Gaming Cap and Trade: Should We Worry?

Worries about “gaming” or market manipulation sometimes crop up as an objection to cap and trade, often with reference to recent shenanigans in the financial markets. Some fear that a cap-and-trade system could be manipulated to artificially raise—or lower—permit prices to generate profits for a few at the expense of consumers. While distrust and concerns about scamming a carbon market are understandable, they’re not warranted.

To put some of these fears to rest, it’s informative to look at existing cap-and-trade programs. Neither of the two programs regulating greenhouse gases nor a third controlling acid rain pollutants has been corrupted by gaming or market manipulation.

The European Union’s Emissions Trading Scheme (ETS) was the world’s first cap-and-trade program restricting carbon dioxide releases when it started in 2005. The system has succeeded in creating a Europe-wide carbon market and trading program. There have been hiccups in the ETS, including an initial overallocation of allowances to polluters and some price volatility. Yet the problems are fixable and are already being addressed as the program evolves. The challenges are not attributable to a fundamental flaw in the policy or to lack of regulatory oversight. And the market has grown more robust as the number of traders has increased, making price manipulation difficult. Partly thanks to the ETS, the EU is on track to meet its emissions reduction obligations under the Kyoto Protocol.

The Regional Greenhouse Gas Initiative (RGGI), with a membership of 10 Northeastern and Mid-Atlantic states, held its first auctions in September 2008. Additional auctions are scheduled. While still in its early days, RGGI appears to be off to a good start, with low permit prices and no evidence of gaming.

The US Acid Rain Program has a track record dating to 1995. The program regulating power plants has exceeded expectations, beating the SO2 emissions cap years ahead of schedule and costing only one-fourth of what was expected. After more than a decade, analysts have concluded that the SO2 cap-and-trade program has also been free of gaming.

In short, cap-and-trade programs are already up and running with no evidence of sinister manipulation. That’s no surprise to specialists who study markets.

The very nature of carbon permit markets makes them hard to game, unlike California’s “spot” electricity market, and not terribly prone to speculative bubbles, unlike real estate and subprime mortgages. Mortgages and pollution permits are very different commodities; a mortgage is a promise to pay a debt—a promise that a mortgage holder may not be able to keep—while a carbon permit is an allowance to emit fixed quantities of pollution. Carbon markets are not like “spot” power markets either, in part because electricity must be supplied immediately to consumers, while firms need permits to cover their emissions at most only once a year, eliminating the urgency to acquire them at any particular time.

In a poorly designed cap-and-trade program, traders might try to hoard permits and manipulate prices to harm consumers. Yet commonsense rules of the road can address the gravest concerns. To minimize price volatility, authorities can ensure transparency about prices and the number of permits available, both at auction and on secondary markets where permits are traded. Authorities can also restrict the share of permits that any single entity can hold, to perhaps a few percent of the total permits in circulation for any year.

Other particulars of market design also help. The larger the permit-trading market and the more linked it is with other cap-and-trade systems, the more stable prices will be. Making permits perpetually bankable also stabilizes prices. For example, a hydro-dependent utility can use banking to accumulate a cushion of permits for use in an unexpected December cold snap during a “low-water” year, when the utility must generate (or import) more coal-fired power. Opening auctions to all bidders with adequate financial reserves, conducting auctions frequently and early, and limiting the number of permits any one actor may hold—all these things will keep prices stable and prevent market manipulation.

There are also built-in disincentives for manipulation. The public doesn’t want it because it could raise power bills, and the market participants themselves, the polluting firms, don’t want to pay more to pollute. Both provide strong motivations for keeping the system honest. As with any policy, a cap-and-trade system’s success will ultimately depend on oversight and vigorous public institutions. But there is every reason to believe that a well-crafted and -regulated system for auctioning and trading carbon permits can function smoothly and cost-effectively.

This blog post comes directly from Sightline’s Cap and Trade 101: A Federal Climate Policy Primer (pdf). Please see the full primer for more details, including endnotes that elaborate on  some of the points above.