Common Tragedies

Thoughts on Environmental Economics

Ryan Avent is angry

Posted by Daniel Hall on December 11, 2008

Someone at the American Prospect blog started criticizing cap-and-trade and Ryan decided to eviscerate him:

Price volatility when demand shifts is an inevitable outcome, period. If you doubt me, please direct your attention to gasoline prices. This uncertainty is supposed to be bad for business? When does business ever have a clear picture about future energy costs? They don’t, which is why we have thriving markets in energy futures, so that firms can hedge against the risk of big price swings. At least with a cap-and-trade system, firms could potentially bank and borrow permits in order to address volatility.

Ryan is responding to the criticism that energy price volatility from a cap-and-trade system will hamper investment and hence a carbon tax is the way to go.

The post over at TAP is indeed execrable (I fully expect that any of our readers could find more errors than facts in the post) but the author’s point about volatility is actually not so far off the mark:

The major con of C&T from an economist’s perspective, said Shapiro, is the “inevitable outcome” of energy price volatility when demand shifts. If a desired outcome of any of these policies is producing revenue necessary for investment in clean energy technology, then C&T price volatility would be bad for businesses since they need a clear and steady picture of future energy costs.

I would focus more on uncertainty, where volatility (and expectations about volatility) are a component of uncertainty. Uncertainty does influence the optimal investment path. (Dixit is one prominent economist to write about this.) Higher uncertainty (around the same expected price) will increase the value of delaying investment since the next period may bring further info that will influence how you invest.  Thus cap-and-trade systems may tend to delay investment relative to a carbon tax with the same expected price path.

The next logical question is whether the costs of this uncertainty are big or small.  I tend to think the costs are small given the ready availability of hedging instruments for energy and commodity prices.  Remember, the ‘cost of uncertainty’ is not necessarily a delay in investment; it could just be the economic cost (transaction or opportunity) of any hedging strategy.

Another question is whether a cap-and-trade policy and a carbon tax policy that could actually be passed by a majority of Congress would have the same expected price.  If Congress has the political will to pass a $20 per ton CO2 tax or establish a cap-and-trade system that results in an expected permit price of $30 per ton (with some volatility around this price) then the cap-and-trade system could still have more investment.  (Remember here that the only carbon tax that I would bet on Congress passing has a price of $0 per ton of CO2.)

Maybe the most interesting question concerns political uncertainty, which is arguably much higher than market uncertainty and which is also probably harder to hedge.  Is Congress more likely to go back and change a tax system or a cap-and-trade system?  Frankly, I am really not certain. (Also remember that changing a system is not necessarily a bad thing: the decision to change a system down the road could, for example, be a response to new information and could produce large net benefits.)

All in all I don’t see that the uncertainty and investment problem is that big a deal for cap and trade.

Here is an excerpt from the latest issue of the Review of Environmental Economics and Policy.  (I cannot access the REEP site at the moment.)  Note that the third paper proposes a hybrid approach that would involve a cap-and-trade system with an expected price window that might in some ways finesse the price volatility question.  Here is a discussion paper from the same authors that I believe covers the same territory.

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