Market Forces

Carbon trading grows up

By Gernot Wagner / Bio / Published: January 28, 2011

When someone robs a bank, nobody challenges the legitimacy of banks. They suggest instead that the bank find better security. Why should carbon markets be any different?

Wednesday last week the European Commission (EC) discovered cyber thefts of carbon allowances valued at around €30 million from accounts in a handful of member states. It promptly halted all trading in its nearly €130 billion/year market until the holes could be plugged, accounts could be cleared, the stolen allowances could be traced by their unique identifying numbers, and culprits could be identified.

The fact that some trading registries are apparently less secure than your Facebook account is a clear problem and points to serious underinvestment in market infrastructure and security.

It certainly does not call into question, however, the idea of carbon trading, although some opponents of carbon markets have taken that step. These people range from outright climate deniers—those who can’t even admit we have a global warming problem—to those who believe that markets aren’t the most efficient way of addressing climate change, to those who can’t capitalize on the carbon market’s opportunities.

Let’s be clear: Putting a firm limit on carbon pollution, and providing polluters with flexibility in determining how to reduce pollution—including through transparent trading of pollution allowances—is fundamentally the best way to combat global warming pollution.

This basic fact is not changed by a €30 million theft of carbon credits that might have been prevented through a €10 thousand investment in security software and better computer hardware. Although not perfect, markets are the most rational and efficient way of allocating resources toward filling a specific need. Every stock exchange on the planet faces attempted cyber attacks, and most are well equipped to deal with them.

A day after the theft was discovered, the EC released a wholly separate, long-awaited decision to stop accepting pollution credits generated by destroying trifluoromethane, HFC-23, and nitrous oxide. Opponents of carbon markets seized on this announcement as further evidence that carbon trading markets aren’t working.

But actually, the EC’s decision to stop accepting these credits is the right move. HFC-23 was originally developed as an alternative to ozone-depleting chlorofluorocarbons. HFC-23 is a potent global warming gas, and destroying it helps the climate.

However, trading in HFC-23 credits creates perverse incentives. With a high enough price for carbon credits, it could make economic sense to build factories that produce HFC-23 for the sole purpose of destroying the gas and collecting credit for doing so. A better way for dealing with HFC-23 would be to subsume it under the successful Montreal Protocol, which is working to repair the hole in the ozone layer.

The coincidence of the EC’s decision to stop trading HFC-23 credits and the temporary suspension of trading on the heels of the carbon allowance theft, gave opponents of trading the opportunity to launch a two-pronged critique of carbon markets. But barring HFC-23 credits from entering the EU system can only be applauded—it’s entirely in the spirit of putting a firm upper limit on carbon pollution.

These two events highlight the carbon opportunity for the EC going forward. The emissions trading system has already proven its worth as the centerpiece of European efforts to cut global warming pollution. By improving the technical security of its trading program, the EC can assure investors that no more emissions allowances will be purloined.

And by closing its carbon market to credits from one-off HFC-23-type projects of dubious environmental value, and instead linking the EU market with jurisdictions that establish high-quality cap-and-trade systems, the EC can strengthen its own market and challenge others who are developing similar policies—from New Zealand to Tokyo to California, and beyond—to follow suit.

In the end, that’s all that counts—and the only thing the planet truly notices.

“The rule of consensus doesn’t mean unanimity”

By Gernot Wagner / Bio / Published: December 17, 2010

Cancun closed with a bang, not least because Mexican Foreign Secretary and Cancun talks chief Patricia Espinosa declared that, “The rule of consensus doesn’t mean unanimity.”

Patricia Espinosa That sentence alone should occupy legal scholars for years to come. Most economists would only applaud. Getting 190-odd countries to agree on anything is extremely difficult. Unanimous consent is almost always out.

If the Espinosa consensus stands, it will certainly insert some new vigor into the UN climate talks. It proved to be crucial to breaking the logjam in Cancun, which would otherwise have been held up by Bolivia as the lone dissenter. (Bolivia is now appealing Espinosa’s decision.)

The building blocks for a global deal are still elusive. Cancun punted on some of the most important issues. Some other crucial ones like Avoiding Deforestation (REDD+) and the basic building blocks for a Green Climate Fund saw some real progress.

Head over to EDF’s Climate Talks blog for a rundown of the most important issues.

In the end Michael Levi has it exactly right:

The Cancun agreement should be applauded not because it solves everything, but because it chooses not to.

It focuses on what the UN does well, and avoids the rest.

That, and the Espinosa consensus—if it withstands Bolivia’s appeal—may well be the most important legacies of Cancun.

Also posted in International / Leave a comment

There They Go Again, Part Two: Mercury

By Gernot Wagner / Bio / Published: December 15, 2010

Sometimes cap and trade isn’t the best solution. Call me a purist, but I want my kid’s amniotic fluid to be toxin-free. In the case of mercury, direct regulation is the best way to go.

It also shows that carbon can have some good uses after all. Activated Carbon Injection can reduce mercury pollution from power plants by 90 percent. It’s clean(er), readily available, already deployed large scale, and affordable. Now it’s up to EPA to set the proper rules.

Steve Cochran tells the full story. Second in a series.

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How environmental economics saved Christmas

By Gernot Wagner / Bio / Published: December 10, 2010

Art Carden has a great piece on the Grinch saving Christmas,

using Pigouvian taxes and the bargaining business.

But it reminds us again that even Coase missed the mark,

when it comes to things outside of Whoville’s small arc.

So to Art’s welcome take on a Yuletide tradition,

We humbly append a climate-change addition:

Since Whoville Whos’ chanting affects only the Grinch,

Bargaining is the solution that works in a pinch.

Climate’s a problem that affects the whole planet,

Coasian bargaining is much too small to span it.

A price on carbon is the better path,

all we need now is the political math.

Failing that, to be sure, we have the EPA,

not a first-best choice, still it may win the day.

To save the world’s Whovilles, we need a solution

that in the end puts a firm limit on carbon pollution.

Cap and trade is the most certain way

to give every Who joy on this and future Christmas Days.

Also posted in Cap and Trade / Leave a comment

One person’s cost, another’s opportunity

By Gernot Wagner / Bio / Published: December 9, 2010

Transitioning into a new, low-carbon energy future costs money. No doubt about it. Yet the flip-side of cost is opportunity.

Pew just released a new study on Global Clean Power: A $2.3 Trillion Opportunity. Is this just a smart attempt at rebranding the inevitable, or is there more behind this?

Costs now, savings later

Cash flow graph First, a quick qualifier on costs. Yes, investing in low-carbon technology costs money upfront. It’s also true, though, that many investments in clean technology reap savings later.

The up-front capital expenditures for wind, solar, nuclear, and other low-carbon technologies are large. But operating costs are much cheaper than using fossils fuels (and I’m not even including the costs of climate change from carbon emissions, which have long been socialized).

CapEx OpEx table That still doesn’t make the transition a freebie, but it makes it much cheaper over time. McKinsey has run the numbers. Global net incremental capital expenditures for a clean energy future are significantly lower than upfront capital investments, once we consider operational cost savings.

These operational cost savings could, in fact, be called “opportunities.” But that’s not what the Pew report has in mind. It refers to the actual costs.

Cost = Opportunity ?

Higher costs imply more money changing hands. So costs do, in fact, equal opportunities in a very real sense for anyone on the receiving end of the transaction.

If you decide which career to pursue, you may well want to opt for renewables instead of, say, petroleum engineering. Your chance of landing a job is much greater. The former will add many more jobs in the foreseeable future. And once you are in a particular industry, you want as much money to come your way as possible. (Of course, a scarcity of petroleum engineers would imply a salary premium for the few who do opt to study a 19th century technology.)

That is different from society’s and especially the government’s perspective, where cost minimization is de rigueur. That’s also what makes market incentives—a cap on carbon emissions—so crucial: it unleashes private investment dollars without government spending.

Investment + Recession = Opportunity

But even the social picture changes completely once we find ourselves in a situation we are in right now.

In a recession, with lots of spare capacity and industry literally sitting on $1 trillion in idle cash, creating incentives for more spending is exactly what we want to do as a society.

Investing in renewable energy, of course, has the added benefit that it also comes with an enormous social benefit—by decreasing the now socialized costs of carbon emissions. That’s one cost we definitely want to avoid.

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No jobs in economic modeling

By Gernot Wagner / Bio / Published: December 7, 2010

Co-authored with Nat Keohane.

Last week Nat Keohane and I tried to shed some light on the inner workings of economic models when it comes to jobs. Among other more specific statements around climate policy, we also said that,

many macroeconomic models don’t actually attempt to model jobs. In fact, they generally assume full employment no matter what happens, which doesn’t leave any room for estimating increases or decreases in jobs as a result of specific policies.

We should have been clearer here. If you think of employment as “total units of labor employed, given equilibrium wages and household labor-supply decisions,” then yes macroeconomic models do model employment—just as they model the equilibrium values of other inputs and outputs in the economy.

That’s just not how you or I think about jobs, and that has some major implications.

Economic modeling versus the real world

Computable general equilibrium models of the economy literally assume full employment in the sense that everyone who wants to work works.

When we think about unemployment in the real world, it is due to the fact that people actually lose their jobs. More technically, there are market frictions that keep wages high in recessions. As a result, demand for workers goes down.

Not so in the world of general equilibrium economic models. There, wages rise and fall with the fate of the economy. In a recession, wages fall and people simply choose to work less. The technical term is the household “labor-leisure tradeoff.” People work less because they supply less labor to the economy.

Most people, of course, would argue that when wages fall you have to work more to make up the gap. That intuition can’t be true in an economic equilibrium, which is what the models are trying to capture; hence the discrepancy between models and the real world.

Not all models are created equal

So how then do economic modelers estimate employment impacts?

First, not all models are of the “general equilibrium” type that have the full-employment assumption built into them. For example, the Department of Energy’s Energy Information Administration relies on a macroeconomic model called National Energy Modeling System (NEMS), which has a different structure. Partly as a result, the NEMS model does produce employment estimates.

Second, you sometimes see even general equilibrium models being used to derive numbers on jobs. In those cases, however, the jobs impacts are computed after the fact: the modelers take the estimated effects on output and then back out employment impacts using rather arbitrary rules of thumb that assume a high degree of friction in labor markets even over long periods of time, often decades. This is problematic, to say the least, because it goes directly against the grain of the underlying models used to produce those results.

The Peterson Institute study mentioned in our last post, which uses the NEMS model, is in the first camp. It is also among the first to take a more realistic look at the jobs impacts of climate policy given the current recession. Not surprisingly, it comes up with a very different answer on the jobs question.

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