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A cap with a collar …

September 29th, 2009 · No Comments

Well designed, a cap with a collar can be a truly gorgeous thing.

To spark movement away from our carbon addiction, for business (financial) planning, and to gain enough support to pass climate legislation, any “Cap and Trade” structure almost certainly will have to have a “collar” to go with its “cap” on carbon emissions.

To be released tomorrow, the Boxer-Kerry climate legislation looks to include floor and ceiling prices to allowance auctions. Thus, a “collar” guaranteeing both a minimum price and a maximum price, which enables some degree of certainty for planning (government, business, otherwise) in terms of cost while providing some space for ‘trading’ prices to reflect actual demand/supply for carbon permits.

As Joe Romm at Climate Progress notes

The bill makes a monumental improvement over the House bill by adopting a version of the carbon collar …

The floor price is $11 (the draft bill above is, as I say, not final) and the ceiling is $28 — and they both starting rising 5% plus inflation each year.  The draft bill adds an excellent twist — from 2018 on the ceiling rises 7% plus inflation each year.  …

Fence-sitting Senators and industries can legitimately see the Carbon Collar as achieving stronger cost-containment protection than their analysis suggests the House bill now provides, including protection against speculators running the permit price up, while progressives can legitimately see it as achieving better environmental outcomes than their analysis suggests the House bill now provides.Win-win.

Severe volatility can be destructive, creating demands for near term change that might undermine achievement of long-term objectives, and moving off our carbon addiction is a long-term objective (requiring a near-term serious start).  A floor/ceiling on allowance prices would constrain the extent of volatibility

Certainty enables planning and long-term investment, the type of planning and investment required to move toward a prosperous, climate-friendly society.  A floor/ceiling on allowance prices would provide certainty as to the “worst” and “best” case in terms of direct carbon costs.

Thus, on the face of it, placing a price collar on allowance auctions for a Cap and Trade program makes much sense.

However … “on the face of it …” Some examples of issues to consider:

Will polluters pay?

A A core principle for any climate legislation is that polluters should pay, that polluting the air our children breathe and the water they drink is no longer some “externality” that is given a free ride.  Just like paying for trash pickup at the home or a dump fee when hauling that decrepit mattress to the county dump, people and businesses should pay for dumping their carbon pollution.  Placing significant (actually any) portions of the carbon cap into giveaway programs to subsidize polluters undermines (rips to shred) this basic principle, undermines the power of the allowance price collar, invites future speculation, and will undermine the effectiveness of our efforts to reduce carbon emissions.

Collaring speculators

Placing the allowance price increases at above inflation creates an incentive to reduce emissions sooner rather than later since it is certain that the cost will be higher, in real terms, from one year to the next. This helps counter the basic fiscal calculation of net present value (NPV) which discounts future costs (or gains) to try to understand the value of a $1 a decade from now in today’s terms (which would, a conservative sense, be about 50 cents of value). The proposed guaranteed increases put the carbon costs in the range of typical discounting formulas, thus encouraging an appropriate fiscal (green-eye shade) calculation of reducing pollution today vs reducing pollution tomorrow in a way that reduces incentives to put off cost-effective pollution options.

But, there is a speculative problem to consider. If guaranteed a minimum price increase of a minimum of 5% above inflation, does this create incentives for serious fiscal speculation. Why not buy some carbon credits for long-term investing, knowing that you can sell for that minimum price growing above inflation with the potential, at least, for significant growth above that if the permits are trading above the minimum price? Considering the item above, what if you’re a polluting industry which receives significant carbon allowances for free?

Thus, how allowances are “banked” and provisions for constraining this sort of fiscal speculation could matter. For a variety of reasons, it might make sense to ‘degrade’ unused permits, retiring them on some schedule to enable doing better than targets and to restrain/control speculation.

On the positive … driving change faster …
There is a serious value to the collar, especially on the low side. If the analysis is correct. If “proponents” (like me) of options like energy efficiency are on target. If technology rises to the fore. If people begin to undertake personal/cultural shifts. If … If many things that I (and others) see likely if significant legislation occurs and business/government begin to take climate change seriously, then the progress on cutting emissions could be striking and significant.

We are, already, at more than half the emissions reductions targeted by the Waxman-Markey American Clean Energy & Security (ACES) Act for 2020! Actual targeted emissions reductions could be achieved virtually by sleep walking (if the sleep walker is pointed in the right direction). In the face of this, without a collar (without a floor price), carbon allowance values could fall to essentially free since there would be so many more allowances than actual pollution.

The floor price will incentivize people to continue to find ways to cut emissions, even if the “free market” price of allowances for the that year’s ‘authorized’ pollution would be near free.

From my perspective, for the next 10+ years, it seems almost certain that the floor will have more impact on actual carbon prices than the ceiling … thus, having that floor will help drive more emissions cuts than a program without a cost collar.

Details to be seen …

Boxer-Kerry will be released tomorrow. And, then it goes into the Senate sausage making process (as if it hasn’t already been sausage-making). On a wide range of issues, we will need to create momentum to strengthen the bill while fighting efforts to weaken it.
Thus, how allowances are “banked” and provisions for constraining this sort of fiscal speculation could matter.

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Tags: business practice · cap and trade · carbon dioxide · climate legislation