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