Saturday, May 2, 2009

Global Warming And Cap And Trade Markets Are Not Like Other Markets

Global warming trading markets are not identical to a typical goods, commodities, equity or debt trading market. A US Cap and Trade market in CO2 must overcome several, not so easily resolved, problems.

While all trading markets that have regulatory oversight will have some distortions due to their governing regulatory process, the costs of market distortions and failure of a trading market intended to protect the continuing habitability of our planet are potentially more devastating than failures in other pricing markets. The result of one is inhabitability of the planet versus the investors' wealth losses result of the other.

Arbitrage is a part of all trading markets. It occurs not just in identical goods in different markets, but also in equivalent and substitutable goods. Additionally, there is the potential for regulatory arbitrage.

Some and certainly not all of the known problems needing solution for a successful US Cap and Trade market in CO2 are:

Imported Goods

Identical and substitutable products produced outside of the US and sold in the US must have identical or higher greenhouse gas pricing per unit of greenhouse gas emission as US produced products. Otherwise, the US buyer (industrial, government or consumer) will substitute the cheaper foreign produced goods with a higher greenhouse gas emission than US produced goods, and worldwide greenhouse gas emissions will increase.

Process Substitution

The pricing in a cap and trade market may create undesirable substitution into other greenhouse gases so that the result is a greater global warming effect. For example, methane is about 25 times more potent than CO2 in its global warming effect. If the total cost of substituting into a methane emission process is not at least 25 times greater than the costs to obtain a CO2 permit purchased in a Cap and Trade system, a producer of CO2 could cost effectively substitute a methane process. However, there will be no reduction in the effect of global warming greenhouse gases and there might even be an increase in a detrimental effect. Since the market will determine the permit prices, how do we prevent economically beneficial substitutions that hurt the climate?

Producers will continue to look for processes than emit gases that are believed neutral for global warming based on our current knowledge and that do not need a Cap and Trade permit. Of course, scientific knowledge is always expanding and changing. These alternative emissions may be discovered subsequently to be detrimental to global warming or other as potentially harmful climate effects. In other words, we may reduce CO2 but not global warming or climate harm. This is a societal benefit, proxy mismeasurement problem.

Permits As Investments

Any Cap and Trade system must not interfere with process innovations that decrease CO2 (and other greenhouse gas) output. In other words, producers of some particular goods may have no incentive to invest in new equipment that will lower greenhouse gas emissions because all the manufacturers of those goods will see a wealth loss in their permits greater than the cost savings and benefits of the new lower greenhouse process.

Price Increases

It is likely, but not certain, that the additional cost of purchasing a permit in Cap and Trade will increase prices to buyers of the produced goods. Price increases are not certain because competition does not always allow production cost increases to be passed on to buyers. If the industry cannot achieve pricing that allows for a fair return on its investment, the industry will disinvest and eventually go out of business. However, if the price is increased, competitors with alternative lower greenhouse gas emission, equivalent processes and products will see an opportunity to enter the business whereas before the additional costs of Cap and Trade, the lower pricing did not give these new competitors an economic incentive to enter the business. It is uncertain how government will respond to a price increase or to industry competition. Based on the likely political effects of a price increase, especially if it is significant, politicians will chastise the industry and call for it to lower prices or as likely, the politicians will enact price controls. Both could be detrimental to the survivability of the particular industry. Another potential political outcome could be that the industry with a high cost cap and trade permits may not be competitive against a new competitor that either does not need a permit or can produce at a lower level of greenhouse gas emission. Will we see a replay of the current auto industry crisis in a different industry and how will the politicians respond? Will the political reaction ensure the continuation of a high level of greenhouse gas output?

Incentive to Decrease CO2

Since Cap and Trade fixes the amount of unwanted emissions output, how will we allow for innovations that decrease detrimental emissions over time that matches industries' abilities to innovate without negatively affecting output? Will a fixed allowable amount of CO2 and other greenhouse gases distort and remove the incentives for process innovations that lower CO2 and other greenhouse gas emissions?

Alternative Energy

Will the US allow investment into alternative processes that lower greenhouse gas emissions but have other practical and political problems, such as nuclear energy, wind energy in the visual landscape, etc.? Won't permit prices have an additional price volatility related to changes in potential government energy policies?

Permit Price Volatility

How will industry respond to the normal Cap and Trade permit price volatility that exists in all trading markets? Will the volatility have unwanted effects?


Will industry use hedges to offset changes in permit prices and will government desired outcomes be different with hedging than without hedging?

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