Cap and take

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The debate over global warming is alive and well, but the European Trading Scheme (ETS), Europe’s carbon market, has been declared “dead.” With the price of European carbon allowances plummeting, Johannes Teyssen, CEO of Germany’s E.ON, says, “I don’t know a single person in the world that would invest a dime based on ETS signals.”

Falling carbon allowance prices are partly due to low natural gas prices, which have caused a switch from coal; partly due to the sagging global economy, which has reduced energy demand; and partly due to the increasing number of allowances that have been issued to subsidize alternative energy investment.

But the fundamental reason for the death of ETS is the uncertainty created by regulatory manipulation. As Philippe de Buck, president of Business Europe, put it, regulators have “created further uncertainty and price volatility, and established a risky precedent of rapid political interference in the market.”

If there is any doubt about how regulatory manipulation affects cap-and-trade schemes, consider what has happened to the U.S. sulfur dioxide trading scheme. This scheme was considered by most economists to be the poster child of cap and trade. It was created by the Clean Air Act Amendments of 1990 to fight acid rain. Companies reducing their sulfur emissions were given allowances which could be banked or sold to companies unable to meet their targeted caps.

By 2007 annual sulfur emissions had fallen to 8.95 million metric tons at a cost of $747 million, one-third less than it would have cost had the Environmental Protection Agency (EPA) used standard command-and-control regulation. The system worked beautifully — for a while.

During the Bush administration, the EPA tried to further reduce emissions in response to growing concerns about the health effects of airborne particulates. It implemented the Clean Air Interstate Rule (CAIR) in 2005, expanding the reach of the trading scheme. In 2008, however, the D.C. Circuit Court remanded CAIR to the EPA, saying it was “fundamentally flawed.” In response, the EPA reverted back to the use of technology-based, command-and-control rules.

Worse, CAIR and subsequent rules from the Obama administration have significantly undermined the sulfur dioxide trading scheme by preventing the use of 12 to 14 million pre-2010 banked allowances for future trading and changing the ratio of allowances per ton of sulfur emissions from 1:1 to 2:1 for 2010-2014 and to 2.86:1 for 2015 and beyond.

Not surprisingly, sulfur dioxide allowance prices began falling in 2005 from $1,600 per allowance and hit an all-time low in April of $0.56 on the spot market and $0.12 on the seven-year future market. For all intents and purposes, the EPA’s taking of banked allowances and manipulation of the trading ratio wiped out billions of dollars worth of assets held in the form of allowances.

Here’s how Jeff Immelt, the CEO of General Electric and a proponent of carbon trading schemes, explained his lobbying efforts to get carbon allowances: “If you are not at the table, you are on the menu.” The EPA’s manipulation of the sulfur dioxide trading scheme puts all companies on notice that they are on the menu.

The cause of death for the sulfur dioxide trading scheme and for ETS is the same — allowances are not treated as property rights. Rather, they are given and taken at the whim of regulators.

If the U.S. and Europe want to bolster their emission trading schemes, or any other cap-and-trade scheme such as wetland banking or tradable fishing quotas, they will have to treat allowances as real property subject to laws against takings. Otherwise we are doomed to command-and-control environmental regulations which are expensive and ineffective.

Terry Anderson is a senior fellow at the Hoover Institution and the executive director of the Property and Environment Research Center. Gary Libecap is a senior fellow at the Hoover Institution and a professor at the University of California, Santa Barbara.