Common Tragedies

Thoughts on Environmental Economics

On hoarders, speculators and do-gooders

Posted by Rich Sweeney on November 19, 2007

Over the past few weeks there’s been a lot of debate on this page and others about the relative merits of a carbon tax versus a cap-and-trade system. Increasingly I’ve come to feel like this is all much ado about nothing, as practically speaking a cap-and-trade system with full auctions and a safety valve is essentially the same thing as a carbon tax. Yet with that being said, there is one difference between the two that has a lot of insiders/bureaucrats worried, but that hasn’t been discussed all that much in the blogosphere to date: the potential for manipulation of carbon permits. I’ll discuss some of the potential threats, real and imagined, below the fold.

* Disclaimer – this post mainly applies to the electricity sector

** Thanks to Anthony Paul for explaining most of this stuff to me.

Hoarders

As California and the RGGI states forge ahead with their plans to cap carbon, insiders and interested parties have become increasingly concerned about possibility of hoarding. When permits are eventually auctioned off, some fear that large generators or colluding groups of generators could buy up large shares of permits in order to drive up the electricity price and increase profits. Some very preliminary analysis at RFF reveals that this threat is in fact plausible. There is essentially only one price for electricity in a given market at a given point in time, which all generators receive. Thus, for a clean (i.e. low carbon emitting) generator, an increase in the price of carbon permits increases revenues without affecting costs. Under certain circumstances, for certain firms, this increase in revenue more than offsets the price of buying up and sitting on unnecessary permits.

What makes hoarding truly problematic is the fact that it would be very difficult to detect or punish. This is because most cap-and-trade systems allow banking. So even if a regulator observed a generator buying up and not using permits, it would be very hard to prove that it was doing this in an attempt to drive up the price, as opposed to simply preparing for future cap restrictions.

Allowing firms to borrow as well as bank permits could potentially offset this threat. Moreover, while colluding to hoard permits may seem profitable in theory, it could prove impractical in real life. Cheating would be profitable and hard to detect. Finally, there is an enormous amount of regulatory uncertainty/risk, especially in the early years. If a group of generators colluded to raise the price of electricity too high, weary politicians might simply step in and issue more permits.

Speculators

One fear I’ve heard mentioned several times, is that outsiders (i.e. big banks from Wall Street) are going to buy up permits and drive up the price, putting businesses and consumers at their mercy. On the whole, this concern is driven by little more than the layman’s anti-market bias. Barring any monopolization or cartelization of permits, which seems unlikely given the size of the carbon market and the politics involved, I don’t see how speculation from investors could be anything but beneficial. Again, the likely institution of permit banking, and maybe even borrowing, makes this even less of an issue. The main point is, you can’t make money by simply buying up or trading assets, and attempting to do so will do little more than tease out price inconsistencies in the carbon market- which is precisely why we should welcome Wall Street, not fear it.

With that being said, I haven’t thought all the way through this scenario. Banks and hedge funds will no doubt attempt to execute a multitude of complex strategies involving the carbon market’s relationship to other assets. While theoretically I’d like to say that such activities would still promote efficiency, I’d definitely be willing to hear from anyone who thinks otherwise.

Do-gooders

Finally we come to the do-gooders (read George Soros). Some insiders worry that radical lefty outsiders will recklessly attempt to accelerate the carbon curbing process by buying up and retiring large blocks of permits. It’s hard to tell how much of a threat this is. On the one hand, a wealthy individual or well endowed green organization might see this as a good value for money, and logistically this would be very hard to prevent (of course the value of the purchase would be subject to the same regulatory risk I mentioned above). Yet on the other hand I kind of doubt anyone would really be willing to go through with it given the potential for public backlash. Restricting the permit market will drive up electricity prices even further, at a time when customers are already adjusting to the concept of internalizing their carbon costs. Seems like anyone truly concerned about longterm climate change wouldn’t risk a potentially crippling political setback.

One Response to “On hoarders, speculators and do-gooders”

  1. dave.s. said

    I haven’t heard anyone with power talking about full auctions, I have heard people talking about giving away allocations and then letting people trade them. Which means the money goes to current emitters, and to the scumsucking lowlifes on Wall Street who will take a percentage on the trades. Mark me down for taxes.

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