Monday, May 18, 2009

Krugman Misses the Point on Waxman-Markey

A careful reading of the latest column by Paul Krugman shows that he doesn’t see what the problem is with the climate change bill now on its way to the House floor. He defends the concept of a cap relative to a tax, which is fine with me. (Jim Hansen, who is a hero in climate science but not a specialist on the economics front, has only muddied the waters by raising this complaint.) He laments the giveaways in Waxman-Markey, but agrees with me that they can be remedied by moving toward full auction in the future. What never makes an appearance, however, is the problem that Waxman-Markey caps individual uses of carbon fuels one sector at a time, and this is not fixable without overhauling the whole approach. What’s wrong with the W-M model? Let me count the ways:

1. The ability to achieve carbon targets depends on the coverage of the program. W-M starts with limited coverage (few sectors capped) and then sets up a protracted battle for extending cap-and-trade to more sectors in the years to come. In spite of timetables written into the bill, you can be sure that each extension will be fought over; there will always be a reason (amplified by lobbying largesse) to postpone bringing in new parts of the economy.

2. Once you have agreed to a sectoral approach, and once you start handing out carbon permits to everyone on the receiving line, you get to haggle over each sector’s carbon budget. There is always a reason to make your sector’s emission reduction target a little lower than the next guy’s.

3. Contrary to what Krugman claims, verifying the actual carbon emissions of each sector is herculean and quite likely to fail.

4. The experience of the European Trading System, which W-M emulates, confirms all these predictions; it has been a disaster. Fixing it, and fixing a future system along the same lines in the US, will mean scrapping it and starting over.

The irony is that there is a much simpler, much more effective alternative: put a limit on the amount of carbon fuels available to the economy by requiring a permit to extract or import them. Coverage is complete, there is a single, economy-wide target, and verification is a snap. There is little opportunity under such a system for businesses to offer or politicians to demand favors for loopholes and special-interest tweaks. Maybe that’s why it’s not on the table.


TheTrucker said...

The lack of political Tom Foolery is exactly why it will not be done in the more straight forward manner you propose. The effort of educating the public to the economics and the fairness, elegance, and effectiveness of an "excise tax" approach (you can dress it up in carbon permits all you will and it is still an excise (punitive) tax) is only a small part of the problem. Because even if the voters are educated and understand the ramifications, the payola system of government will still prevail. Campaign funds are a very big part of what keeps the Congressional people and their respective parties in their seats of power. The dynamic duo will always find some "hot button" issues of distraction on which to pin the outcome of elections. All the real issues will be a raft of scientific counterclaims or just ignored while we focus on Gay Marriage, gun control, and bank bailouts.

Gar Lipow said...

I think you are too tolerant of giveaways vs. auction.

1) Not in practice seperable from the downstream sectorial caps you lament. How can you target your giveaways unless your caps are downstream? If the permits were required upstream, then the only sector you could give large amounts to would be the fossil fuel producers and importers. (With maybe secondary giveaways to industry for F5 and Portland cement.).

2) Giving away a large percentage of permits increases volatility by removing a percent of steady demand from the market. (That it removes equal supply does not prevent remaining ratio of demand to supply from being more volatile than if everything was auctioned.)

Also one other problem - the huge amounts of offsets. And for various reasons, in spite the language about them being varifiable, additional and permanent, the types of offsets in two cases cannot meet those requirements, and in the third are politically unlikely to do so. So the offsets further reduce any emissions reductions from this bill.

Peter Dorman said...

Gar, I'm still missing your argument about giveaways and demand, although I agree that there is a synergistic negative impact of having both downstream capping and giveaways. (You could have giveaways with upstream capping by handing permits to, say, electrical utilities that they could use to purchase fuel inputs at lower cost.)

You are right that the offsets are another horror of W-M, although in principle they too are on a continuum, and you could ramp them down. There is no ramping down the wrong choice of where to require permits in the first place.

Gar Lipow said...

I guess the combination of giveaways with upstream capping would take place as follows: fossil fuel company needs permit. Electric utility has permit. So Utility buys fuel with combination of money and permit thus saving fossil fuel company from having to buy permit, and letting them charage a lower price.

OK, but then it becomes very obvious what you are doing. The whole point of giveways is to provide subsidies without it being obvious that this is what you are doing. It may be something you can model, but politics of giveways pretty much require the real large permit giveaways go to someone who would otherwise have to buy permits. In other words giving away permits is always a political decision. The same politics that motivate giving permits rather than auctioning and then providing a cash subsidy of equal value, also require assigning caps in such a way that those getting the free permits also need permits to continue doing business.

I'll do a second comment on the effect of giveaways on demand.

Gar Lipow said...

OK, how large giveaways contribute to volatility.
You can find details at:

However briefly:

Your local icecream stand has only two customers, one who buys 1 ice cream daily, another who buys daily a random number of ice creams between 1 and 3. Remove that steady customer from your (failing) business, and reduce the ice cream stand's order by one icecream a day. The remaining business will be more volatile. Even though you cut the supply of ice cream by an amount equal to demand reduction, volatility has increased.

With steady customer and volatile customer


Same order from volatile custome with no stead customer 1,2,3

So 2,3,4 high Ratio of high to low demand=2 to 1

Or 1,2,3
Ratio of high to low demand =3 to 1.

And minimu demand was 2, now minimum demand is 1

Removing the steady customer increases volatility, and also ensure a lower bottom to the market.

Peter Dorman said...

Aha, now I get it. The assumption is that only the auctioned permits trade; the giveaways don't. So you end up with a thinner, more volatile market. (No need to assume any behavior differences between those who bid and those who just get.) The usual assumption in these things is the opposite, however, that there will be a robust secondary market in permits, so the initial giveaways will not affect volatility. I don't know how much secondary trading there is in the ETS; this is an empirical question.

This issue affects only price volatility and not emissions, since emissions are capped -- assuming perfect enforcement, no offsets, etc.

Shag from Brookline said...

Does it make any difference what ice cream flavors are offered? said...


I am more open to your idea than I was before. May be easier to monitor. Also, agree that the cap and trade should be across sectors, not a bunch of divvied up sectoral markets. What a mess.

However, I do not think there is any reason to believe that given away permits are not tradeable. Were not the permits given away at the beginning of the relatively successful SO2 system? They have certainly been traded since.

BTW, hi Gar, long time no hear, :-)

Gar W. Lipow said...

>The assumption is that only the auctioned permits trade; the giveaways don't.

No the assumption is only that SOME Giveaways don't trade. If 100% of permits given away trade then it makes no difference to volatility. But surly some will be kept. Power companies, for example, are not going to sell all their permits in the early years. Half of U.S. power comes from coal. Much of the rest comes from natural gas. A trickle (in really exceptional circumstances) still comes from oil. Certainly not every bit of that fossil fuel power will be phased out overnight. So when the electric company is given a bunch of free permits, sure they will make some inexpensive reductions and sell some of the permits. But they will kepp some of them.
And what my long post argues is that even holding to a small percentage of the permits given away increase volatility. For exampl, WM gives away 80% of permits. It is not unreasonable to think that less than a third of that 80% (amounting to 25% of all permits) will be kept and not resold. And that is enough to affect volatility.

And Peter the point about it affect volatility but not emissions is formally true but practically wrong if the cap is a tightening one. All the caps in the world don't do any good if not enforced. A widely disobeyed cap is more likely to be modified than enforced. Extreme volatility especially volatility that encourages price dips, discourages capital investment in the first phase. Low capital investment in the first phase makes it likely that when a second phase kicks and in and the cap tightens, that it won't be compled with and be modified in response.

This is exactly what happened in the RECLAIM disaster in Southern California. Giveaways led to volatility and extreme price dips during the first phase. No one made capital investments. Everyone assumed that in the second phase they could buy credits at a price higher than the current price but sill not high. In short, everbody assumed everyone else would save emissions on their behalf.

When the cap tightened it turned out out that no one could comply. New command & control regs were put in place, companies were given an extension to comply. So volatility can have real consequences.