coal-burning power plants under regulations still being drafted — and likely to draw legal challenges.

The administration plans to supplement that step by adopting new energy efficiency standards for home appliances and buildings, a seemingly small advance that can have a substantial impact by reducing demand for electricity. Those standards would echo the sharp increase in fuel economy that the administration required from automakers in the first term.

via www.nytimes.com

Demonizing cap and trade

In case you missed it (it was in the 12/25 NYTimes):

In recent months, as the start date of the new cap-and-trade program neared, California regulators have fine-tuned the rules, industry by industry, to avoid imposing severe economic hardship while trying to keep the rules stringent. It is a delicate balance. Regulators do not want California companies to lose their competitive edge, because that could make other state governments reluctant to adopt this approach.

Cement plants near Los Angeles compete with plants across the Arizona border. State tomato processors control more than 95 percent of the American market, but they fear that the fast-growing Chinese sector could make inroads.

Officials in affected industries acknowledge they are struggling with how to proceed. As Meredith Fowlie, an economist at the University of California, Berkeley, explained, “Their calculations have to be that we either sit here and emit and pay the cost of doing so, or alternatively we can look at options” like paying for major capital improvements to reduce emissions.

The state’s Air Resources Board is using an array of policies to reach its intended goal of reducing emissions to 1990 levels by 2020. It has tried to structure the cap-and-trade program to encourage industry investment in energy efficiency that could cut costs as well as lower emissions. Investing in energy efficiency may make sense for companies under California’s rules, Dr. Fowlie said, “but if they are making them before their competitors, that could be fatal.”

The rules are relatively simple for producers like Morning Star. At the end of 2014, they must present state-issued allowances — one per metric ton of emissions — for the greenhouse gases they emitted in 2013.

For the 200,000 metric tons of carbon dioxide emitted annually by Morning Star’s three plants, the company is being awarded about 192,500 free allowances the first year; the company must buy the remainder on the open market. In the first allowance auction in November, the allowance price settled at $10.09 a ton, meaning in the first year Morning Star has to pay roughly $75,000 to cover its emissions.

But over the next five years, the number of free allowances will decrease sharply to encourage further emissions cuts. At current rates, that means Morning Star will have to buy 100,000 allowances for both 2017 and 2018, by which time the prices may have doubled or tripled in an open market. The company estimates the law will cost it an extra $20 million over the next seven years.

Nick Kastle, a company spokesman, said it would almost certainly pass on the new costs to makers of ketchup and frozen pizza, which would be likely to share the extra costs with consumers. “People nationwide are going to be affected by AB 32,” he said.

But, isn't that the point? Passing on (some of*) the costs of pollution to consumers encourages consumers to use less of the polluting product.

*Note: Producers aren't able to pass on all of the costs of pollution control. If producers could pass on all of the costs they wouldn't fight so hard to try to avoid them, right? The magnitude of the incidence of regulatory costs depends on demand and supply elasticity. 

Aguanomics: Cap and trade in practice

David Zetland:

I ran a cap and trade experiment in my class,* to show students how they could benefit from a market that allowed them to trade their (capped permits) for pollution emissions.**

This experiment [65 minute mp3] clarified how "normal" people can listen to the idea but not understand how to implement it.

It also clarified the importance of setting a real cap, understanding whether manufacturers are pursuing profit or volume, and the efficiency with which market prices reveal social values

via www.aguanomics.com

If you know of any elected government officials who are, oh, I dunno, looking around for revenues, please let them know that California figured out how to raise $300 million while discouraging a bad activity

More on California's carbon auction from Jasmin Ansar:

The results of the auction announced by the California Air Resources Board showed that all ‘current’ 2013 allowances, totaling 23.1 million tons, were sold at a price of $10.09, nine cents above the regulator’s minimum (reserve) price of $10 per ton. In addition, about 14 percent of the advance 2015 allowances were sold for $10 per ton. The buyers in the auction were primarily major polluters who will need to pay for their carbon emissions starting in 2013.

The broader public should also be sanguine about the auction results. There was no evidence of any market impropriety, and bidding was brisk for the current auction, with bid volume being three times greater than the volume for sale.

One slightly puzzling result did emerge. The current auction had a much larger bid volume than did the advance auction, where only 5.5 million out of 39.5 million available 2015 allowances were sold. This could mean that companies are waiting to buy these 2015 allowances closer to the compliance date, or possibly, that companies are planning to ramp up new programs to abate future emissions and expect these programs to be more profitable than investments in carbon allowances.