We report on an economic experiment that compares outcomes in electricity markets subject to carbon-tax and cap-and-trade policies. Under conditions of uncertainty, price-based and quantity-based policy instruments cannot be truly equivalent, so we compared three matched carbon-tax/cap-and-trade pairs with equivalent emissions targets, mean emissions, and mean carbon prices, respectively. Across these matched pairs, the cap-and-trade mechanism produced much higher wholesale electricity prices (38.5% to 52.6% higher) and lower total electricity production (2.5% to 4.0% lower) than the \equivalent" carbon tax, without any lower carbon emissions. Market participants who forecast a lower price of carbon in the cap-and-trade games ran their units more than those who forecast a higher price of carbon, which caused emissions from the dirtiest generating units (Coal and Gas Peakers) to be signicantly higher (15.2% to 33.0%) than in the carbon tax games. These merit order \mistakes" in the cap-and-trade games suggest an important advantage of the carbon tax as policy: namely, that the cost of carbon can treated by rms as a known input to production.

To maximize environmental benefits from the rollout of its cap-and-trade program for greenhouse gas emissions, California should focus on achieving a positive demonstration effect from the program by doing as little as possible to harm the state's economy, as transparently as possible and as fast as possible.

^Abstract

There have been dramatic advances in understanding the physical science of climate change, facilitated by substantial and reliable research support. The social value of these advances depends on understanding their implications for society, an arena where research support has been more modest and research progress slower. Some advances have been made in understanding and formalizing climate-economy linkages, but knowledge gaps remain [e.g., as discussed in (1, 2)]. We outline three areas where we believe research progress on climate economics is both sorely needed, in light of policy relevance, and possible within the next few years given appropriate funding: (i) refining the social cost of carbon (SCC), (ii) improving understanding of the consequences of particular policies, and (iii) better understanding of the economic impacts and policy choices in developing economies.

This paper summarizes the lessons learned from implementing a realistic, game-based simulation of California’s electricity market with a cap-and-trade market for greenhouse gas (GHG) emissions and fixed-price forward financial contracts for energy. Sophisticated market participants competed to maximize their returns under stressed (high carbon price) market conditions. Our simulation exhibited volatile carbon prices that could be influenced by strategic behavior of market participants. General uncertainty around carbon price as well as the deployment of strategies that were privately profitable but adversely affected overall market efficiency resulted in total costs of electricity supply that were significantly higher than would have been observed in perfectly competitive allowance and electricity markets. 

We observed several striking phenomena in our game. First, all teams in our game found themselves in a position to prefer higher carbon prices, even those holding high-emitting power plants. This occurred both because electricity price rose faster with carbon price than the average variable cost of producing output for most teams and because the initial allowance allocations functioned as “free money” with a face value that could be increased through the unilateral actions of market participants. Second, teams exercised unilateral market power on both selling and buying sides of the carbon allowance market, with the net effect being a carbon price far above that which would have been expected based on allowance supply and demand in a perfectly competitive market. Third, disagreement among teams over the appropriate price of carbon allowances combined with the exercise of unilateral market power in both electricity and allowance markets dramatically increased electricity prices and often resulted in the use of a more expensive set of generation units to produce the electricity demanded.  Numerous authors have pointed out that electricity markets are extremely susceptible to the exercise of market power, and emissions allowance markets can exacerbate this problem, as demonstrated in Kolstad and Wolak (2008). Fourth, there was very little liquidity in the secondary market for carbon allowances until right before the final emissions “true-up,” with a flurry of trading at the last minute, which resulted in inefficient market outcomes as several trades failed to be completed before the deadline.

These findings have several important policy implications. First, policy measures that increase the transparency and liquidity of the carbon allowance market would make both the allowance market and the electricity market work better. In our simulation, all market participants showed a strong unilateral desire to limit the amount of information publicly available about conditions in the carbon market, much to the detriment of market performance. Second, guardrails that constrain market outcomes, such as price floors and ceilings, can play a valuable role by limiting carbon price volatility.  Third, position and holding limits can reduce the ability and incentive of market participants to attempt strategies that, while privately profitable, have a negative impact on overall market efficiency.

Reducing carbon-dioxide emissions is primarily a political problem, rather than a technological one. This fact was well illustrated by the fate of the 2009 climate bill that barely passed the U.S. House of Representatives and never came up for a vote in the Senate. The House bill was already quite weak, containing many exceptions for agriculture and other industries, subsidies for nuclear power and increasingly long deadlines for action. In the Senate, both Republicans and Democrats from coal-dependent states sealed its fate. Getting past these senators is the key to achieving a major reduction in our emissions.

Technological challenges to reducing emissions exist, too. Most pressing is the need to develop the know-how to capture carbon dioxide on a large scale and store it underground. Such technology could reduce by 90 percent the emissions from coal- fired power stations. Some 500 of these facilities in the U.S. produce 36 percent of our CO2 emissions.

But these plants aren’t evenly spaced around the country. And therein may lie the key to addressing the political and technological challenges at the same time. If the federal government would invest in carbon capture and storage, it could go a long way toward persuading politicians in every state to sign on to emission reductions.

I’ll get to the specifics of the technology shortly. But first, consider how the costs of emission reduction fall hardest on certain parts of the country: A carbon tax levied on all major sources of released CO2, the approach favored by most of the environmental community, would make energy from coal-fired power plants cost more. To make a significant difference, such a tax would have to amount to $60 a ton.

Midwest Carbon Footprint

As a result, gasoline prices would rise 26 percent, and natural gas for household usage by 25 percent, nationwide. Rich and urbanized states could probably tolerate this. The West Coast, with its hydroelectric power, and the Northeast, which relies to a large extent on natural gas, could most easily absorb the associated increase in energy costs.

But the price of energy in the rural, Midwestern states would more than quadruple because of their large carbon footprint. Midwesterners get most of their electricity from coal; they drive relatively long distances to get to work, shopping and entertainment; and rural homes and buildings use more energy for heating and cooling.

One carbon-tax proposal now being considered is a “cap and dividend” plan that would send the tax revenue back to all U.S. citizens equally. But that would also favor the rich states that are less dependent on driving and coal.

It would be more helpful for the coal-dependent states if the federal government would use revenue from a carbon tax to help develop the technology for carbon capture and storage.

And that brings us to the technological challenges: No plant of any size with the capacity for CCS yet exists, but it has been demonstrated to work at small scales. Three different processes for capturing the CO2 are being tested, and scaling them up for 500-megawatt or 1,000-megawatt facilities should be possible.

For two years, the Mountaineer plant in New Haven, West Virginia, has been capturing and storing a tiny amount of its CO2 -- 2 percent of it -- but plans to build a full-scale carbon-capture plant here have been abandoned. Because Congress has dropped any idea of imposing a tax on carbon emissions, the investment doesn’t make sense.

A large plant in Edwardsport, Indiana, was being constructed with the expensive gasification process that makes it easy to add carbon-capture facilities, but it, too, has been shelved.

China may finish its large demonstration carbon-capture plant before the U.S. gets any model up to scale. Others are planned in Europe, and a small one is operating in Germany. This plant has been unable to get permission for underground storage, so it is selling some of its CO2 to soft-drink companies and venting the rest.

Subterranean Storage

Storing captured CO2 is eminently possible, too. For 15 years, the Sleipner facility in Norway has been storing 3 percent of that country’s CO2 underneath the ocean floor, with no appreciable leakage. Algeria has a similar facility, the In Salah plant, operating in the desert.

One storage strategy under consideration in the U.S. is to inject captured CO2 into huge basalt formations off both the east and west coasts. Inside the basalt, the carbon gas would gradually turn into bicarbonate of soda.

There are other ways to dispose of carbon dioxide. It has been used for enhanced oil recovery for many decades without any danger, and has been effectively stored in depleted oil reservoirs. (The gas is dangerous only in high concentration.)

It remains uncertain how much of the captured CO2 might leak during storage. Even if this were as much as 10 percent, however, it would mean that 90 percent of it would stay underground.

As CCS technology develops, it will have to be made more efficient so that it uses less energy. As it is, the capture phase is expected to require that a power plant burn 20 percent to 25 percent more coal than it otherwise would.

The technological challenges may explain why energy companies haven’t lobbied for subsidies to develop CCS. The electric-energy sector isn’t known for innovation and risk- taking. Just look at the U.S.’s outdated power grid.

But the federal government could pay for the subsidies through a tax on carbon. Such a levy would have other advantages, too: It would raise the cost of energy to reflect the damage that burning coal and oil now do to the environment, and spur the development of renewable sources.

If states with large carbon footprints can’t accept such a tax, the CCS subsidies could be paid from the general fund. The cost to build coal-fired power plants with CCS technology is estimated to be about $5 billion to $6 billion -- about the price of a single nuclear power plant. The total price for the U.S.’s 500 large plants would be $250 billion. That’s as much as the planned modernization and expansion of our missile defense system over 10 years.

But it would slash our carbon emissions by at least 20 percent. There is no other politically possible way to cut CO2 as much, and as quickly -- in a decade or two. And devastating climate change is far more likely than a missile attack.

U.S. investment in CCS technology could also induce China and Europe to follow suit. And this would allow the world time for renewable-energy technologies to mature -- to the point where we could do away with coal burning altogether.