Summary. This project investigates important dynamic aspects of the regulator’s problem of implementing ambitious carbon abatement goals over a 20 to 40-year horizon, given a rational response of the private sector to boundary conditions set by the regulator. The new aspects investigated in this study include regulatory commitment, carbon-allowance trading with banking, irreversible investment in R&D, and the design of derivative carbon securities. The presence of derivative carbon securities can significantly improve the efficiency of the market outcome, but only if their design takes private incentives for R&D investment into account.
Research Questions. To limit the effects of global warming the Intergovernmental Panel on Climate Change (IPCC) found that worldwide annual carbon emissions need to be cut by about 50 percent over the next 40 years (IPCC 2008). In the United States, the “American Clean Energy and Security Act of 2009,” introduced by Waxman and Markey, includes provisions for clean energy, energy efficiency, pollution reduction, and for a transition to a ‘clean-energy economy.’ The relevent time horizon covers the next 40 years, from 2010 until 2050. – A mix of different policy instruments is required to deliver the targeted emissions reductions, including a price for carbon, incentives for technological innovation, and suitable administrative procedures. This study addresses the following four aspects.
Regulatory Commitment. Because of the extended time horizon and the irreversibility of the emitters’ investments in carbon-abatement technologies, a fundamental difficulty is to design a regulatory scheme that, while providing strong incentives for emitters, is also flexible enough to be adjusted in the future. This study aims at providing a better understanding of the nature of regulatory commitment, in terms of both its degree and its implementation.
Carbon-Allowance Trading with Banking. The presence of inventories can stabilize prices for commodities. Similarly, if it is possible for firms to bank emissions allowances and use different vintages of carbon permits to account for current-year emissions, the price volatility in the carbon market decreases. This in turn makes the cap-and-trade market more closely resemble carbon taxation. Indeed, while it mimics the key advantage of carbon taxation (price stability, since taxes are known), it also renders intertemporal quantity arbitrage feasible, thus increasing the responsiveness of emissions output to macroeconomic uncertainties.
Irreversible Investments. Private-sector innovation in abatement technologies requires significant capital outlays that are driven by the firms’ prospect of being able to capitalize on technology improvements in the future by having to pay a smaller marginal cost for carbon. Such R&D investments are, at least to a large degree, irreversible (unless the innovation is successful and then sold to another party, it is not possible to undo the financial commitment). A successful innovation provides an option on its use and subsequent commercial exploitation.
Design and Valuation of Carbon Derivatives. A cap-and-trade market, even with simple price controls in the form of caps and floors, does not implement the socially optimal relationship between prices and quantities. This question is important, since at the time when the quantity of allowances is fixed, the actual demand for them is unknown. Macroeconomic shocks affecting both factor prices and demand for finished goods generate a price volatility in the carbon market and at the same time a volatility in the volume of exercised emissions allowances. Using additional financial instruments (termed “carbon derivatives”), typically options issued at different strike prices, it is possible to significantly increase social efficiency with relatively few additional instruments.