The Economic Policy Risks of Cap and Trade Markets for Carbon Emissions

A Monetary Economist’s View of Cap and Trade Market and Carbon Market
Efficiency Board Designs

Executive Summary

As federal lawmakers scramble to meet the aggressive deadlines they’ve announced for cap-and-
trade legislation, they must still recognize the importance of taking the steps necessary to review
proposed policies with a critical eye. In order to successfully mitigate the affects of global
warming, the White House and Congress must first assess the ability of government policy,
regulator responsibility and market mechanisms to deliver a stable carbon price.

In this report, Dr. Joseph R. Mason -- Hermann Moyse Jr./Louisiana Bankers Association
endowed professor of banking at Louisiana State University -- examines the two most prominent
approaches for mitigating carbon emissions: controlling the quantity of emissions through cap
and trade schemes (cap and trade) and establishing price incentives for reducing emissions
through a tax on carbon (carbon tax). By analyzing which program provides the most effective
means of curbing pollution while also minimizing economic distortions, Dr. Mason concludes
that a carbon tax-shift is the most cost-effective policy option.

Complex Financial Tools: Mitigating Price Uncertainty at the Cost of Benefit

Certainty
A cost-benefit analysis of emissions reductions reveals that there is an optimal level where the
societal benefits of pollution abatement are greatest per dollar spent. But as pollution levels
approach zero, further abatement becomes incrementally more expensive and far less valuable to
society – particularly because it could be argued that the benefits delivered would be shared
worldwide while the cost burden is exclusively carried by the U.S. and additional efforts here
will merely be offset by larger and faster growing economies worldwide. So it is likely that
because extreme caps will have a disproportionately large effect on economic behavior and
deliver far less societal benefit, a moderate tax on carbon will be a much more effective way to
deliver many of the same benefits.

Market Risks: Opportunities for Manipulation and Fraud

Wall Street will no doubt exacerbate the negative economic consequences under a cap and trade
plan. The climate change financial sector includes 90 hedge funds and 80 private equity funds, so
the opportunities for the sort of manipulation seen in the mortgage crisis are abundant. Some
academics have called it “the most complex financial market ever created.” Manipulation will
not only cause serious economic problems, but may also result in inefficiencies that either delay
or reduce environmental gains.

Public choice theory reminds us that when a public policy plan like cap and trade is established
as a potential source of profit, certain vested interests will exploit the system with exotic
derivatives and lobby for future provisions that could be a detriment to society as a whole. Two
companies most famously associated with establishing a cap and trade system are Enron and
AIG.

Price Volatility: Risk of Booms and Busts from Carbon Value Manipulation
In fact a closer look at cap and trade schemes already in place suggests that there are numerous
pricing anomalies that remain to be understood, and that tremendous price volatility threatens the
viability of the entire system. Carbon permit demand has fluctuated due to factors such as
weather, political uncertainties and other idiosyncrasies. The European system in particular
foreshadows a cap and trade energy economy that will exhibit different periods of behavior that
include price spikes, volatility spikes, and heteroskedatstic returns. Similar results are found in
other countries.

Perplexing pricing anomalies have undermined the ability of the market to properly internalize
both short- and long-term price dynamics. As a result, firms are less likely to invest in cleaner
technologies of long-term benefit, which may ultimately delay progress on the climate change
issue because most agree that innovation is central to solving the problem. The source of these
anomalies stems from the fact that although carbon permits are treated as commodity contracts
and option contracts, their pricing does follow the behavior of typical commodities or options.

Carbon Market Efficiency Board: Inefficiencies & Conflicting Goals

The last problem with a cap and trade is the costly bureaucracy inevitable in such a complex
scheme. Theoretical mathematical and economic models have been designed to show that the
program can, with sufficient banking and borrowing can, in principle, deliver a better outcome
than taxing emissions. That conclusion, however, relies on several mechanisms borrowed from
central bank policy. As a result, most recent carbon market development proposals now routinely
borrow institutional features from central bank design and organization that are thought to be
able to effectively regulate and constrain carbon markets to achieve environmentalists’
objectives.

Proponents have therefore recommended something like a central bank, most recently referred to
as a “Carbon Market Efficiency Board” to control contract supply and adjust it according to
pricing volatility and policy goals. But we’ve seen from the current financial crisis that
government lacks the resources and ability to effectively regulate complex financial markets.
And without benefit certainty, the convoluted carbon permit market design and risk of market
collapse is unnecessary.

Carbon Tax Alternative: Transparent, Predictable, Easy to Administer

The most efficient policy approach, then, would be to impose a carbon tax on all coal, natural
gas, and oil produced domestically or imported into the United States. While both a carbon tax
and a cap and trade system achieve the same goals in theory, a carbon tax would be simpler to
implement, more transparent, and less vulnerable to manipulation.

In terms of simplicity of administration, carbon taxes are both easier to enforce and can more
readily be adjusted if the policy is too weak or too aggressive. A carbon tax also reduces the time
lag between the promulgation of a pollution target and its achievement, as a tax can be
administered immediately. A cap and trade system, in contrast, requires extensive administrative
and market infrastructure that will take decades to develop. Additionally, a carbon tax would
result in an immediate revenue inflow.

Furthermore, a carbon tax would result in an immediate revenue inflow as it would rely on the
existing Federal tax structure for collection. This revenue could then be used to promote further
environmental protection in form of research grants for the development of alternative energy
sources, which are not forthcoming from carbon permit market revenues.