Common Tragedies

Thoughts on Environmental Economics

Point Carbon gets it wrong

Posted by Rich Sweeney on April 7, 2008

Today Environmental Capital touted a new study by Point Carbon on free permit allocation. Commissioned by the WWF, the report unsurprisingly finds that free allocation has lead to windfall profits in Europe. Largely a tutorial on opportunity cost supplemented with an empirical analysis of pass through in Europe, everything seemed straight forward until the one quote the WSJ decided to pull out of the summary:

“Providing a free allocation to individual plant that is carbon intensive does reduce the
incentives provided by the scheme to invest in low emissions generation technology -
thereby off-setting one of the main aims of the scheme.”

Um, no. Firms have an incentive to maximize profits, which depends on price and cost. And as the report explains beautifully, and as I’ve said here numerous times before, what matters is opportunity cost, not nominal cost. Thus the CO2 price, and therefore the resulting electricity price, is the same in both scenarios, giving firms the same incentive to innovate as before. The only difference is that they make a lot more money under free allocation.

H/T to Anthony Paul for actually reading the summary carefully.

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3 Responses to “Point Carbon gets it wrong”

  1. I think the exception is investment into R&D that would “leak” to other companies so that they would also benefit from the discoveries. In this case a company initially owning carbon credits would have a relatively smaller incentive to invest into mitigation technology, since the development of the technology would decrease the value of the credits that it owns.

  2. Rich Sweeney said

    Aleksi,

    This is a very very good observation. Lemme think about it some more and get back to you.

  3. drwoood said

    While the opportunity cost is the same, there is the problem that some methods of free allocation of permits can lead to ‘perverse dynamic incentives’, which could reduce incentives to invest in low emission technologies. The problem is that if the amount of permits allocated in the future depends on emissions during the present, then there is a perverse incentive to not reduce emissions during the present. This could be a problem during the lead-up to emissions trading. One way of addressing this is by having extras incentives for early abatement, but this introduces more complexities and transaction costs. IMO it is much better to not grandfather permits in the first place.

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