Arnold Kling  

Option Value and the Non-Equivalence of Cap and Trade with Carbon Taxes

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Notes from the Portable Bookst... A Sentence Too Good to Miss...

Timothy Carney writes,


Julian Robertson, the legendary hedge fund manager, has placed a big bet on the long-term decline of the U.S. economy. Additionally, Robertson is invested in the nuclear energy industry and in Chinese biofuels. He’s also launched an aggressive lobbying campaign to pass federal legislation instituting mandatory caps on greenhouse gas emissions.

...GE is deeply invested in alternative energy sources that have little demand absent government mandates or restrictions on effective sources of energy such as coal and oil. The firm has already bought up “greenhouse gas credits” — worthless goods until Congress actually caps the gases. DuPont, Goldman and dozens like them have also positioned themselves to get rich from government action on this front.


Pointer from Will Wilkinson, who adds this interesting question:

why have all these big players lined up behind cap and trade and not a tax? Wouldn't the equivalence thesis predict indifference? I suspect that the answer is that their expected competitive advantage given a tax is lower than their expected advantage given cap and trade. In which case, that's a pretty significant real-world failure of equivalence, no?

Suppose that you invest in green energy, and that the price of your output will go up 10 percent if people are induced to shift away from carbon-based energy. If we are certain about the 10 percent increase in price, then we should not care whether it comes from a tax or from a permit system.

Under uncertainty, the story changes. With uncertainty, we do not know whether the value of a permit will be higher or lower than the value of a tax. But the upside is much higher than the downside. The value of a permit cannot drop below zero. But if substitution away from carbon proves difficult, the value of a permit could turn out to be tremendous.

For a green energy speculator, the permit acts like a call option, with limited downside and nearly unlimited upside. A tax lacks that option value.

Again, think about the scenario in which substitution away from carbon proves unexpectedly difficult. With a tax, this surprise results in less carbon reduction than what was originally intended, but not much additional profit to green energy producers. With a cap, the carbon reduction has to take place, and the green energy producers score an enormous gain. It is that scenario, and the fact that there is no offsetting scenario in which the permits have negative value, that makes cap-and-trade a better lottery ticket for the energy producers.


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TRACKBACKS (3 to date)
TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/846
The author at A Stitch in Haste in a related article titled More on Cap-and-Trade versus Pigou Taxation writes:
    For those who may have had some trouble following the (very minor) debate between Doc Palmer and me in the comments to my previous post on cap-and-trade, Arnold Kling [Tracked on June 5, 2008 7:26 AM]
COMMENTS (8 to date)
Chris writes:

With a cap, the carbon reduction has to take place

For many, this is a feature, not a bug.

Gary Rogers writes:

Once we understand that if the conversion is difficult there are large gains for the speculators, we should also understand that big winners mean big losers for the general economy. I hope the point you are making is that cap and trade has more potential to make big losers out of the economy where carbon taxes limit this downside risk. Either way, the general public comes out a loser.

aaron writes:

This doesn't seem right. The advantage is in access in the initial stages. Cap and trade can be directed.

Taxes are more broad.

The option analogy is bad. It's the same for tax and cap and trade. There is a floor in both, the amount invested in the regulation dependent businesses.

TL writes:

Not to quibble, but a it's a put option that limits the downside.

Hal Varian writes:

Take a look at Marty Weitzman's paper on "Prices vs Quantities".

Arnold Kling writes:

Indeed, I cited Weitzman's paper in a previous post on this topic.

Arnold Kling writes:

The Prices vs. Quantities paper is relevant, and not to be confused with the Weitzman paper on the Stern report, which is also relevant.

Steve writes:

TL,

Whenever you buy an option, your maximum loss is your purchase price. So buying options always has limited downside risk (buying a call has unlimited upside, and buying a put has a larger but limited upside).

Buying a put option does limit exposure to downward price movements if you're also long in the underlying asset. I think that's what you mean. But if you're short, buying calls would do the same thing, right?

As for the issue at hand, isn't it evidence for the proposition that large organizations have a comparative advantage in rent seeking so they figure they can obtain economic profits in gov't directed markets (like the potential carbon emmisions market)?

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