Waxman-Markey: Unintended Consequences of the Auction Reserve Price

A marked-up version of the American Clean Energy and Security Act of 2009 passed out of the House Committee on Energy and Commerce on May 21, 2009 as H.R. 2454.

The revised draft bill is 932 pages and covers a broad range of big-picture energy issues, including energy efficiency, renewable energy, and a federal cap-and-trade program to reduce greenhouse gas emissions.

In this short comment, we focus on the cap-and-trade part of the Waxman-Markey bill. In particular, we consider the implication of the auction price provision in Section 791 (d), which imposes a minimum price for auctioned allowances of $10 in 2012, escalating by the rate of inflation plus 5% per annum.

We argue that the minimum auction reserve price functions as a parameter that sets the effective reserve price, which in turn is determined by a no-arbitrage condition. This condition depends critically on the market's beliefs about the stability of the program and many other factors. The impact of the approach is to increase carbon prices and provide larger windfalls to those who are given allowances in early years. The provision essentially turns the cap and trade system into a complex carbon tax. Unfortunately price certainty is lost to a large degree, since the effective price depends heavily on beliefs about government actions and technological progress in future years.

Price certainty would be improved if the 5% escalation rate is reduced to a level equal or lower than the real risk-free rate on comparable assets. Thus, an improvement, although potentially difficult politically, would be to raise the initial reserve above $10 and reduce the 5% escalator to achieve the same price path with less risk of price arbitrage.

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