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Shapiro: Don’t Regulate Energy Market

There’s a certain irony in the recent push to apply stricter regulation to commodity and other financial markets — just as we’re contemplating creating new markets that are even harder to regulate.

To an economist — and political observer — the effort in certain respects amounts to taking a step forward on a path that circles back around to where we started. Even as our lawmakers try to rein in Wall Street some, they’ve simultaneously been advancing cap-and-trade legislation that would create a new, highly complex, opaque and volatile market for around a trillion dollars in new financial instruments. And that’s not counting their inevitable derivatives.

Once linked to global markets also trading emission permits — as its advocates support — this new market would dwarf most other areas of commodity trading. And because the commodity to be traded — energy, through the emissions it produces — is so fundamental to economic activity, the economy would have a big stake in how this new market behaves. Further, the prices set and traded for permits in this market would inevitably and unavoidably be very volatile, while additional trading in derivatives could threaten the market’s ability to deliver its primary objective: a fair (if not stable) price for emissions.

These are all dynamics that resemble much too closely for comfort those that helped to bring about last year’s financial market meltdown.

The Waxman-Markey bill, the House version of this scheme, passed by a single vote. This narrow margin suggests how tentative support for a cap-and-trade approach still is, despite some of the most extensive lobbying efforts and political horse-trading in recent memory. In fact some major environmental groups such as Friends of the Earth and the Environmental Justice Campaign actually oppose the bill, because they don’t believe its convoluted scheme can deliver either the emissions reductions our planet needs or economic stability.

They also know that putting a national emissions trading program into real-life practice could be a very drawn-out process. It could take years to establish the new markets for trading carbon permits and bring regulators up to speed. These problems also could be exacerbated by the scheme’s complexity and the public’s consequently limited understanding, which may produce resistance when the scheme leaves people’s energy prices more volatile as well as higher. Additionally, the House-passed bill gives away 85 percent of the initial carbon permits to special interests, making it one of the biggest pork-barrel bills in our history.

Still, the biggest drawback of the bill is the weakness of its response to the climate crisis.

On top of the giveaways, the price volatility — which economists warn is inevitable under a cap-and-trade system — will undermine the incentives for businesses and households to invest in the new low-carbon technologies. In the first three years of the European Union’s cap-and-trade system, its permit prices moved up or down by an average of 20 percent per month. Combined with the existing volatility in energy prices driven by international supply and demand, a U.S. emissions trading program will make it virtually impossible to reasonably predict prices, undermining future investments based on some expectations about the future price of carbon.

This volatility is built into the bones of cap-and-trade. Because the price of carbon and the permits to emit it will move with the relationship between energy demand and the supply of permits, inevitable developments such as faster or slower growth than anticipated, unexpected weather shifts, geopolitical tensions and natural disasters all will move those prices up or down. As a consequence, these permits would soon give rise to widespread speculation, since speculators make their money off the sudden shifts in price that are inherent to a cap-and-trade system.

Volatility in prices also further opens the scheme to financial abuses. Its permits will almost certainly become the focus of financial speculators, because such speculation thrives on price changes. The futures and other derivative markets for these instruments also could be a target for market manipulation, since large energy producers and utilities will see shifts in market demand before anyone else — and some may try to take advantage of that advance information.

Nor is it likely, based on the recent record, that federal regulators will be able to effectively monitor yet another market with large volumes of complex, daily transactions. The underlying asset of these permits is the energy that fuels the economy. Surely, given the recent crisis, we should not consider leaving the economy and the climate hostage to yet another volatile and hard to regulate market in exotic financial instruments.

Even when the permits are not a focus of speculators or market manipulators, the trading itself will increase the costs of energy and climate policy. Every transaction will involve fees and commissions for Wall Street firms, all of which will add to the price of the permits and the underlying energy we all use. That’s why already some 90 hedge funds and 80 private equity funds have established business lines for climate permits.

There’s an alternative that would be better for the climate, better for the economy, and better for average Americans: a straightforward carbon-based tax that returns its revenues to households through reductions in payroll taxes.

This approach, which most economists support — and which Al Gore endorsed in his Nobel lecture — would set a known and stable price on carbon, providing businesses and households the incentives they will need to invest in developing and adopting new technologies and alternative fuels. The tax itself will change the relative price of different fuels based on their effect on the climate, while the accompanying payroll tax cuts will preserve both Americans’ incomes and overall growth across the economy.

There are no new financial instruments to be abused or speculated upon — and the approach clearly works. Sweden adopted a carbon-based tax in 1990; today, the Swedish economy is about 50 percent larger (adjusted for inflation), and the nation’s carbon emissions are 8 percent less than they were in the 1990s. By contrast, emissions have risen sharply across the EU over the past five years, despite its cap-and-trade program.

We and our children will have to live with the outcome of this debate for decades. It’s vital that we get it right this time, because we may not get a second chance for a long time. As the Senate turns to this issue in the coming months, it has the responsibility and opportunity to acknowledge the profound problems with cap-and-trade and move to a better Plan B, a revenue-neutral carbon-based tax.

Dr. Robert J. Shapiro, chairman of the U.S. Climate Task Force and head of the economic advisory firm Sonecon, served as undersecretary of Commerce in the Clinton administration.

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