The recent spate of hearings in the Energy and Natural Resources Committee and those planned this week for Environment and Public Works Committee signal the Senate’s re-engagement on comprehensive climate legislation. Surely, one of the front-and-center issues will be the higher energy prices resulting from a cap-and-trade program for greenhouse gases (GHGs). The magnitude of the energy price increase is directly linked to the price of GHG allowances—the permits firms must have to emit GHGs—, which in turn depends on the severity of the cap. Generally, the more strict the cap, the greater the allowance price and therefore the greater the energy price increase.
Clearly, higher energy prices are politically undesirable and therefore some legislators are likely to argue for weaker early-year emission caps than those in the Senate’s Kerry-Boxer bill. But would weaker caps in, for example, the first decade of a program actually lower allowance prices?
Like far too many questions in economics, the answer is maybe. The logic behind the answer has to do with banking of allowances and expectations of future allowance prices.
Kerry-Boxer grants emitters the right to bank allowances. An emitter of can buy allowances when the program begins, hold on to them indefinitely, and use them for compliance purposes at any point in the future.
Why would an emitter do this? The emitter may expect the cost of reducing future emissions (reflected in allowance price) to be very high due to tight future caps. If the emitter expects the allowances price to rise faster than the rate of return the emitter can earn on its capital, the emitter will save a portion of the allowances it purchases or is given today, and use them in the future, thereby profiting on the rise in the allowance price.
This savings is precisely the behavior one sees in analyses of the House’s Waxman-Markey (America’s Clean Energy and Security Act) by both The Environmental Protection Agency and Energy Information Administration where emitters build up a very large bank of allowances. Since they are not using the allowances for compliance, they actually reduce their emissions by an amount greater than that called for by the cap—termed over compliance. This over compliance results in allowance prices greater than they would be if emitters simply complied with the year-by-year caps.
If all emitters have the same and accurate expectations about future compliance costs, the price of allowances will rise at the rate of interest. Again, this is exactly what you see in the EPA and EIA analyses.
Now suppose you weaken the early-year emissions caps, but future caps remain unchanged. If expectations of future compliance cost are unchanged, the weaker caps simply lead to an even larger bank and greater over compliance, and allowance prices generally will not decline. Thus, weakening the early period caps seemingly does not make allowances cheaper and therefore will not dampen the resulting energy price increases.
Why, then, did I say the answer is maybe when I just argued above that the answer is no? Because we are not sure that real emitters act as the models assume. Emitters in the models, 1) have perfect foresight, i.e., they know what the future holds with respect to the cost reducing emissions, 2) are long-run maximizers, i.e., will sacrifice short-term gains in favor of larger long-term gains, and 3) all share the same rate of return on capital that is equal to the rate of interest in the model.
Obviously, in the real world the future is not known and everyone must guess. Those guessing that future compliance costs will be high will be savers, those expecting technology breakthroughs to lower cost will use their allowances now. As the recent recession has demonstrated, not all (perhaps none) of the emitters may be long-run maximizers, choosing instead to focus on near term gains, in which case they will be less likely to bank allowances for use in the future. Finally, emitters may have investment hurdle rates (the rate of return they require on capital) that differ from emitter to emitter. Those with lower hurdle rates will bank; those with higher rates may not.
So, if you believe in the assumptions of the models, weakening near term caps is unlikely to lower the near term price increase in energy. However, if you reject those assumptions, one can argue that weakened near term targets will dampen energy price increases.
Of course, none of this touches on the important issue of short-run price volatility in the allowance market which can lead to short run spikes in energy prices. This too is liable to be of considerable concern to senators as they consider climate and energy legislation.
Raymond J. Kopp is a senior fellow and director of Resources for the Future’s Climate Policy Program.
