Common Tragedies

Thoughts on Environmental Economics

Collar-poppin’

Posted by Danny Morris on April 8, 2010

Like all climate nerds, I’m eagerly anticipating the upcoming release of the Kerry-Lieberman-Graham Tri-Partisan-Super-Moderate-Climate/Energy Cavalcade, currently scheduled to grace my computer screen around Earth Day. Since first announcing they would be working together on a new way forward on climate legislation in December, the three senators have been stingy with details, letting them dribble out from time to time. The last blast of info came in mid-March and provided enough titillating details to show that this bill won’t be massively different from Waxman-Markey (17 percent reductions of ’05 emissions levels by 2020, consumer rebates, regulating facilities that emit more than 25,000 tons of CO2).

In my excitement over this modicum of information about the bill, I missed a small phrase that probably doesn’t mean much to anyone who doesn’t take a daily swim in a metaphorical pool of climate economics. Quoth Darren Samuelsohn:

Additional layers of certainty for industry come via a “hard price collar” that limits greenhouse   gas allowances to between $10 and $30 per ton tagged to inflation, with an increase at a to-be-determined “fixed rate” over time. The legislation would also set aside a “strategic reserve” of 4 billion greenhouse gas credits that could be released into the market to help control price volatility fluctuations.

See anything wrong with that statement? Allow me to help with a brief discussion of price collars from an economist’s perspective.

A hard price collar in the world of environmental economics is one with a firm price floor and ceiling where once the market hits the price ceiling, emissions allowances are released into the market to maintain the ceiling until the price drops back down below it. There is no limit to how many allowances are released; the point is simply to drop the price.

Contrast that with a soft price collar, which is a collar that draws allowances from a pre-established reserve of allowances once the market hits the ceiling price. Again, the goal is to drop the price below the ceiling, but there is a limit on how many allowances can enter the market (the amount available in the reserve).

Now look at the quote again. It claims the bill has a hard collar, but then also says it has a strategic reserve, which would clearly make it a soft collar. The difference between the two is subtle, but it has important implications. A market with a hard collar is less desirable from an emissions control perspective because once the market hits the price ceiling, there is no way of knowing how many credits will enter, meaning the amount of extra emissions allowed is unpredictable. A hard collar puts a premium on price certainty. Conversely, a soft collar has more emissions certainty because once the reserve is exhausted, no more allowances enter the system, regardless of the allowance price. Environmentalists prefer this approach because it maintains the emissions cap.

If the KLG bill does truly have a soft collar, then it will have to take allowances from somewhere (presumably the initial allocation) to fill the strategic reserve. It will also have to develop mechanisms to replenish the reserve if it gets drawn down, possibly in a similar way to Waxman-Markey, which uses revenue from the reserve auctions and international forestry offsets. Bottom line: there will be slightly fewer allowances available to regulated firms both at the beginning of the program and throughout the life of the program than there would be with a hard collar.

So, what do the good senators mean when they (through Darren) say a “hard price collar?” Well, if I could read legislators’ minds, I would probably have a different job. Based on the context of the statement, however, my guess is that they are using hard collar to mean that the collar prices will increase at some fixed rate over time. This is a different approach from Waxman-Markey, which keeps collar prices 60 percent above a rolling 36-month average of daily allowance prices. Increasing the price collar at a fixed rate is better for firms as it provides more price certainty over time and protects against a steeply rising price ceiling. It’s a good idea, but it’s not a hard price collar.

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3 Responses to “Collar-poppin’”

  1. Carlos Ferreira said

    I’d personally endorse the idea of maintaining the price between limits, bringing certainty into the market, but I also fear that, when those limits are politically decided, the allocation of permits and the usage of the strategic resource becomes prey to rent-seeking from market participants, meaning less efficiency. Ultimately, under the guise of reducing uncertainty to consumers, emissions would be allowed to rise, removing incentives for investment. If the collar is meant to be a hard one, I think I’d prefer a tax.

  2. [...] Collar-poppin’ « Common Tragedies [...]

  3. Peter Wood said

    Now that the legislation has been released, the ‘collar’ seems to be a soft one – but 4 billion dollars worth of credits is a lot, so it is not very soft, hence it being described as ‘hard’. One thing that I like about the cost containment reserve is that if the ‘ceiling’ price is not met, a small (but increasing over time) amount of permits are not auctioned. So if the marginal costs of abatement are high, there could be an extra 4Gt of cumulative emissions; while if abatement costs are low, and the carbon price stays below the ‘ceiling’ price, the amount of emissions by 2050 could be nearly 4Gt less. And if abatement costs are particularly low, emissions can be even lower.

    Furthermore, money raised from selling ‘ceiling price’ permits goes towards international offsets, the the impact on global emissions will be less than the amount covered by extra permits.

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