Economics, Energy and the Environment

Regulatory Petrification

Regulations have many side effects. One is the risk of causing petrification by creating a vested-interest group that will oppose alternative approaches to achieving the desired outcome. The type of regulation is irrelevant: it’s equally true for environmental regulations that set up trading schemes, like carbon cap-and-trade. You can’t create a group of people holding “emission credits” worth millions of dollars, and expect them to welcome new technologies or regulations that undermine their “investment,” whether that investment was really in technology, or simply lobbying. Once such groups are created, regulatory flexibility declines, and petrification takes hold.

Back in 2007, my colleagues and I warned about this when cap-and-trade was on the table here: “Permit holders will see value in further tightening of caps, but will resist efforts outside the cap-and-trade system that might devalue their new carbon currency.”

Lo and behold, look at what’s happening in Europe, where carbon permit values have plunged (again), and alternative approaches are being considered:

There is an unwillingness across the European Commission generally to stick with the existing climate policy,” said Henry Derwent, the Geneva-based president of the International Emissions Trading Association. “We have to be clear where that leads…

“Once the EU has adopted a cap-and-trade mechanism as its main policy tool then indeed it is important that other regulatory interventions in the form of overlapping directives are avoided,” said Imtiaz Ahmad, an executive director at investment bank Morgan Stanley in London. This is necessary to give “investors in greenhouse gas abatement technology … confidence that the cap-and-trade system will function in a robust manner with the price setting the incentive signal.”

So that’s how it works: rent-seekers lobby government for environmental trading programs, and amass paper wealth in the form of permits. If the exercise turns out not to work (i.e. the price isn’t stable, effective, or economically sustainable), permit holders and their bankers lobby the government to shore up their program with self-defeating things like price floors and ceilings, at the expense of potentially better alternatives.

Petrification ensues.

2 thoughts on “Regulatory Petrification

  1. I find it ironic AEI would find fault with a statement opposed to “regulatory intervention in the form of overlapping directives.” The beauty of cap-and-trade is that it allows market forces—rather than government bureaucrats—to drive behavior. When the government decides it can do a better job than industry in deciding which technologies to deploy where—as the EU currently seems to believe—the result is a complicated web of overlapping mandates that add cost and red tape, with no environmental benefit.

    A 2009 study by the trade association representing electric utilities in Europe, Eurelectric, shows that the lack of trading in Europe’s renewables policies are resulting in more installed solar capacity in cloudy Germany than in sunny Spain and the rest of Southern Europe. The result: 17 billion Euros ($24 billion US) in added cost per year in 2020. Small wonder that IETA—whose members include companies in oil, gas, electric, mining, cement, finance, and many other sectors—opposes overlapping regulatory directives in favor of a market based approach where covered industries are given the flexibility to find the cheapest way of reducing emissions.

    By way of example, a more detailed analysis of the impact of a particular UK policy on the EU-ETS can be found at http://blogs.shell.com/climatechange/2011/03/the-problem-with-two-carbon-prices/

  2. Your post makes two primary assertions, and both are dead wrong – at least from my real-world experience from working several years in a London firm active in the EU carbon market.

    First, you allege that in functioning carbon markets, companies holding emissions credits resist new technologies and sensible regulations. This is absolutely false. The European experience has shown that carbon market participants are constantly on the prowl for new investments in technologies and techniques for reducing emissions. Why? Because the market provides a financial reward for deploying new technologies. Investors certainly see this, as do companies covered by the program who seek to use innovative technologies to lower compliance costs and improve competitiveness.

    Carbon reductions in Europe obtain their initial financial value from the regulatory limit imposed. But over time, prices adjust to reflect a range of market forces, including technological advancements, relative fuel prices and energy production trends. Companies in the market embrace technology breakthroughs when the price is right, and shun the ones that cost too much. That’s a hallmark of a functioning market. Private entities in a market tend to do this better than government bureaucrats in other policy models, such as taxation or regulation.

    Second, you suggest that releasing market forces for climate change is dangerous business, because companies will resist changes to the program that could weaken prices or deflate investments. This is also false. Carbon market participants typically support the fundamental policies that establish the market to meet the environmental need – and they appropriately oppose cumbersome or duplicative regulations that impair market performance. The concerns you cite from recent European industry comments about EU proposals for cumbersome efficiency mandates ON TOP of a functioning carbon market were off the mark. They were about market and regulatory efficiency, not about “petrification” around trading positions.

    Don’t get me wrong – companies in the carbon market realize that government plays a critical role in market formation, and they fully expect policy changes over time. In fact, companies adjust pricing expectations when there are threats of government intervention – a reality that has proven to be a frequent cause of volatility, whether in EU carbon markets or US SO2 markets. Environmental markets are less volatile when government resists the temptation to step in, and more volatile when they intervene. Most companies want the government to set the environmental target at the level science indicates, but not to ease or tighten it based on short-sighted political whims – nor to complicate it with duplicative regulatory systems.

    Finally, your note slams “rent seekers” (a.k.a. capitalists) in carbon markets, presumably as an evil to be avoided. But capitalists are at the center of every proper market. In market economies, we generally view their presence as signs of success rather than failure. As you note, many environmental programs attract profit-seeking investors – but market-based solutions attract more of them. This is because they are based on the premise that a profit incentive is the most powerful tool for addressing the climate change problem, and our nation will succeed in reducing emissions only if businesses are motivated to act by the potential for reaping rewards.

    It’s unfortunate that your post misses the forest for the trees on this one. The only way that climate change can be addressed effectively is by establishing appropriate financial incentives for business. An emissions trading system that unleashes the creativity and ingenuity of the private sector will deliver environmental benefits far better than inflexible governmental mandates, complicated carbon taxes or clever subsidies

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