Carbon trading, windfalls, and consumers

2008-03-31

in Economics, Law, Politics, The environment

Air conditioners from above

This background note on carbon trading from the Sightline Institute does a good job of explaining the relevance of different modes of permit allocation to consumers. That sounds terribly dull, I’m sure, but it’s simple and important. The basic idea of carbon trading is that you set some level of allowable emissions for a facility, firm, sector, or economy. Say you want to reduce total national emissions by 2% over the next year. You multiply current national emissions by 0.98 and create permits for that quantity of emissions. What you do next is very important. You can either auction these credits to the highest bidder, requiring firms that produce greenhouse gasses to purchase them, or you give some or all of them away for free to such firms.

The critical point here is that these credits are money. Auctioning them does two things: it requires polluters to pay for their emissions and it raises funds. These can be invested in research, used to subsidize low-carbon technologies, or just used to fund general tax cuts. When these credits are given away for free, they give firms the option of either continuing to pollute for free or selling the right to pollute to someone else.

The point made in this document is that consumers end up bearing the cost from either approach. This is because unless firms are tightly regulated or in competition with other firms that don’t face emissions restrictions, they will both profit from any permits they are allocated for free and pass along the cost of permits to consumers. The analogy used in this document is a good one:

Try buying World Series tickets from a scalper. Would he charge you any less if he found the tickets on the ground? Of course he wouldn’t. Like energy, the street price of World Series tickets is based on supply and demand. The supply and demand for tickets is the same no matter how much the scalper paid for them, and so the price he charges you will also be the same no matter how he got them.

Of course, the scalper would much rather get his tickets for free – and that’s precisely the point. Polluters are financially much better off if permits are given away instead of auctioned, but the cost of cutting emissions and the resulting effect on energy prices will be the same no matter how the permits are delivered.

As such, the superiority of an auction system is further reinforced. Not only does it implement the Polluter Pays principle, but it also provides a mechanism through which governments can compensate consumers for the manipulative behaviour of firms.

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{ 16 comments… read them below or add one }

Milan March 28, 2008 at 1:33 pm

I found the document discussed above on this Gristmill post.

Milan March 28, 2008 at 1:42 pm

From this page:

“In a carbon-constrained economy — that is, a economy in which emissions are strictly limited — a permit to emit carbon is has a value in the marketplace, much as an World Series game with a limited number of seats has a market value.

And when something has a market value, a rational business will want to sell it to the highest bidder, rather than just giving it away.

So, regardless of how Exxon acquires those permits, and regardless of who buys them, the company won’t give carbon permits away for free. Exxon will either sell a little less oil, allowing them to sell unused permits to the highest bidder; or they’ll use all the permits to sell as much oil as possible, but also raise prices. In the former case, they make a profit from selling unused permits (which they paid nothing for). In the latter case, they essentially require their customers to compensate them for the profits they could have made by selling permits instead of oil.

Either way, grandfathering lets Exxon reap a profit from something that it paid nothing for — and it gets that profit even if it never reduces its emissions one whit!”

tristan March 31, 2008 at 10:21 am

The correct analogy would be if all world series tickets were simply given to scalpers, not if one were to find it on the ground. What would be the effect on the average price of world series tickets if all the tickets were gotten for free, and if only scalpers sold tickets? The price would go down – because all tickets would be bought wholesale (scalpers are suppliers not retailers). Pricing between scalpers would be fixed in an auction-like manner. Prices would be wildly unstable as well.

It’s not a good analogy. As far as carbon credits are concerned, yes it costs money to reduce your emissions regardless – but it costs more if you also have to pay for the right to pollute at all. In the agregate, charging companies for CCs is effectively another form of taxation, it simply adds another charge onto the more expensiveness of business, and that will be passed on to consumers. If the extra cost per product unity for reducing your emisions two percent is A, and the cost of purchasing CCs equivalent to 98% of the pollution you put out last year per unit product is B, then the difference is do we want the consumer price to go up A or A+B.

Milan March 31, 2008 at 10:39 am

Tristan,

If enough emissions credits are given away, they will significantly diminish the market value of emissions, true. That said, the point of the article is more that the costs get passed to consumers regardless of whether permits are given for free or auctioned.

In the agregate, charging companies for CCs is effectively another form of taxation, it simply adds another charge onto the more expensiveness of business, and that will be passed on to consumers.

True, though the critical thing is that the tax isn’t applied evenly to all businesses and business activity. It should encourage those who can improve to do so, and those who cannot to close up shop.

R.K. March 31, 2008 at 1:45 pm

Where was today’s photo taken? Have you been running around on icy rooftops?

Sarah March 31, 2008 at 1:54 pm

This is an interesting argument, & I see the logic re. scalpers. However, if a gradual reduction in CO2 is envisaged then there shouldn’t be sudden price hikes – after all, you wouldn’t make much cash as a scalper if there were only 2% fewer tickets than people who want them. Of course, some industries would be more affected than others – I presume the tar sands exploitation would get shut down quite quickly (presuming one also withdrew the subsidies) & people might be resentful about the continually rising costs of air travel.
One can also see how the extra tax revenue might prove useful – for instance to provide loans or grants to individuals and companies who install lower carbon technology early in the process (ie. they invest in expensive technology that makes a 20% cut in their CO2 in year one, but it would be scary to take out a huge loan and assume you could pay it off with the uncertain cost of carbon credit sales in future years, plus the credut markets might be all screwed up).

EH March 31, 2008 at 6:54 pm

I love that photo! Was it Photoshopped to be much different from the original?

The colours are really crisp and complementary, and the way the fans are centred is great!

Milan March 31, 2008 at 11:06 pm

EH,

It is barely modified. There was a slight levels adjustment, it was resized (not cropped), and a mild unsharp mask was applied.

I will lead you onto that rooftop sometime.

tristan April 1, 2008 at 2:37 am

I can see a pretty big loophole in this system – what do you do when a company exceeds its emissions limit? I mean, you can fine them, but unless you fine them infinite funds, there seems to be a chance that medium sized violations on the part of many companies will result in net emissions going up, not down.

Sarah April 1, 2008 at 2:46 am

I imagine you could fine them a lot, & that ultimately if the scale of violation were large enough and/or they were a repeat offender you would suspend or shut down their business. There is precedent for the government stepping in to halt a plant after a company has caused major environmental pollution problems.

Milan April 1, 2008 at 7:43 am

I can see a pretty big loophole in this system – what do you do when a company exceeds its emissions limit?

Under the incoming Canadian system, they would be prosecuted under the criminal code. I am not sure exactly what that entails.

alena prazak April 1, 2008 at 5:14 pm

This photo is really wonderful. It reminds me of the gas masks that we wore as small children in Czechoslovakia in anticipation of a US nuclear attack.

tristan April 1, 2008 at 6:37 pm

“Under the incoming Canadian system, they would be prosecuted under the criminal code. I am not sure exactly what that entails.”

Likely nothing. Or fines. If anyone goes to jail, I won’t fly for a year.

Milan April 1, 2008 at 7:21 pm

Tristan,

I think jail time will probably be politically acceptable, for people who breach mandated emissions limits. We would jail people now for dumping toxic or radioactive waste.

What needs to change is the deadly seriousness with which people should think about GHG emissions.

tristan April 2, 2008 at 11:36 pm

I figured out what’s wrong in the initial analogy. You say that the prices of world series tickets are based in supply and demand. That’s actually wrong (prices arise out of supply and demand, but are not based in it), but just imagine it was right for the sake of argument. Whether or not the world series tickets are given away or sold in the first place affects the supply side. The world series is a bad example because its micro economic, while carbon credits have macro economic effects. The point is, charging for CCs in the first place takes money away from all industries, making them as a whole less profitable. This is in addition to the repairs they have to make to lower their emmisions. Both of these things are costs to the supply side, and will result in some firms closing down, reducing supply. Thus, macroeconomically, supply is reduced and prices go up by some amount if we institute carbon trading, and by that amount plus more if we charge for the credits.

. April 28, 2008 at 5:33 pm

Economist Peter Dorman has a suggestion to clear up the confusion about free carbon permit allocation and windfall profits:

…I’m thinking of the decision to commit the WCI as a whole to auctioning only a portion, between 25 and 75%, of the carbon permits they intend to issue, distributing the rest gratis. Isn’t it generous to be handing out free money to the most polluting businesses?

Of course, it’s difficult for the general public to see just what’s going on. To remedy this, I propose the following: auction all the permits. Then take some of the money, between 75 and 25%, and deliver it to the doorstep of firms that emitted the most carbon in the past, preferably in suitcases with unmarked bills.

Maybe if you put the whole operation on YouTube people would get the point.

Nicely put, I thought.

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