The underrated efficiency of cap-and-trade

I have a lot of respect for Geoff Styles, who is always very thoughtful in his writing on energy and related issues, but I disagree with him here (I'll reproduce my comment):

Hi Geoff,

I don’t think the current state of economic research on cap-and-trade (both theoretical and empirical) would support your statement that, “The problems with this thinking lie in the enormous distortions and unnecessary economic hardship those uneven allocations will create over the next 20-plus years and the opportunity cost of the emissions reductions that could have been achieved more quickly and cheaply.” See for example Robert Stavins here:

It is exceptionally important to keep in mind what is probably the key attribute of cap-and-trade systems: the allocation of allowances – whether the allowances are auctioned or given out freely, and how they are freely allocated – has no impact on the equilibrium distribution of allowances (after trading), and therefore no impact on the allocation of emissions (or emissions abatement), the total magnitude of emissions, or the aggregate social costs...

Generally speaking, the choice between auctioning and freely allocating allowances does not influence firms’ production and emission reduction decisions. Firms face the same emissions cost regardless of the allocation method. When using an allowance, whether it was received for free or purchased, a firm loses the opportunity to sell that allowance, and thereby recognizes this “opportunity cost” in deciding whether to use the allowance. Consequently, the allocation choice will not influence a cap’s overall costs.

I agree there’s a lot of room to argue that the W-M allocation of permits is unfair, and some shareholders will benefit while others will suffer. But the attractive efficiency properties of the cap-and-trade mechanism (as opposed to a carbon tax, incidentally) mean that the aggregate social outcome is likely to be fairly efficient, rather than “enormously distorted” as you worry.

Update 1: bartman on merchant power generation:

R:

If you read the text of Waxman-Markey, you will find that in one key way it invalidates Stavins' statement that you cited.

The key feature is the dynamic allocation of permits to merchant coal plants. Since their annual allocation is based upon their previous year's production, then a merchant coal plant has a greater incentive to use the permits than to trade them, because trading them means that they get a lower allocation the following year. The end result is that, ceteris paribus, there will be more coal burned than in a world with static allocation or full auctioning.

We've had a lot of debate at work whether this is a feature or a bug.

R:

bartman,

Good point that the dynamic allocations for merchant power generation may not uphold optimal efficiency. As you say, TBD whether the dynamic allocations are a feature or a bug. But these are only 5% of total allocated permits, so even in the worst case this won’t drastically compromise the efficiency of the overall outcome (and 95+% efficiency would be a pretty good outcome of the political sausage-making process).

Update 2: Geoff responds:

R,
I'd go further than Bartman and suggest that while Stavins might be right about the "equilibrium distribution after trading", such systems rarely attain equilibrium in the real world. Dr. Stavins has an impressive bio, but I don't see any real-world commodity trading experience in there.

The fundamental problem is that for the first 15-18 years of cap & trade, the highest emitting sector will receive the lion's share of free allowances and have the least incentive either to alter operations or to invest in more efficient hardware. That's compounded by W-M's structural requirement that the utilities pass on the benefits to their customers; without that, they'd have more incentive to reduce their own emissions and sell their free allowances to the poor refiners who already operate at 90% effeciency and have little scope for reducing emissions further. The result of that structural flaw will be higher emissions from the electricity sector than under full auctioning or even-handed allocation, while refiners will be unable to cut enough to compensate for that and will merely have to pay up, perhaps at the penalty level, with the resulting increase in their costs driving up fuel costs for consumers and putting marginal US refiners out of business, leading to higher imports of refined products than otherwise. None of those outcomes looks good for energy security, and they won't do very much for the global climate, either.

R:

Geoff,

Re “such systems rarely attain equilibrium in the real world”, the empirical research I’m aware of shows that cap-and-trade systems have often reached efficient equilibria in the past (e.g. the SO2 allowance trading system) – see this paper for more detail, and please let me know if you’re aware of other evidence contradicting this.

Re “the highest emitting sector will receive the lion's share of free allowances and have the least incentive either to alter operations or to invest in more efficient hardware”, Stavins’ key point is free allowances alone don’t alter operating incentives (in this sense they’re similar to sunk costs). If the allowances market is clearing at $20/ton CO2e, any company (utility, refinery, whatever) with available abatement opportunities at a cost of $15/ton can make money by implementing that project. If it’s a utility with allocated allowances, the benefit will come from selling a credit for $20, whereas the benefit to a refinery without allocated allowances is avoiding the purchase of credit for $20, but the incentives are the same. The case for abatement opportunities at a cost above the market-clearing price is similar – implementing these projects doesn’t make economic sense, whether or not the company was allocated allowances.

So an initial overallocation to utilities will not in and of itself result in high inefficiency. The tricky part is that utilities don’t capture the full benefits of cost-effective abatement, since as you rightly point out these must be passed on in part to consumers. If I remember correctly, states and municipalities have some latitude to regulate the credit pass-through locally, so there is some flexibility to mandate investment in energy efficiency at the local level. I agree that this makes the overall efficiency properties messier. But if utilities capture even a part of the benefits of their own investments, efficiency investments below the market-clearing cost of carbon will still be profitable, and it seems overall efficiency will still be pretty good.

Update 3: The dialogue continues:

R,
I'm sorry, but those arguments would have been much more persuasive had we not been treated to such a massive display of behavioral inefficiencies in markets. Nor am I terribly reassured that SO2 markets might have reached equilibrium, since at scale the GHG markets seem likely to look a lot more like energy commodity markets, which manifestly are rarely in equilibrium, except by sheer coincidence. In that light, it matters very much how those free allowances are allocated. I don't mean to imply that any economic analysis of the situation is irrelevant, but rather that it must be tempered with the fruits of real-world experience.

R,
I'd like to add a thought to my response above. Without invoking the whole sub-prime, CDO/CDS debacle, a much more relevant example comes from the California electricity crisis. Contrary to conventional wisdom that lays all the blame on certain bad actors, the underlying problem--which created the loopholes through which traders drove Mack trucks--was poor market design. From my long experience in real markets, a situation that so massively skews the initial allocation looks like another recipe for inefficiency, distortion and exploitation; i.e., it constitutes poor market design. Good market design requires listening not just to the lobbyists, regulators, economists, and NGOs, but also to folks who have run or participated in actual markets.

R:

Geoff,

I totally agree that good market design is critical, and I appreciate that you're skeptical of markets reaching relative equilibrium based on recent events and your real-world experience (which is totally fair).

I don't understand the mechanism by which you believe initial allowance allocations (a.k.a. unconditional free money) will affect the decisions made by actors like utilities. Are you arguing that they'll behave irrationally, or do you think allowance allocations in some way affect the actual economic incentives they face?

Geoff:

There are many issues and uncertainties here, and it's important to note that behavior that might seem irrational to you could seem perfectly rational in the context of these players. For example:

A. At the foreseeable price of allowances in the early phases of cap & trade the foregone opportunity cost of selling allowances (the benefit of which passes to customers, anyway) is unlikely to be sufficient to compensate utilities for not running their fleets of billion-dollar assets. I.e., for the largest group of allowance recipients, it may be more rational for them to consume the allowances they receive and pass on their notional value to customers than to under-run and sell them to refiners.

B. The impact of the large share of allowances allocated to non-commercial recipients is hard to predict. Will they sit on their allowances until they need revenue, sell them cheaply to middlemen to get funds up front, strike long-term deals with refiners, or choose to retire them in an effort to accelerate reductions? Some of these outcomes could impede market liquidity and leave refiners exposed to penalties or higher costs than anticipated.

R:

In situation A), whether the utility was originally allocated allowances doesn't change their rational action. If the benefit of running their legacy assets exceeds the market price of the necessary allowances (as you describe), a rational utility would run those legacy assets no matter what, buying allowances on the market if necessary.

B) is a valid point, but I'm not sure the danger of strange market behavior would be lessened by giving those allowances to refiners with sophisticated trading operations instead.

Update 4: And... the dénouement:

R,
Your background on your blog indicates you're a strategy consultant. Are you telling me that all of your clients have treated an opportunity cost exactly the same as a cash cost? I'm highly skeptical, because in my own experience businesses treat the two very differently. Anyone else want to weight in on that one?

R:

Businesses don't always treat cash costs and opportunity costs the same in practice, but I would categorize this as irrational behavior (or making bad business decisions, if you prefer).

For example, imagine your exact scenario A), except in the world where the utility wasn't allocated allowances. Running legacy assets would still be the right business decision (and not doing so would be a bad decision). Whether the utility should run its legacy assets depends on the allowance market price, but not the utility's initial allocation of allowances.

My point is not that utilities won't behave irrationally, but rather that A) is not an example of rational commercial incentives leading to inefficient outcomes.

Thank you, by the way, for the spirited but respectful tone of this discussion.

Geoff:

Spirited but respectful is what we aim for. Thanks.