“Free Market” Approaches to Global Warming

An increasingly popular measure in environmental regulation is the creation of trading markets that allow polluters to buy and sell emissions credits between themselves. While this arguably has some benefits, such as allocating emission penalties more efficiently, or decreasing the costs of public administration, there are several very important objections to be aware of.

First, with apologies to a number of starry eyed politicians, environmentalists, business people, and journalists who wax romantically about them, these are not free markets, and referring to them as such is just so much hogwash. Free markets arise from the complex and voluntary interactions of numerous heterogenous agents, whose individual actions create a feedback loop between changes in the prices of scarce resources and the total quantities desired and brought to market. This is a bottom-up process, one whose success can be enhanced by sensible top-down regulation and enforcement. Emission markets, on the other hand, are created entirely from the top down, being imposed and incentivized via government legislation and regulation. The typical emission trading market starts with output quotas (the cap in "cap and trade") and a fixed initial starting price (penalty, really) for the pollutant being regulated. Participants can then exchange pollution credits for money, depending upon whether they are above or below their output quota. Through the use of futures contracts, they can also hedge against future output liabilities, based upon their current expectations for both output and the regulatory stance of government (as an aside, anyone with capital markets expertise should recognize the potential incentives for malfeasance, as governments and regulation-favored participants may be incentivized to impose higher degrees of uncertainty on the market in order to reap the benefits of higher price volatility and derivative pricing). Because the political process is a key element in these markets, and because most of the economic costs and benefits will accrue outside of the trading markets themselves, we should expect feedback loops to be more distorted and mispricings to be corrected less efficiently than would be the case in a true free market.

Second, those who favor these markets imply that a top-down approach will be as optimal and efficient as a bottom-up one. The starting point for any emission trading process is the initial cap limits, future reductions, and pricing imposed by regulators. Thus, the argument for trading markets is based on a rather dubious assumption that regulators can get the price of the externality right, and avoid the economic costs associated with arbitrariness and inefficiency. It’s especially important to recognize that while cap and trade markets are intended to address the real cost of a specific externality, the price signal in these markets does not contain information about the cost of the externality itself–it only contains information about the costs imposed on participants by regulators, costs that might not be in line with reality. And as noted above, there’s no intrinsic mechanism in these markets to correct significant mispricings.

Third, while these markets may improve upon the administrative efficiency of government and lower the public cost of climate change policy, they will also create new classes of rent-seekers. Although Sen. Boxer scolded some participants and committee members for mentioning Enron at a recent hearing, it is worth noting that it was one of the primary rent seekers in the cap and trade area until its demise a few years ago. Is mentioning Enron in conjunction with the current push for climate legislation a taint on the character and intentions of, for example, the corporate members of USCAP? Of course not. But it does get people’s attention, and helps illustrate the intimate ties between rent-seeking, business competition, and politics.  In the final analysis, concerns about rent seeking depend on the degree of material benefits that accrue to society relative to those who benefit from pollution trading markets. In other words, if this rent seeking activity does indeed produce economic value, then technically it’s not rent seeking. So if stabilizing CO2 emissions does prevent significant economic harm in the future, then the trading rents might be an acceptable tradeoff. However, if the CO2 hypothesis is disproven by real events–for better or worse–while new rent seekers have benefitted at the expense of competitors, taxpayers, and consumers, then the tradeoff and the political machinations that made it possible will prove to be a disaster in hindsight.

In response to concerns like rent-seeking, analysts of various political stripes have called for carbon taxes instead of trading markets (e.g., here and here). Comparing the net costs and benefits of taxes-versus-trading is a complicated and imprecise exercise, but like cap and trade, if the CO2 hypothesis holds true, and carbon taxes help us to avoid significant economic harm in the future, then higher consumer prices they cause might be an acceptable tradeoff; if the CO2 hypothesis is disproven, then the opportunity costs incurred by taxpayers will be a disaster. But whether through tax or trade, political measures aimed at reducing CO2 emissions will still create winners, losers, and rent seekers in the short run. For example, if we assume that carbon taxes are used to finance climate technology R&D, it’s clear that one group of people will benefit at the expense of the rest. We would hope that their research produces technologies that have real economic value to society, but as with any investment, there’s plenty of uncertainty involved, and sunk costs are sunk costs; there’s also a high degree of agency risk involved when politicians and experts decide how to invest everyone else’s wealth.

All told, it’s clear that the essential political risk at hand relates to decision making, to which we would point out that the more brains involved, the better. In a field as novel and complex as climate science, and indeed, in any pursuit involving estimation under uncertainty, the least bad method is to aggregate as many competing opinions as possible–in this case via a political analogue to free markets, referendum. Despite the growing body of evidence for such an approach, it’s likely to meet with resistance, as such measures might threaten to: marginalize the hard earned expertise of climate scientists; diminish politicians’ power and sense of self-importance; devalue the compelling business opportunities perceived by some firms; and force true believers on all sides to give some control to those they disagree with.

We encourage people to think openly and critically about the climate debate, but we suggest being especially critical of "free market" allegations. Public action to remedy a perceived externality of the free market is n
ot "free" in any sense of the word. Wise, perhaps, but never free.

Kling on Global Warming

Democrats’ Congressional leaders have committed to holding hearings twice weekly on climate change (nee global warming) until April. Given this emphasis, we’re working on a longer Idle Speculator piece that investigates the political economy of climate change, but in the meantime, we’ll provide links to some of the more interesting sources we come across. Be warned–the pieces we select will tend to focus on alternative perspectives that we perceive as having some value. In this way, we hope to bring some needed balance to the current debate over climate change, and this piece by economist Arnold Kling* meets our criteria. Among the salient points:

• Atmospheric CO2, like economic wealth, has accumulated at an exponential rate over the past century. However,  material well-being has increased to a far greater extent than average global temperatures. As Klingman puts it, "The global warming that has taken place so far is minor. The improvement in living standards that has taken place in the past one hundred years is enormous."
• What matters in climate change modelling is the future, i.e., the degree of warming we should expect over a certain period for a given level of greenhouse gases. While the IPCC’s "90% confidence" datapoint has received a great deal of media attention, this only refers to whether humans have played a role in the accumulation of atmospheric CO2. It does not tell us what the future will look like. Klingman points out that, like the disappointments associated with complex macroeconometric modelling in the 20th century, we do not have enough data or experience to design complex models that can predict future climate outcomes with any certainty: "Climate data looks to me suspiciously like macroeconomic data. The true information content probably is not sufficient to produce a reliable model for forecasting."
• The inescapable conclusion is that current climate predictions could be overly pessimistic, or not pessimistic enough, and dealing with this kind of ‘fat tailed’ uncertainty is not as straightforward as managing the risks associated with normal statistical distributions. Citing Martin Weitzman’s critique of The Stern Review, Kling points to the importance of considering tools that are better suited to uncertainty, such as climate engineering technologies and other "just in case" measures, as opposed to what, in our view, is a political engineering push whose only certain outcome will be to strengthen the position of select oligopolies.
• In his conclusion, Kling articulates a well-reasoned objection to charging ahead recklessly with climate change policy measures: "If we lack "just-in-case" mechanisms, then any approach that we take toward climate change risks making significant errors. We might sacrifice a lot of the world’s standard of living in order to reduce carbon dioxide emissions, only to discover that it was unnecessary, because global warming was not going to accelerate, regardless. Conversely, the reductions that we carry out might turn out to be insufficient."
• Finally, Klingman offers a badly needed admonition that addresses both the quantitative and qualitative shortcomings of the present debate: "It is possible to have a civilized, sensible discussion about the issue of global climate change. However, doing so requires speaking in the language of uncertainty, rather than moral righteousness."

* In the interest of full disclosure, Mr. Kling is associated with the Cato Institute and George Mason University, both ‘hotbeds’ of economic and political liberalism (heaven forbid). TCS Daily is a publication of Tech Central Station, which has received funding from Exxon Mobil, according to Sourcewach.org, funding that has attracted written scrutiny from Senators Snowe and Rockefeller, to wit: "’We are convinced that ExxonMobil’s long-standing support of a small cadre of global climate change skeptics, and those skeptics’ access to and influence on government policymakers, have made it increasingly difficult for the United States to demonstrate the moral clarity it needs across all facets of its diplomacy,’ the letter said" (emphasis added–recall Klingman’s argument about the proper language for climate policy debate).

Chavez Redux #1

Reuters released a short piece today on the "canny tactics" of Chavez, appearing to put him somewhere between Bolivia’s Evo Morales and Brazil’s Lula. The story follows on the heels of Venezuela’s recent offer to purchase Verizon’s stake in CANTV at a price equal to $17.85 per ADR (symbol: VNT). That’s a better deal than markets first assumed when the ADR shares fell to the $12-14 range in mid-January:

VNT was trading between $19 and $20 going into 2007, so $17.85 implies a 6-10% haircut. It could have been worse–in fact, as haircuts go, it’s not much worse than a typical sales charge for "A shares" in a mutual fund! Canny indeed.

Govts Still Hold Top Spot in Latest CEO Survey

PWC recently released its 10th annual CEO survey, and as with last year’s survey, governments ("Overregulation") continue to rank highest among "potential business threats" (see chart on page 11 of the Acrobat pdf).

This year’s survey also includes a human capital component, termed "availability of key skills", and this ranked as the second weightiest concern. This datapoint is encouraging to us, as it confirms one of our secular investment themes: an increasing relative scarcity of human capital.

Would the Real Globalization Challenges Please Stand Up?

Question: What are the biggest challenges to globalization according to CEOs? Surely they must be the bogeymen that we’re used to hearing about in the popular press, such as terrorism, corruption, unfair currency policies, and intellectual piracy, no?

Incredibly, no.

According to Price Waterhouse Cooper’s 9th annual Global CEO Survey, the weightiest challenges to globalization are wielded exclusively by politicians: over-regulation and protectionism.