If you want a good primer on the dos and don’ts of designing good climate legislation, watch the Senate hearing, “Economic and International Issues in Global Warming Policy.” This was a hearing last month in front of the Environment and Public Works Subcommittee on Private Sector and Consumer Solutions to Global Warming and Wildlife Protection, which is chaired by Joseph Lieberman (I/D, CT) and John Warner (R-VA), who have been working together on a climate bill.
All of the witnesses were good, but I thought the presentation by aptly named Blythe Masters, Managing Director, JP Morgan Securities, was especially cogent. She makes a compelling case against the safety valve:
From the perspective of greenhouse gas emitters, a safety valve provides certainty of the upper limit of the cost of compliance. However one characterizes this approach, in economic terms this is a price control. It has been argued that a price control on emission credits may be justified in the initial phases of a cap and trade program given the relatively higher degree of uncertainty over the compliance costs.
In both the near and long term, however, the case for price controls is not compelling.
Commodity markets exist to buy and sell commodities. High prices tend to incent an increase in supply in that commodity and/or reduce demand. Carbon markets are no different. Obviously, carbon markets do not exist to incent an increase in the supply of carbon but rather to increase the capital allocated to expanding the supply of low carbon technology. By controlling the maximum price an emitter must pay for emissions, Congress would be quite directly decreasing the capital available to invest in new and innovative low carbon technology.
The effect of such price controls on investors and emitters should not be underestimated. For example, a frequently proposed price cap for carbon is $10/ton/CO2equivalent. At the same time, the International Energy Agency estimates the cost of carbon capture and storage technology at $30 to 90/tCO2.
With that differential, it’s hard to see the economic logic of investing in CCS. And given that over 50% of U.S. electricity generation comes from coal, that demand is still increasing, and that over 150 coal fired power plants are on the drawing board, a price cap that retarded the commercialization of a technology that would allow the U.S.–and the world–to safely use its most abundant fossil fuel would seem inappropriate.
It is not too dissimilar to wonder how much exploration and production activity would be occurring in the global oil markets if the price of crude was capped at $30 a barrel. It’s safe to say that the oil majors would be returning most of their exploration budgets to their shareholders and that recoverable reserves would, at best, slowly continue to decline. No new supply would be coming to market.
Sadly, a price control has another drawback–it may prevent the U.S. market from linking to the EU ETS and other international carbon markets. Other systems, principally the EU ETS, will be unlikely to allow carbon credits and offsets from outside the EU if the cost of those credits is artificially low due to price controls and if the price control simply acts as a carbon tax that allows emitters to bust the cap.
Quite a part from the diplomatic fallout of such a policy, failure to link to other carbon markets will reduce liquidity and, therefore, raise compliance costs to U.S. emitters.
It is worth noting that neither the acid rain program or the EU’s ETS have used price controls. In the case of the acid rain program, there have been price spikes but they have been temporary and self correcting. Moreover, the cost of compliance in the SOX and NOX markets was initially estimated from $3-$25 billion annually. After the first 2 years of Phase I, the costs were around $800 million per year.
In the case of the EU ETS, despite not having a price control in place emission allowance volatility and/or high prices have not caused major dislocation to emitters or consumers.