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Mason: EU Cap-and-Trade System Provides Cautionary Tale

In the past several months, energy and climate discussions have taken center stage on Capitol Hill with lawmakers scrambling to meet the aggressive deadlines they’ve announced for cap-and-trade legislation. Top House and Senate Democrats agree that it’s imperative they pass climate change legislation. However, our nation’s leaders must also recognize the importance of taking the steps necessary to review proposed policies with a critical eye.

[IMGCAP(1)]In order to successfully mitigate the effects of global warming, the White House and Congress must first assess the ability of government policy, regulator responsibility and market mechanisms to deliver a stable carbon price. Stability and predictability are critical to success. If U.S. businesses and consumers aren’t able to predict carbon prices with a reasonable degree of confidence well ahead of time, there’s little incentive to invest in new technologies or to switch to more energy-efficient products and services.

Any analysis should start by looking abroad. The European Union carbon market demonstrates serious problems with price stability under a cap-and-trade policy. In Europe, unscrupulous companies and hedge funds have been cashing in ETS carbon credits — valuable allowances that the government gave them for free. As a result, the price of carbon has dropped almost 75 percent in recent months to the lowest prices on record. And volatility has spiked to levels only seen in May 2005, when the EU’s first annual official report confirmed a 45-million-ton surplus of carbon allocations over actual carbon emissions for the year.

Then, as now, lower carbon prices led to a tail-off in clean-technology offset projects, diluting the policy’s main purpose: to encourage investment in low-carbon technology.

In a report titled “The Economic Policy Risks of Cap and Trade Markets for Carbon Emissions— set for release later this month, I demonstrate that the reason for Europe’s price dynamics lies in the difficulty of engineering and managing the market for carbon permits, which is arguably more difficult than managing a central bank. Like managing the money supply in central banking, it is hard to identify the equilibrium of “contract demand— and “contract supply.— Furthermore, some “contract demand— function will ultimately result in a long-term effect on economic growth, but identifying the channel through which that dynamic operates is extremely difficult.

Consequently, establishing targets and tools to manage the process in order to encourage growth — but not a bubble — will be, as with central banks, an imperfect process. And this method is likely to cause economic disruptions along the way. Given all of these parallels to Central Bank policy, manipulating carbon values will probably wind up causing booms and busts — the kind of volatile cycle that helped cause the current economic crisis.

There’s more. The auctioning procedure (and later the secondary markets in the emission rights exchanges) are open to all bidders, including institutional investors, pension and hedge funds, state funds, etc. This open market increases the likelihood for purely speculative price formation in the market. The securitization of carbon allowances turns them into financial products that can be sold directly or wrapped in innovative financial packages — just as Wall Street did to the subprime mortgages. The EU carbon market has already seen the development of securitized products far more complex than those that helped cause the mortgage crisis.

Even more so than mortgages, however, the value of carbon dioxide contracts is driven not only by fundamentals but also strongly by regulatory and political factors. Hence, the unsettling similarities between the structured finance products that carbon traders are designing right now and the mortgage-backed securities that brought our financial system to its knees are striking.

As demonstrated by the EU system and the U.S. subprime housing market, the reality of an opaque, complex trading system like a cap-and-trade scheme — fraught with corruption, manipulation, noncompliance and mismanagement — is this: high profits for Wall Street/market traders, high energy prices for consumers and negligible carbon reduction for the environment. The fundamental fact is that our ability to engineer markets, whether they’re markets for central bank reserves or for mortgages, has recently been jarringly put into perspective.

Central banks can no more tame business cycles than a carbon market efficiency board can tame emissions. Unlike business cycles, however, we have choices of how to approach emissions. In contrast to carbon market experiments, a simple carbon tax is transparent, predictable and easy to administer.

A carbon tax would secure funding for low-carbon technology regardless of the market conditions. Additionally, the revenue generated by a carbon tax could be given back to the American people. Let’s really cut emissions, and let’s not experiment with American economic growth any more than we have to.

Dr. Joseph R. Mason is Hermann Moyse Jr./Louisiana Bankers Association endowed professor of banking at Louisiana State University. He is the author of an upcoming study on the market risks of the cap-and-trade system being debated in the Senate.