Unintended Consequences of Free Carbon Permits—Burning More Coal

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Government climate policies at work

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.

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  1. Unintended Consequences

    Paging RC, paging RC.

    1. Ignorance of the Iron Laws is no excuse.

      Just because you ignore them doesn’t mean they are ignoring you.

      1. Is there actually a place where the Iron Laws are listed ?

        1. Non-existance of a written form of The Iron Laws is no excuse for ignorance of The Iron Laws. (Iron Law #2, subsection 4, paragraph 1.)

  2. You can count on anything with Waxman’s name attached to it to be shit.

    1. Including the man himself.

  3. 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.

    So this adjustment would have added enough complexity to the political system to allow it to successfully manage the process?

  4. kilroy: Not necessarily, but it would involve far less Rube Goldbergesque economically inefficient accommodations to rent-seekers.

    1. Honestly, a tax and credit system seems no less convoluted to me. If it’s carbon you’re concerned about (I’m not), why not just set a legal limit for co2/kwh and let the cost of cleaning the production drive the market?

      1. kilroy: Not sure what you mean by tax and credit, but the general idea is to set a per ton tax at the wellhead and minehead and let market actors adjust their carbon use accordingly. The taxes would be fully recycled by reducing income or payroll taxes.

        1. I wonder if the fine folks who did the Hayek v Keynes rap would do a Coase v Pigou one also?

        2. I guess I was thinking of your tax reduction as a tax credit to consumers. So tax the producers and credit the consumers. That seems like more government apparatus than is necessary to me. There already exists the policy infrastructure for regulating the amount of compound X you can legally generate. Why not just set whatever limit is fashionable for co2 and force the compliance costs into the cost of the end product? Wouldn’t that be a lot less complex?

  5. they designed an allocation scheme which in the end created perverse incentives

    *staggers off in general direction of fainting couch*

  6. I’ve got a certificate for 1,000,000 carbon offsets on my cubicle wall. I figure I’m set to emit all the gases I want for life.

  7. If all you want is a peace of mind regarding the sin of your very existence and the carbon dioxide you spew out with every breath you take, go to http://www.freecarbonoffsets.com/home.do and get your absolution at no cost. Why pay for it when it’s free?

    1. Martin Luther on line 2.

  8. I trust that Barack Obama has purchased sufficient carbon credits to offset the greenhouse gasses generated by his kinetic military action in Libya. Or is there a “we have to avoid a humanitarian apocalypse” exception to climate change?

    1. The military is always an exception. If people would stop pretending that the military is some great honorable thing and accept that it is at best a necessary evil, it would be a lot easier to understand why.

  9. 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.

    NO. WAY.

    The government, creating perverse incentives? Say it ain’t so, Shoeless! Say it ain’t so!!!

    http://mises.org/humanaction/chap26sec1.asp

  10. You know who else created a “dash for coal” in Germany?

  11. You would think that those who believe that government is the best solution to the tragedy of the commons would recognize when government creates it.

  12. I’m less cynical than most people here, but I have to say I think it’s naive to speak of carbon permits’ unintended consequences. Politicians intend those consequences. Imagine you’re the rep who brings home “free” carbon credits for your bit of the Appalachians. You’re looking at campaign funding (from whichever company gets the goodies) and campaign talking points (“I brought home jobs to preserve our way of life!”) into perpetuity.

    Beyond this, my complaint about free carbon credits is that they obviate the innovation that should be the top priority of any state intervention at this (early) stage of our energy infrastructure transition.

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