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Price Regulation in Greenhouse Gas Emissions Cap-and-Trade Systems: From Theory to Policies
Abstract
Notwithstanding the infinite debate on price versus quantity instruments in the design of a global climate policy, Cap-and-Trade systems are dominating the policymakers' choices worldwide. This is a prime issue for the traditional equilibrium economics, which has argued that the structure of the costs and damages in climate change gives a strong presumption to price-type approaches, building on the seminal work of Weitzman (1974). Therefore, price regulation of Cap-and-Trade systems has been widely proposed as an efficient way to tackle cost uncertainty of abatement, which represents one of the main theoretical problems of using emissions trading. A further issue is the possible carbon price volatility. This paper reviews the theory behind different types of price cap systems and tries to highlight some insights for the existing and upcoming real world climate policies. The outcome is that a price cap alone, without a price floor, would prevent any Cap-and-Trade policy to reach the abatement target. Banking and borrowing are already available flexibility mechanisms through which combating the carbon price volatility. However, in dealing with price spikes, it might be useful to consider the possibility of linking a reserve allowance system with the access to certain types of offset credits.
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... Price caps or “safety valves”, and possibly price floors , have been offered as possible complements to quantitative emission limits and emissions trading to set up a more flexible response to the threat of climate change in the context of uncertain costs. ...
With climate change as prototype example, this paper analyzes the implications of structural uncertainty for the economics of low-probability, high-impact catastrophes. Even when updated by Bayesian learning, uncertain structural parameters induce a critical "tail fattening" of posterior-predictive distributions. Such fattened tails have strong implications for situations, like climate change, where a catastrophe is theoretically possible because prior knowledge cannot place sufficiently narrow bounds on overall damages. This paper shows that the economic consequences of fat-tailed structural uncertainty (along with unsureness about high-temperature damages) can readily outweigh the effects of discounting in climate-change policy analysis. Copyright by the President and Fellows of Harvard College and the Massachusetts Institute of Technology.
On efficiency grounds, the economics community has to date tended to emphasize price-based policies to address climate change -- such as taxes or a "safety-valve" price ceiling for cap-and-trade -- while environmental advocates have sought a more clear quantitative limit on emissions. This paper presents a simple modification to the idea of a safety valve: a quantitative limit that we call the allowance reserve. Importantly, this idea may bridge the gap between competing interests and potentially improve efficiency relative to tax or other price-based policies. The last point highlights the deficiencies in several previous studies of price and quantity controls for climate change that do not adequately capture the dynamic opportunities within a cap-and-trade system for allowance banking, borrowing, and intertemporal arbitrage in response to unfolding information.
In the Pigouvian tradition, economists have frequently proposed the adoption of a system of unit taxes (or subsidies) to control externalities, where the tax on a particular activity is equal to the marginal social damage it generates. In practice, however, such an approach has rarely proved feasible because of our inability to measure marginal social damage. This paper proposes that we establish a set of admittedly somewhat arbitrary standards of environmental quality (e.g., the dissolved oxygen content of a waterway will be above x per cent at least 99 per cent of the time) and then impose a set of charges on waste emissions sufficient to attain these standards. While such resource-use prices clearly will not in general produce a Pareto-efficient allocation of resources, it is shown that they nevertheless do possess some important optimality properties and other practical advantages. In particular, it is proved that, for any given vector of final outputs such prices can achieve a specified reduction in pollution levels at minimum cost to the economy, even in the presence of firms with objectives other than that of simple profit maximization.
One hundred and three estimates of the marginal damage costs of carbon dioxide emissions were gathered from 28 published studies and combined to form a probability density function. The uncertainty is strongly right-skewed. If all studies are combined, the mode is $2/tC, the median $14/tC, the mean $93/tC, and the 95 percentile $350/tC. Studies with a lower discount rate have higher estimates and much greater uncertainties. Similarly, studies that use equity weighing, have higher estimates and larger uncertainties. Interestingly, studies that are peer-reviewed have lower estimates and smaller uncertainties. Using standard assumptions about discounting and aggregation, the marginal damage costs of carbon dioxide emissions are unlikely to exceed $50/tC, and probably much smaller.
The “safety valve” is a possible addition to a cap-and-trade system of emissions regulation whereby the authority offers to sell permits in unlimited amount at a pre-set price. In this way the cost of meeting the cap can be limited. It was proposed in the US as a way to control perceived high costs of the Kyoto Protocol, and possibly as a way to shift the focus of policy from the quantity targets of the Protocol to emissions price. In international discussions, the idea emerged as a proposal for a compliance penalty. The usefulness of the safety valve depends on the conditions under which it might be introduced. For a time it might tame an overly stringent emissions target. It also can help control the price volatility during the introduction of gradually tightening one, although permit banking can ultimately serve the same function. It is unlikely to serve as a long-term feature of a cap-and-trade system, however, because of the complexity of coordinating price and quantity instruments and because it will interfere with the development of systems of international emissions trade.
Uncertainty about compliance costs causes otherwise equivalent price and quantity controls to behave differently and leads to divergent welfare consequences. Although most of the debate on global climate change policy has focused on quantity controls due to their political appeal, this paper argues that price controls are more efficient. Simulations based on a stochastic computable general equilibrium model indicate that the expected welfare gain from the optimal price policy is five times higher than the expected gain from the optimal quantity policy. An alternative hybrid policy combines both the political appeal of quantity controls with the efficiency of prices, using an initial distribution of tradeable permits to set a quantitative target, but allowing additional permits to be purchased at a fixed “trigger” price. Even sub-optimal hybrid policies offer dramatic efficiency improvements over otherwise standard quantity controls. For example, a $50 trigger price per ton of carbon converts the $3 trillion expected loss associated with a simple 1990 emission target to a $150 billion gain. These results suggest that a hybrid policy is an attractive alternative to either a pure price or quantity system.
The Stern Review on the Economics of Climate Change concluded that there can be “no doubt” the economic risks of business-as-usual (BAU) climate change are “very severe” [Stern, 2006. The Economics of Climate Change. HM Treasury, London, p. 188]. The total cost of climate change was estimated to be equivalent to a one-off, permanent 5–20% loss in global mean per-capita consumption today. And the marginal damage cost of a tonne of carbon emitted today was estimated to be around $312 [p. 344]. Both of these estimates are higher than most reported in the previous literature. Subsequently, a number of critiques have appeared, arguing that discounting is the principal explanation for this discrepancy. Discounting is important, but in this paper we emphasise that how one approaches the economics of risk and uncertainty, and how one attempts to model the very closely related issue of low-probability/high-damage scenarios (which we connect to the recent discussion of ‘dangerous’ climate change), can matter just as much. We demonstrate these arguments empirically, using the same models applied in the Stern Review. Together, the issues of risk and uncertainty on the one hand, and ‘dangerous’ climate change on the other, raise very strongly questions about the limits of a welfare-economic approach, where the loss of natural capital might be irreversible and impossible to compensate. Thus we also critically reflect on the state-of-the-art in integrated assessment modelling. There will always be an imperative to carry out integrated assessment modelling, bringing together scientific ‘fact’ and value judgement systematically. But we agree with those cautioning against a literal interpretation of current estimates. Ironically, the Stern Review is one of those voices. A fixation with cost-benefit analysis misses the point that arguments for stabilisation should, and are, built on broader foundations.
This article presents the case for using a cap and trade program (i.e., tradable permits) to control U.S. greenhouse gas emissions.
The analysis draws two basic distinctions between such an approach and a carbon tax (the alternative favored by many economists).
The first concerns how the value of emissions is allocated. Under cap and trade, the government can capture the value of emissions
by auctioning permits or by freely distributing allowances to emitters. A carbon tax would generally capture the entire value
as revenue. While free distribution has efficiency costs, it gives policy-makers important flexibility to resolve distributional
issues. The second distinction is that a tradable permit system sets the quantity of allowable emissions, while a tax sets
the price. In the context of international policy, cap and trade promotes cost-effective abatement and broad participation.
A quantity approach may also be preferred on efficiency grounds. Although the prevailing view among economists is that uncertainty
about marginal costs favors taxes, that view ignores the possibility of allowance banking and borrowing, and overlooks growing
scientific evidence that climate change will be highly nonlinear and characterized by “tipping points.” A simple thought experiment
illustrates how a prices-versus-quantities argument might favour cap and trade.
Economic theories of managing renewable resources, such as fisheries and forestry, traditionally assume that individual harvesters are perfectly rational and thus able to compute the harvesting strategy that maximizes their discounted profits. The current paper presents an alternative approach based on bounded rationality and evolutionary mechanisms. It is assumed that individual harvesters face a choice between two harvesting strategies. The evolution of the distribution of strategies in the population is modeled through a replicator dynamics equation. The latter captures the idea that strategies yielding above average profits are demanded more than strategies yielding below average profits, so that the first type ends up accounting for a larger part in the population. From a mathematical perspective, the combination of resource and evolutionary processes leads to complex dynamics. The paper presents the existence and stability conditions for each steady-state of the system and analyzes dynamic paths to the equilibrium. In addition, effects of changes in prices are analyzed. A main result of the paper is that under certain conditions both strategies can survive in the long-run.
This discussion paper has resulted in a publication in the Journal of Evolutionary Economics , 2003, 13(2), 183-200.
Two important decisions in designing markets for tradable emissions permits are whether to allow banking of permits (coupons) and whether to allow trading in entitlements to future permits (shares). Banking is predicted to reduce price instability when firms trade in a reconciliation market after the quantity of emissions has been determined. Tradable shares are a common feature in proposals for emissions trading in Canada. We conduct a laboratory experiment to investigate how bankable coupons and tradable shares affect efficiency and prices under uncertainty. Cognitive demands on the subjects are reduced by computerized advice on the optimal allocation of coupons across periods and the implied marginal values of coupons and shares. Banking, share trading, and uncertainty conditions are introduced in a complete factorial design with three observations per cell. High efficiencies are observed across all treatments. Uncertainty in the control of emissions leads to substantial price instability when banking is not allowed. Banking virtually eliminates the instability, but reduces the efficiency of the market institution. Share trading reduces trading volumes, increases price stability, and improves efficiency.
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