Unintended Consequences of Free Carbon Permits—Burning More Coal

Proponents of cap-and-trade carbon rationing argue that it will encourage inventors to develop and companies to adopt low-carbon energy technologies. A new study, "How emission certificate allocations distort fossil investments: The German example," [download here] by the German Economic Research Institute in Berlin finds that allocating emissions permits at the beginning the European Trading Scheme for free actually encouraged the "dash for coal" in Germany. Below are some excerpts detailing relevant findings:

Despite political activities to foster a low-carbon energy transition, Germany currently sees a considerable number of new coal power plants being added to its power mix. There are several possible drivers for this "dash for coal", but it is widely accepted that windfall profits gained through free allocation of ETS certificates play an important role….

We find that technology specific new entrant provisions have substantially increased incentives to invest in hard coal plants compared to natural gas at the time of the ETS onset. Expected windfall profits compensated more than half the total capital costs of a hard coal plant….

While German policy-makers intended not to hamper investments in the power sector by carbon regulation, they designed an allocation scheme which in the end created perverse incentives and massively promoted investments into emission-intensive hard coal plants. Obviously, policy makers failed to take the effects of free allocation-related windfall profits on coal profitability into account. We have thus shown that the details of implementing carbon regulation can be extremely important in a dynamic perspective. Different allocation regimes may not just have distributive effects, but also important consequences for investment choices.

Although the analysis has a retrospective focus, our findings are relevant in support for current policy-making. We conclude that by introducing full auctioning of emission permits from 2013 on [National Allocation Plan III] (NAP III) Germany is providing the right incentives from an environmental perspective. However, the new coal capacity brought on the way has created a heavy burden for ambitious future transition to lower carbon intensity.

Back in 2009, the House of Representatives passed the Waxman-Markey cap-and-trade scheme which shared many elements of the European Trading Scheme such as giving away most emissions permits for free. In a commentary on the study the Breakthrough Institute (which advocates as an alternative to cap-and-trade that governments spend tens of billions researching low-carbon energy technologies) notes:

Back in 2009, Breakthrough Institute analysis warned that "high levels of offsetting allowed in Waxman-Markey [a bill which proposed to introduce an US cap and trade regime based on the EU model] and the substantial allocation of emissions allowances to coal-burning utilities and energy companies may make it more cost-competitive to build new coal plants." …

The findings of Pahle's study are the latest in a series of major setbacks for cap and trade supporters around the world, most importantly the European Commission. After five years of out-of-control price volatility and reckless rent-seeking, profiteering, theft, fraud and speculation, it's really high time for the Commission to start recognizing the critique of cap and trade made in the influential Hartwell paper [which critiqued cap-and-trade and proposed massive low-carbon energy R&D spending as an alternative]. Not only is the EU ETS structurally flawed to begin with, but the entire idea of cap and trade is bound to produce such failure systemically, by its very nature.

Economist Alex Tabarrok makes a nice and relevant observation about the law of unintended consequences:

The law of unintended consequences is what happens when a simple system tries to regulate a complex system.   The political system is simple, it operates with limited information (rational ignorance), short time horizons, low feedback, and poor and misaligned incentives.  Society in contrast is a complex, evolving, high-feedback, incentive-driven system.  When a simple system tries to regulate a complex system you often get unintended consequences.

Interestingly, the Breakthrough Institute analysts skip over the fact that the German study suggests that had the emissions permits been auctioned and the revenues recycled (in the manner of a carbon tax) by reducing income or other taxes, energy investments would have been more likely channeled toward lower carbon energy alternatives, e.g., natural gas. The folks over at the Breakthrough Institute clearly see some of the unintended consequences of cap-and-trade, are not so good at seeing what might go wrong with regard to the top-down centralized R&D spending policies they favor.