Aug 2, 2009, for the National Journal In “Safety Valves Are Very Dangerous,” Environmental Defense tells us “The safety valve [a price ceiling] uses price controls to ‘bust the cap’.” This argument attacks a straw man—the real policy to argue with is a collar. Its ceiling weakens the cap, but its floor adds strength, so together they need not “bust the cap” at all.
But let’s pursue the idea of a price ceiling “busting the cap.” This assumes we have a cap to bust and that the cap is indestructible. In that case, adding a price ceiling can only result in more emissions—busting the cap. True enough. But what if a ceiling helped with passing a stronger cap or, after passage, protected the cap from political backlash? Looking into this tradeoff—perfect capping vs. acceptance and durability—shows that it pays to limit risk. But could there be a better way? A check of proposed alternatives shows that a collar is the sensible approach.
Risk Is a Cost. First, consider the tradeoff. Suppose the public is willing to spend up to a certain amount on climate security. Call that amount $100. If one climate bill costs $95 for sure, and another bill costs an expected $80—plus or minus $50—it’s quite likely the public will avoid the risky one and choose the sure $95 cost. That cost is acceptable. Taking a chance on a $130 cost ($80 plus $50) is beyond the public’s willingness to pay. The $95 climate bill is like a cap with the tightest price collar and pre-determined prices. The risky bill is like a cap with no collar and untamed prices.
Now which bill would give us the more effective cap? The $95 climate bill wins on three counts. First, it spends $15 more on average than the $80 bill. Second, if carbon reduction is unexpectedly costly, so that the $80-plus-or-minus bill turns out to be a $130 bill, it will likely be reined in or scuttled. Third, the risky bill imposes more risks on investors as well as on the public. This delays investment because risky investments cost more, and because uncertain prices confer an option value on waiting to invest.
The $95 bill with the collar is more politically acceptable and stronger. By looking at only one side of the issue, environmentalists have accidentally picked the weaker approach to designing a cap. In short, the more risk you attach to an abatement plan, the less abatement the public will buy and the slower investors respond. Even a ceiling strengthens a cap. Combining that with an equally strong floor makes a collar that’s all upside.
Waxman-Markey. Now, turn from theory to practice. In the House bill, we find (1) domestic offsets, (2) foreign offsets, (3) a strategic allowance reserve, (4) allowances being sold in advance, (5) banking, (6) borrowing, and (7) a price floor. Each serves only to reduce price risk. With a price collar, the first four could be eliminated.
Does this complexity provide some advantage compared with a collar?
The best first step for reducing risk is generally agreed to be some form of banking and borrowing. That’s a help, but the E.U.’s carbon market, with full banking, has three times the volatility of the S&P500. Banking relieves short-term supply-and-demand problems, but it turns carbon pricing into a guessing game about emission abatement costs in the distant future. And that will lead to volatility.
