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Executive Summary: The Economic Policy Risks of Cap and Trade Markets for Carbon Emissions

Executive Summary: The Economic Policy Risks of Cap and Trade Markets for Carbon Emissions

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Published by Climate Task Force
A Monetary Economist’s View of Cap and Trade Market and Carbon Market Efficiency Board Designs
A Monetary Economist’s View of Cap and Trade Market and Carbon Market Efficiency Board Designs

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Published by: Climate Task Force on Sep 10, 2009
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The Economic Policy Risks of Cap and Trade Markets for Carbon Emissions
 A Monetary Economist’s View of Cap and Trade Market and Carbon Market  Efficiency Board Designs
Executive Summary
Asfederallawmakers scrambleto meet the aggressive deadlines they’ve announced for cap-and-trade legislation,they must stillrecognize the importance of taking the steps necessary to review proposed policies with a critical eye.In order to successfully mitigate the affects of globalwarming, the White House and Congressmust first assess the ability of government policy,regulator responsibility and market mechanisms to deliver a stable carbon price.In this report, Dr. Joseph R. Mason --Hermann Moyse Jr./Louisiana Bankers Associationendowed professor of banking at Louisiana State University --examines the two most prominentapproaches for mitigating carbon emissions:controllingthe quantity of emissions through capand trade schemes (cap and trade) andestablishingprice incentives for reducing emissionsthrough a tax on carbon(carbon tax). By analyzingwhich program provides the most effectivemeans of curbing pollution while also minimizing economic distortions, Dr. Mason concludesthat a carbon tax-shift is the most cost-effective policy option.
Complex Financial Tools: Mitigating Price Uncertainty at the Cost of BenefitCertainty
A cost-benefit analysis of emissions reductions reveals that there is an optimal level where thesocietalbenefits of pollution abatement are greatest per dollar spent. But as pollutionlevelsapproach zero, further abatement becomes incrementally more expensive and far less valuable tosociety –particularly because it could be argued that the benefits delivered would be sharedworldwide while the cost burden is exclusively carried by the U.S. and additional efforts herewill merely be offset by larger and faster growing economies worldwide. So it is likely that because extreme caps will have a disproportionately large effect on economic behavior anddeliver far less societal benefit, a moderate tax on carbon will be a much more effective way todeliver many of the same benefits.
Market Risks: Opportunities for Manipulation and Fraud
Wall Street will no doubt exacerbate the negative economic consequences under a cap and trade plan. Theclimate change financial sector includes 90 hedge funds and 80 private equity funds, sothe opportunities for the sort of manipulation seen in the mortgage crisis are abundant. Someacademics have called it “the most complex financial market ever created.” Manipulation willnot only cause serious economic problems, but may also result in inefficiencies that either delayor reduce environmental gains.Public choice theory reminds us that when a public policy plan like cap and trade is establishedas a potential source of profit, certain vested interests will exploitthe systemwithexoticderivatives and lobby for future provisions that could be a detriment to society as a whole. Two
companies most famously associated with establishing a cap and trade systemare Enron andAIG.
Price Volatility: Risk of Booms and Busts from Carbon Value Manipulation
In fact a closer look at cap and trade schemes already in place suggests that there are numerous pricing anomalies that remain to be understood, and that tremendous price volatility threatens theviability of the entire system. Carbon permit demand has fluctuated due to factors such asweather, political uncertainties and other idiosyncrasies. The European system in particular foreshadows a cap and trade energyeconomy that will exhibit different periods of behavior thatinclude price spikes, volatility spikes, and heteroskedatstic returns. Similar results are found inother countries.Perplexing pricing anomalies have undermined the ability of the market to properlyinternalize both short-and long-termprice dynamics. As a result, firms are less likely to invest in cleaner technologies oflong-termbenefit, which may ultimately delay progress on the climate changeissue because most agree that innovation is central to solving the problem. The source of theseanomalies stems from the fact that although carbon permits are treated as commodity contractsand option contracts, their pricing does follow the behavior of typical commodities or options.
Carbon Market Efficiency Board: Inefficiencies & Conflicting Goals
The last problem with a cap and trade is the costly bureaucracy inevitable in such a complexscheme. Theoretical mathematical and economic models have been designed to show that the program can, with sufficient banking and borrowing can, in principle, deliver a better outcomethan taxing emissions. That conclusion, however, relies on several mechanisms borrowed fromcentralbank policy. As a result, most recent carbon market development proposals now routinely borrow institutionalfeatures from central bank design and organization that are thought to beable to effectively regulate and constrain carbon markets to achieve environmentalists’objectives.Proponents have therefore recommended something likea centralbank, most recently referred toas a “Carbon Market Efficiency Board” to control contract supply and adjust it according to pricing volatility and policy goals. But we’ve seen from the current financial crisis thatgovernment lacks the resourcesand ability to effectively regulate complex financial markets.And without benefit certainty,the convoluted carbon permit market design and risk of marketcollapse is unnecessary.
Carbon Tax Alternative: Transparent, Predictable, Easy to Administer 
The most efficient policy approach, then, would be to impose a carbon tax on all coal, naturalgas, and oil produced domestically or imported into the United States. While both a carbon taxand a cap and trade system achieve the same goals in theory, a carbon tax would be simpler toimplement, more transparent, and less vulnerable to manipulation.In terms of simplicity of administration, carbon taxes are both easier to enforce and can morereadilybe adjusted if the policy is too weak or too aggressive. A carbon tax also reduces the timelag between the promulgation of a pollution target and its achievement, as a tax can be

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