Cap-and-Trade or a Carbon Tax for Greenhouse Reductions?

By Kennedy Maize

Pages: 1 2 3 4 5

Is Cap-and-Trade a Texas Showdown?

Here’s a skeptical notion, derived from my understanding of high-stakes poker: Industry may be arguing for an up-front energy tax, knowing it is political poison in Congress and cannot pass, leaving nothing in its place. That will warn the Obama administration off of any kind of energy tax in the future. That cynical notion may be wrong, but it can’t be dismissed. Look for “tells” in their take, the winks and twitches and grimaces that betray their hand.

Industry opponents of cap-and-trade make an interesting case. They argue that cap-and-trade recreates an energy version of the market for subprime mortgages and the slice-and-dice financial instruments created in the mortgage markets of the 21st century. It’s not necessarily obvious, according to economists who study the market, but it’s worth considering.

Some energy CEOs who are opposed to a cap-and-trade market—and it’s not clear whether they are a majority—argue that the carbon market will turn CO₂ trading into an economic poker game, capable of manipulation by savvy card sharks, as they believe occurred in credit and mortgage markets. If so, they want the pot of poker chips, owned by the government, given to them to start the game. That is, they want the initial allowances—their stake in the game—distributed in advance, not auctioned off in a way that could produce very high values for CO₂ emissions, cutting into company profits and raising customer electric rates.

Many environmentalists have argued for a full auction of allowances to the private sector in exchange for real dollars, which they believe will generate large returns for the federal government. Some in the environmental groups and some in the Obama administration say they believe the windfall proceeds from the emissions auction could support of the costs of a new health care regime.

Congress isn’t buying. The Waxman-Markey bill allocates the vast majority (85%) of the initial CO₂ allowances to various industry groups up front. That’s a major concession to the power industry, making the whole idea of a trading market for CO2 more palatable to the electric distributors and generators.

Some in the electric industry also raise the specter of carbon markets replicating the current financial meltdown in credit and housing. Carbon emissions allowances are—hold your breath now—a door to new derivatives markets. Some in the electric industry argue that speculators can use the carbon-allowances market to derive new tradable securities, in this case the price of future CO₂ emissions, insure against market default, and so on, mimicking the collapsed mortgage market. That also came up at the ELECTRIC POWER Industry Executives Roundtable.

There’s no real dispute about whether cap-and-trade could lead to a derivatives market. I asked William W. Hogan, noted energy economist at Harvard’s Kennedy School of Government, if a spin-off was possible. “Sure,” he said, “and there’s nothing wrong with that. In principle, there’s no reason there couldn’t be a market for forward trading of carbon allowances,” if the cap-and-trade program envisioned in the Waxman-Markey legislation in the House is enacted into law. The derivatives market “provides a price-hedging path, and helps the market function more efficiently,” Hogan said.

Secondary markets, Hogan said, are useful. They provide ways to protect against price swings and cover risks. In a market as big as it looks like the CO₂ market will be, it strikes Hogan as impossible that anyone could fiddle the market to its advantage. So hedging instruments will be valuable to all players in the market.

The development of futures markets, and the ability to hedge price positions and mitigate risk, Hogan said, is entirely worthwhile. Will that offer ways to game the market to the advantage of speculators? “There will always be Enrons,” Hogan said, adding that he has never seen convincing evidence that Enron was actually able to manipulate electric energy market prices during its heyday, despite attempts to game the system. Enron’s real problems, he says, came in its fraudulent manipulation of its balance sheet, not in trading positions.

Pointing to the Hunt brothers’ attempt to corner the silver market in the 1970s, Hogan explained that if a market participant can’t control the physical basis of a market, it cannot manipulate the market. That fact, he said, was true of electricity, a huge and diverse market, and will be true of CO₂, an enormous and diverse market, incapable of capture by any market player. “Nobody is big enough to corner this market,” Hogan said.