Are carbon credit markets inherently prone to fraud and manipulation?

Michael Giberson

The headlines about fraud in Europe’s carbon credit trading system (2010: “Fraud Besets E.U. Carbon Trade System,” 2009: “Europol: $7.4 Billion Lost from Carbon Trading Fraud in Europe“) seem to confirm what some critics of carbon credit trading have been saying all along (2007: “Carbon Trading Open Invitation To Fraud,” 2007: “The greenhouse gas emission trading scam“).  Are these news stories proof that the critics are right? Are carbon credit markets inherently susceptible to fraud?

Victor Flatt, at Flatt Out Environment, says no, these stories are just show the growing pains associated with a new market.

The fraud perpetrated on the EU exchange was basic garden variety thievery.  Criminals got access to an asset (carbon credits) and stole them. This could (and has) happened with many assets, and is a risk of electronic records and trading. … The one way that this can be attributed as uniquely related to the carbon market is that the entire trading system is new, and new systems present more opportunities for thievery, rent-seeking, and fraud. It seems clear that the security protocols on some of the EU country registries were not sufficiently strong or that market participants were not educated enough about the protocols of the exchanges to protect their security information from “phishing.” Luckily, the amounts in play were relatively small, they were quickly discovered, and this will provide lessons for future security upgrades.

So far the RGGI trading in carbon credit appears to be fraud free.  At least my searching through news reports and the market monitor’s statements doesn’t turn up any fraud complaints.

Market manipulation can be achieved without fraud, and whether or not the European market is susceptible to manipulation is not revealed by the above complaints.  Again, so far at least, the RGGI markets have not shown evidence of market manipulation.  (The RGGI design team did go to some lengths to design a market that would be difficult to manipulate.)

Of course, since these trading markets are essentially created by legislative action, they could be revised by legislative action.  The temptation to jump in and “fix” the market will rise any time enough legislators think that the prevailing carbon credit price is too high or too low.  Existing pollution credit trading programs in the U.S. have escaped such meddling mostly by being too small to be of much interest.  Also, they seemed to work so well that few people wanted to mess with them.  Carbon credit trading won’t be “too small to be of much interest,” so its best protection from after-the-fact legislative meddling will be to work so well than few people will want to mess with it.

That and, of course, continuing public support for the underlying science of climate change that is motivating efforts to control greenhouse gas emissions in the first place.

Highly recommended read on Waxman-Markey: The Cap-and-trade Bait and Switch

Michael Giberson

David Schoenbrod and Richard B. Stewart explain why the Waxman-Markey “cap-and-trade” bill isn’t, fundamentally, a market-based approach to regulating greenhouse gasses:

As a candidate for president in April 2008, Barack Obama told Fox News that “a cap-and-trade system is a smarter way of controlling pollution” than “top-down” regulation. He was right. With cap and trade the market decides where and how to cut emissions. With top-down regulation, as Mr. Obama explained, regulators dictate “every single rule that a company has to abide by, which creates a lot of bureaucracy and red tape and often-times is less efficient.”

… [Yet] Waxman-Markey is largely top-down regulation dressed in cap-and-trade clothing. It purports to set a cap on greenhouse gases, but the cap is so loose in the early years that through the use of cheap offsets the U.S. need not significantly reduce its fossil-fuel emissions until about 2025. …

The top-down directives come in three forms. First, electric utilities, auto makers and states get free allowances on the condition that they comply with regulations requiring coal sequestration, alternative energy sources, energy conservation, advanced auto technology and more. Second, many other provisions of the 1,428 page bill mandate outright regulation on subjects ranging from how electricity is generated to off-road vehicles and household lighting. Third, still other provisions provide subsidies for government-chosen technology “winners” such as alternate energy sources, plug-in vehicles and weatherization of old buildings.

Progress on most or all such fronts will be needed, but when, where and how should be decided principally by a cap-driven market, not the “red tape” that candidate Obama deplored.

The bill would impose dramatically lower limits in the future, but the authors see little reason to expect future politicians to allow them to go into effect. What would go into effect in the legislation are hundreds of pages of new energy mandates, more industrial policy directives from Washington and many more subsidies for politically favored technology choices.

The authors believe that cap-and-trade can be successfully applied to greenhouse gas emissions, and they much prefer the approach to the likely alternative (source-by-source EPA regulation of greenhouse gas emission). But Waxman-Markey isn’t going to do the job.

A problem with market-based approaches to emission reductions

Michael Giberson

Market-based approaches to regulating emissions are the new conventional wisdom, according to Robert Stavins, and it would be hard to disagree. Among proponents of regulating greenhouse gasses in the United States, the big debate is over which of two market-based approaches to regulating emissions should be pursued: emission tax or cap-and-trade. Is anyone proposing “best available control technology”? Market-based approaches have become favored in part because of some high profile successes, notably the cap-and-trade program for SO2, seen as achieving its goal at a considerable cost savings compared to alternative approaches to regulation.

The primary strength of market-based approaches comes from the decentralizing of compliance decision-making, which enables each entity responsible for compliance to pursue the lowest-cost means of meeting the requirement. This strength, though, may also be the biggest problem with market-based approaches, at least when proponents of regulation hope to achieve goals beyond efficiently addressing externalities associated with emissions.

At TNR’s THE VINE, Bradford Plumer asks, “If Carbon Caps Are Coming, Why Mandate Renewables?“, and reports some of the responses he received.  Rich Sweeny asked the same question at Common Tragedies a while back.  In both cases it appears to be the case that proponents of greenhouse gas regulation are worried we might achieve the targeted reductions too easily, i.e. while still burning a lot of coal, not cutting back on consumption, and not garnering enough market share for renewable power. That is to say, some proponents of regulating greenhouse gasses hope to not only to reduce externalities, they have additional preferences about other people’s future energy choices that they want to control through the public policy process.

From Plumer:

Hummel explained that in wholesale electricity markets, the price of carbon would need to get very high—around $60/ton—before pushing dirty coal out onto the margins. So a renewable standard is a good way to manage a steady transition away from coal long before reaching that point.

In the comments responding to Sweeny’s discussion:

Cap and trade purists don’t seem to understand that there is something out here in the real world called an electricity market, and that under any politically viable national cap, coal use is barely touched.

Once we get beyond “internalizing the externality” in economists’ language, or more plainly, once the third party effects of actions are taken care of, the further ambitions of these regulation proponents sound like a bad mix of industrial policy and meddlesome preferences. The problem with market-based approaches, from the point of view of some folks, is that they don’t help enforce these further ambitions for social reform.

Actually, in my view, this “problem” is another great strength of the market-based approach.

Cap-and-trade and politics

Michael Giberson

From Environmental Capital, reports that selling all greenhouse gas emission permits under a cap-and-trade scheme may not be politically attractive:

Europe already saw what happened when it gave away emissions permits—utilities gobbled up more than 100 billion euros in windfall profits.

The pain for the consumer—i.e., the voter–will be the same whether the permits are sold or given away.

Writer Keith Johnson notes that “for the overall emissions-targets to work, prices would have to rise more in other parts of the economy to compensate” (if, that is, giving permits to utilities serves to limit power price increases).

Billions in profits for companies well represented in D.C. versus non-transparent price increases in unspecified other industries? I guess we can work out the political calculus easy enough.

And for readers who think this is a reason to prefer a carbon tax…, well, I’m not convinced that lobbyists or their congressional aides would keep their hands off the tax code, either.

Because it is not news until it is on Comedy Central; or, carbon taxes their brains

Michael Giberson

Carbon tax and cap-and-trade fun, courtesy of the Wall Street Journal editorial page and bloggers at Common Tragedies.

In brief: on Monday the WSJ lead editorial complained about the distributional effects of cap-and-trade, correctly noting that the effect of pricing carbon would depend on consumption but misleadingly illustrated with a chart based on carbon-emitting production by state.  Two economists at Resources for the Future sent a letter to the editor pointing out the problem, and after the WSJ said it would not run the letter, one of the economists – Rich Sweeney – posted it on his blog at Common Tragedies.

Subtlety being the soul of blogging, he headlined the post: “The Wall Street Journal is an idiot.”

This morning at CT, Sweeney is back with, “Write a letter to the editor, and nobody cares. Call someone an idiot on the internet and…….”

The answer is: get your letter published in the WSJ. Nearby on the editorial page is a rejoinder, where the editorialists, in their words, “try to take their [the RFF economists'] argument seriously.” [What?  Does this mean the first editorial was done without considering recently published work by the mainstream-if-slightly-staid folks at the pre-eminient environmental policy think tank?  I guess for the second editorial, the difference was that the WSJ editors were actually wearing their thinking caps.]

Elsewhere in the house of WSJ, Environmental Capital blogger Keith Johnson pulls up a chair ringside, “Knockdown, Dragout: Think Tank v. WSJ Edit Page on Cap-and-Trade.”

Johnson concluded:

The RFF guys responded this morning: “Now the question is whether the WSJ really cares about the true net effect of carbon policy on households in states like Michigan and Pennsylvania, or if they’re simply clinging to any story that will allow them to politically undermine cap and trade.”

It’s certainly fodder for a lively debate. The only thing that would make it better would be moving it to Comedy Central.

I’m all for getting this debate onto Comedy Central.  We will be talking about cap-and-trade and carbon taxes in a few weeks in the Energy Economics class.

Students here are leaving for Spring Break this afternoon.  I figure Comedy Central is about the only chance I have got to get a serious energy econ idea entertained by even a handful of students for the next 9 days.

[Note to Jon Stewart: Call me.  I can play straight man.]

Falling carbon permit prices in Europe: Threat or menace?

Michael Giberson

At Environmental Capital Keith Johnson notes that the financial market meltdown is driving down carbon permit prices in Europe, and as a result it is harder to fund clean-energy projects in the developing world.

Johnson calls this change in prospects for clean-energy developers “a negative side effect” of falling permit prices.  I can see how this change might be a negative side effort for investors in these projects, but for the rest of us falling permit prices are a good thing. After all, if the permit price reflects approximately the cost of reducing carbon emissions (a big “if”, but approximately justifiable*), then falling permit prices mean that the cost of reducing carbon emissions is going down.  If reducing carbon emissions is a worthy public policy goal, then attaining that goal is becoming cheaper.

To the non-investor, worry about the economic prospects of clean-energy projects seems to mix the ends of policy and one particular way of attaining those ends.  One advantage shared by both cap-and-trade and carbon tax proposals is that they do not wed the attainment of a goal to specific means (i.e. particular technologies or approaches), but rather let the market sort those things out in a least-cost way.

I understand, of course, reducing carbon emissions is becoming cheaper at the margin because the scale of overall economic activity is down.  That falling level of overall economic activity is a negative factor worthy of public policy attention, but the investment-worthiness of clean energy businesses is per se of no more public policy interest than the growth of dingus makers or widget manufacturing.

(*”Approximately justifiable” because companies coverned by the requirements must choose between reducing carbon emissions or buying a permit, so at the margin the price should reflect the cost of abatement.)

ASIDES:

Just because the falling level of economic activity is appropriately a matter of public policy attention doesn’t mean that public policy makers have a clue. On this topic, see Mario Rizzo’s ThinkMarkets blog post, intelligently named “The Macroeconomic Knowledge Problem.” (Around here we usually focus on microeconomic knowledge problems, so it is nice to know someone’s got our back.)

The comments by Rob Stavins comparing cap-and-trade and carbon taxes at the National Journal site (noted in my post yesterday) have now been supplemented by a number of other responses.

Rob Bradley reminds us that the policy choice isn’t just between cap-and-trade and carbon taxes.

Generally speaking, Johnson’s post at Environmental Capital provides an illustration of the mild counter-cyclical effects of a cap-and-trade approach that I mentioned briefly in yesterday’s post.

Carbon tax vs. cap-and-trade, again

Michael Giberson

The U.S. Climate Action Partnership report, mentioned by Lynne last Friday,  has stimulated a spate of new newspaper stories comparing cap-and-trade and carbon taxes as ways to regulated greenhouse gases.  A story by Tom Fowler in the Houston Chronicle looks pretty good as an overview of “carbon tax vs. cap-and-trade.”

One thing to notice about some of the points raised on one side of the argument or the other is that they apply pretty strongly to both.  Rice University’s Amy Meyers Jaffe is right to be worried about “aberrations that can be created when you design a market through the political process” – see the initial California ISO power market design for an example – but the carbon tax would similarly be designed and imposed through the political process.  I don’t see much reason to believe that the tax code is less susceptible to lobbying than other parts of the political process.

According to the Chronicle, “many are skeptical that the government would make good use of tax proceeds,” but the same people should also be skeptical that the government would make good use of permit auction proceeds. Similarly, emissions will have to be monitored under both programs, either to ensure sufficient taxes are paid or that sufficient permits are acquired.

S. David Freeman is worried that a permit system would be unpoliceable.  The example quoted refers to offset programs, not the cap-and-trade system itself, and design of offset credits raise separate issues.  Freeman worries about manipulation of a permit market, but I’d say manipulation of a permit market (which would be show up in market prices and be accomplished through registered market participants) is likely to be more transparent than manipulation of the tax code by lobbyists and their Congressional  pals in Washington (which could be snuck into obscure tax code amendments inserted during late-night conference committee mash-ups).

Craig Pirrong is quoted as saying “just like any large commodity market, CO2 prices could be highly volatile.” In a Washington Post story, Rob Shapiro also suggests that cap and trade would introduce “enormous volatility” and would allow “a lot of mechanisms for gaming the system.”   Yes, if badly designed, then a cap-and-trade market could be volatile and susceptible to gaming.  A well-designed CO2 market would not likely pose significant problems on volatility or gaming.

The RGGI market appears reasonably well designed and carefully monitored; if Shapiro knows of ways to game the RGGI design, then why didn’t he raise them during design of that system?  It will be a few years before the RGGI cap begins to bite and the market is really tested, but it looks like a reasonably sound design.

Pirrong is also quoted in the Chronicle saying, “Banks like the volatility and complexity, because the more volatile and complex, the more money they could make.  But volatility may make companies put off investing in cleaner technology because they can’t get an accurate estimate on the costs.”  On the other hand, volatility raises the value of options, which may increase the value of investing in cleaner technology.

Perhaps it bears mentioning that while a carbon tax would vary more or less directly in proportion to macroeconomic activity, a cap-and-trade approach would likely have a modest counter-cyclical effect.  The cap would become less binding during recessions – permit prices would fall – and the cap would become more binding during economic booms.

I may sound like a cap-and-trade advocate, but not really. I don’t have a hard conclusion on whether cap-and-trade or carbon taxes would work best.  But like Rob Stavins, I am opposed “to the confused and misleading straw-man arguments that have sometimes been used against cap-and-trade by carbon-tax proponents.”

Stavins also writes:

Proponents of carbon taxes worry about the propensity of political processes under a cap-and-trade system to compensate sectors through free allowance allocations, but a carbon tax is sensitive to the same political pressures, and may be expected to succumb in ways that are ultimately more harmful:  reducing environmental achievement and driving up costs.

The Hamilton Project staff concluded in an overview paper (which I highly recommend) that a well-designed carbon tax and a well-designed cap-and-trade system would have similar economic effects.  Hence, they said, the two primary questions to use in deciding between them should be:  (1) which is more politically feasible; and (2) which is more likely to be well-designed?

Stavins answers the two questions in favor of cap-and-trade, citing “real world political forces” as the reason to think cap-and-trade would be better designed.  For more by Stavins on the topic, see “A U.S. Cap-and-Trade System to Address Global Climate Change.”

On the carbon tax side of the issue, Greg Mankiw is probably most prominent among economist-advocates.

At Environmental Economics, John Whitehead advises: the “economic case for cap-and-trade (or a carbon tax) is clear.”