[Part 3 of Values-based vs. Market-based Approaches to the Economy]
As we saw yesterday, the strongest argument for a market-based framework is that it allows for decentralized, flexible, creative solutions vs. what Krugman calls “a ‘command and control’ fix that issues specific instructions in the form of regulations.”
That’s the theory. But step into the nitty-gritty details of creating a market-based solution, and a very different picture emerges. A market-based framework does allow for lots of flexibility and creativity. But the creative energy it unleashes can just as easily be spent making money while undermining the goals the market was supposed to accomplish. This isn’t a showstopper. But to put this destructive creativity in check, you’ve got to create lots and lots of “specific instructions in the form of regulations.”
It’s hard to get a visceral sense of just how much regulation a “market-based” approach requires to actually work. So in this post we’ll take a look under the hood of Krugman’s favorite solution, cap and trade, at five ways it can go south if it isn’t kept in check by lots of regulations.
1) Speculation Pew has a great brief on what it takes to set up an emissions market so speculators won’t blow it up. And baby, it ain’t pretty.
For starters, you have to close “the Enron Loophole, the London Loophole, and the Swaps Loophole.” What are they? Trust me, unless the idea of reading sections like “Options for Improving Oversight of OTC [over-the-Counter] and Exchange-based Transactions” makes you feel tingly, you don’t want to know. And this loophole list is just the beginning, based on past speculative tricks. The creative boys and girls at Goldman Sachs are sure to come up with new loopholes.
Mind you, that’s not a reason to avoid using a market-based solution. The point of Pew’s brief is to explain what we need to do to make emissions markets work. And as Krugman pointed out last year,
Any time you have a market, there’s some opportunity for speculation… So, should fear of speculation lead us to ban trading in wheat? Nobody would say that… Now substitute “emission permits” for wheat. It’s exactly the same story.
My point isn’t that a market-based solution can’t work because of speculation. It’s that it will require lots and lots and lots of rules and regulations to keep speculators from blowing it up.
2) Emissions Offsets. The European Union has been running an emissions market, the Emissions Trading Scheme (EU ETS), for half a decade, and they’ve learned some very valuable, painful lessons. One of them is that if you don’t limit the ability of folks to buy offsets, some people will go at them with all the reserve of a crack addict. And we’re not talking some shady Eastern European country, we’re talking about the Netherlands. According to professors Tamra Gilbertson and Oscar Reyes, the Netherlands’s 2008-2012 emissions trading National Action Plan (NAP)
stated its intention to purchase 20 million tonnes of offset credits every year towards its reduction target. This would be equivalent to outsourcing all of its emissions reductions commitments during that period.
At least these supersized offsets help reduce emissions somewhere else, right? Maybe — if you create a bunch of those icky “specific instructions in the form of regulations” plus monitoring & enforcement to ensure the folks who develop and sell these offsets don’t get too creative…
3) Giving Away the Store. When the EU created their emissions market, there was a lot of political pressure to hand out more permits to corporations where the market could hurt their “competitiveness.” The end result: more emissions permits were given away than the current amount of pollution.
Take ArcelorMittal, one of the world’s largest steel makers. According to Gilbertson and Reyes,
The EU’s own data on emissions showed that ArcelorMittal’s verified emissions increased by 6.7 per cent in 2006 and by 15.5 per cent in 2007, with a downward trend of -8.4 per cent in 2008 due to the economic crisis. Yet whether its emissions increased or decreased, the fact that it was awarded massively more permits than it would have needed even to begin reducing emissions remained a constant: a 36.9 per cent overallocation in 2005, 26.9 per cent in 2006, 25 per cent in 2007 and 31.7 per cent in 2008.
Actually, it’s worse than that. Not only is the emissions market not providing pressure to go green, because so many permits were granted, folks in steel are making a profit off them without lifting a finger. From the industry rag Metal Bulletin in April 2009:
European steel producers are selling allocated carbon permits that have become surplus to requirement due to production cuts, carbon analysts told MB. “Steelmakers are using the EU Emissions Trading Scheme (EUTS) as a cash cow,” one analyst said. “The steel sector has received more permits than it should have.” Nevertheless the steelmaker’s actions are perfectly legitimate as the EU carbon market is a free one, carbon traders said.
Overall, according to the October 2007 UK Parliament’s Environmental Audit Committee’s assessment of the first phase of the EU’s emissions market
most observers believe that too many allowances to emit carbon have been allocated in phase 1, meaning there is overall little or no incentive for firms to cut back on their emissions, and thus that the entirety of this phase is likely to be ineffective in driving down emissions.
4) Banking. Both the EU’s Emissions Trading Scheme and most US proposals allow companies to “bank” some or all of the emissions permits they don’t use. There are a number of reasons why you might want to allow banking. But if you make a mistake at the start — say by giving corporations way too many emissions permits — leading companies bank unused permits is a gift that keeps on giving. A more nuanced approach could give you the benefits of banking without this huge downside. But guess what that nuance means? Lots more “specific instructions”…
5) Fun with Numbers. Another downer from professors Gilbertson and Reyes:
An inquiry by the UK Parliament’s Environmental Audit Committee found that ‘it is widely accepted that UK power generators are likely to make substantial windfall profits from the EU ETS amounting to £500 million a year or more’. The German environment minister cited figures from his own ministry which showed that the four biggest power producers in his country – Eon, RWE, Vattenfall and EnBW – would reap profits of between €6 billion and €8 billion from the first phase of the scheme.
How did the power companies pull this off? Since the politicians didn’t want to hurt corporations who had tough overseas competitors, they put more of the burden on the energy folks, assuming that they could just pass the cost onto the consumer. So the power companies fired up some of that fabulous market creativity:
The costs that are indirectly passed on to consumers through an increase in wholesale energy prices do not reflect what carbon credits actually cost, but rather what the companies assume they could cost. This leaves considerable scope for overestimates: first, by assuming a larger than necessary need to buy permits or credits; second, by assuming that there will be a high carbon price; and third, by assuming the costs of replacing EUAs, irrespective of their actual use of offset credits which have consistently commanded lower prices. Yet if these assumptions turn out to be over-generous, the surplus is more often pocketed as profit than returned to the consumer….They then seek to maximise the value of these permits – so while the cost passed on to consumers approximates to the cost of reducing emissions in accordance with a cap, what the company actually does is whatever it considers to be cheapest – which may be to buy EU ETS permits from other installations in the scheme, or buy offset credits instead.
The EU could stop all of this — with lots more of those icky “specific instructions in the form of regulations” — but so far they’ve only done a half-assed job. A snark from Gilbertson and Reyes sums it up:
It makes more sense, then, to view the EU ETS as two parallel schemes: one that encourages the power sector to buy extra allowances – which, as we have seen, passes the notional cost on to consumers to generate large profits for the energy companies – and another that awards a large surplus of free permits to heavy industry, requiring no emissions reductions but allowing them to sell permits back to the power sector to generate large profits.
Conclusion
Again, we’re talking Europe — a place where you can have a conversation about the health-care system without it degenerating into accusations of Death Panels and Socialism. You can imagine how these issues will play out in the good old USA.
This isn’t to say that cap and trade is a bad idea or that it couldn’t work. I’m not a green policy geek, and I don’t understand the details well enough to say one way or the other. But what I do know is that anybody who thinks using a market based solution is somehow going to be simpler or require fewer detailed rules and regulations is kidding themselves.
Up next: principles of a value-based framework.
