Watermark Economics Blog

Waxman-Markey: Unintended Consequences of the Auction Reserve Price

2009-06-11T12:53:00.005-04:00

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.

To read the full article, click here.

Waxman-Markey Math: What are the numbers and what might they mean?

2009-05-27T12:36:00.009-04:00

A marked-up version of the American Clean Energy and Security Act of 2009 initially released in April 2009 and revised in mid-May (a/k/a the Waxman-Markey draft bill) passed out of the House Committee on Energy and Commerce on May 21, 2009.

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 numbers in the current draft to see what they are, as a starting point for thinking more deeply later about what they might mean for capital, carbon, energy, and related markets.

We consider the minimum carbon prices in the Waxman-Markey bill, and we use them to estimate the minimum value of freely-allocated allowances in the aggregate and to individual industry sectors. We give particular attention to the electric power sector, estimating the minimum value of its free allocations and the minimum cost of purchasing the additional allowances it will need to cover its likely emissions.

The ultimate impacts of a Waxman-Markey style cap-and-trade program depend on many factors beyond the numbers in the draft bill, so we do not project them here. However, the numbers indicate one of the most critical factors will be the collective public and political will for the US to see-through such a program once the costs kick in. Without that will, forecasting carbon impacts based on economic and market fundamentals may generate the wrong projections, and the credibility of the entire program may be at risk.

To read the full article, click here. For the graphs and tables, click here.

A Serious Flaw in the Waxman‐Markey Discussion Draft

2009-04-17T15:26:00.005-04:00

The draft version of the American Clean Energy and Security Act of 2009 released in early
April (the Waxman‐Markey discussion draft) is emerging as the focal point of the US climate
change discussion at the federal level. The draft bill covers a wide range of topics. This
comment focuses on one aspect of the draft bill, namely the handling of existing regional
programs, particularly the Regional Greenhouse Gas Initiative (RGGI) covering much of the
Northeast.

The current proposal allows the conversion of RGGI allowances into federal allowances in a
way that RGGI bidders face no risk from paying too high a price for an allowance. This would
create strong incentives for speculative bidding that would push the RGGI price much higher
than its economic value. Such a price distortion would also negatively impact the federal
cap‐and‐trade program.

The draft approach is readily fixed by limiting the exchange rate of RGGI allowances for
federal allowances to 1‐to‐1. Without such a limit, price distortions in the RGGI program
would be unacceptably large.

To read the full article, click here.

Allocation of Permits would likely make cutting GHG emissions more expensive

2009-04-17T11:45:00.004-04:00

As climate legislation once again gains prominence in the US Congress, so does the question of auctioning versus allocating emission allowances. President Obama’s budget proposal calls for 100‐percent auctioning while proposals by USCAP and others call for mostly allocation. The current Waxman‐Markey draft bill is silent on the issue.

Outside a narrow range of circumstances, free allocation of allowances, especially to electric power generators and integrated utilities, would lower the efficiency of cap‐and‐trade and likely produce windfall profits for some companies at the expense of consumers. Free allocation to regulated electric utilities would dilute the consumer price signal needed to stimulate not only direct reductions in energy use, but also investment and innovation in end‐use efficiency improvement. This runs counter to the widespread agreement that energy efficiency improvements will need to play a major role in combating climate change risk. Full auctioning of allowances may increase the cost of capital of regulated utilities. But that is more a feature of cap‐and‐trade induced volatility than of auction versus allocation, and it is likely less important than the demand effect.

As the European experience has shown, free allocation to non‐regulated electric utilities will, in most cases, lead to windfall profits and a corresponding tax on consumers, the revenues of which get sent to the shareholders of those companies. In narrow cases, an argument for allocation can be made to avoid emissions (and job) leakage and to potentially compensate non‐regulated emitters constrained by existing longterm contracts from passing on carbon costs. However, in the former case, the use of import tariffs would be more appropriate than simply allocating allowances.

All in all, any carbon cap and trade regime should be based on the principle of auctioning and only deviate under exceptional circumstances. Allocation of allowances will not only redistribute wealth (away from consumers), it would also likely make any carbon market less efficient and therefore raise the cost of lowering our greenhouse gas emissions.

To read the full article, click here.

What carbon risk disclosure will (and will not) mean

2009-04-15T17:51:00.006-04:00

Carbon risk is here. So where is carbon risk disclosure?

Whether they like it or not, U.S. companies and investors are starting to accept the reality of carbon constraints. Whether as a result of a new carbon tax, the establishment of a US carbon market, or $140 per-barrel oil sparking a free-market shift toward energy efficiency and renewable energy, the fact is clear: the things we do that emit carbon are about to get more expensive – maybe a lot more.

In practice, will the kind of disclosure we are likely to get matter? Yes, but not as you might expect. This shift will result in a significant redistribution of wealth and capital, effectively creating carbon winners and losers. It is already happening in capital markets, where private equity and venture capital is placing billions of dollars in bets on clean tech startups while established companies are greening-up to convince stakeholders they won’t become a carbon casualty.

But capitalizing on carbon requires a particularly scarce resource: reliable information about a company’s carbon risk profile – the extent to which its performance may be affected by carbon-related market or policy changes.

Carbon risk disclosure has progressed at a glacial pace until now. But the recent financial meltdown and carbon’s elevated profile in policy and investment decisions have intensified the call for more disclosure. The rules on the books already cover carbon and just need to be invoked. Companies that fail to adequately consider and disclose such risks are putting themselves at significant additional risk of significant losses and costly lawsuits.

Carbon risk disclosure will definitely yield more information, but not necessarily better information. But the mere prospect of heightened carbon disclosure requirements is forcing US companies to focus much more on, and to manage much more effectively, carbon-related risks and opportunities. Those who don’t will pay a much higher price than the price of carbon, courtesy of the market and the plaintiffs’ bar. Those with the best informed view of carbon’s long-term impact will outperform the competition and will attract more capital on better terms.

But stakeholders won’t simply be handed detailed information for make-or-break investment decisions. Investors still have to develop their own forward look incorporating what little new information companies are required to disclose. As it should be. If investors want to realize the returns from forecasting carbon correctly, they should actually have to do the work. Carbon disclosure will not provide the answers; it will just help answer some of the questions.

To read the full article click here.

Cap and Trade versus Tax Debate focuses on wrong issues

2009-04-15T17:46:00.002-04:00

Even though cap and trade seems to be the leading contender for any US climate change legislation, there is an active debate about the merits of cap and trade versus a carbon tax. Unfortunately, the debate draws false distinctions between the two approaches to regulating greenhouse gas emissions and, by doing so, by and large omits a discussion of the real issues separating the two approaches.

In particular, most c&t versus carbon tax discussions focus on the revenue aspect of one or the other. Advocates of a cap and trade approach claim that you can never pass a tax increase such as a carbon tax. The quick response to the $80 billion of revenues included in President Obama's budget proposal from auctioning carbon allowances under cap and trade has however shown that cap and trade also imposes a tax. In both cases, however, the emphasis on tax revenues as opposed to the price signal set by each approach creates a) a false dichotomy and b) diverts attention from the real issue. Either system will potentially raise large amounts of revenues with many competing potential uses. However, the decision of what to do with carbon tax revenues or allowance auction revenues, while important, has little to do with effective climate policy. For climate change, what really matters is what price signal is being set, and cap and trade and carbon tax are largely equivalent there. The political conumdrum is that the hundreds of billions of dollars that will be generated as tax or auction revenues are too tempting a pile of money to ignore, even though the attempts by politicians to hold on to that money will make it much harder to get climate legislation passed - since the result will indeed be a substantial carbon "tax" on consumers.

It would be much smarter to basically refund all the revenues, either through "cap and dividend" or through a carbon "untax" as proposed by Steven Stoft (www.stoft.com) and others. Refunding the revenues will significantly reduce the "cost" of lowering carbon emissions at any carbon price (whether a tax or an allowance price resulting under c&t).

To read the full article click here.