As was said by a sceptic at a futures industry conference early on in the development of carbon markets:

“If you want to keep a donkey healthy, you don’t regulate what comes out of it: you regulate what goes in”.

My approach is not carbon taxation – which is at least at the right end of the donkey – but a new approach to financial products I call ‘unitisation’. Simply put, the creation of units redeemable in payment for carbon fuels, and in energy, within a partnership legal framework, rather than one using company or trust law.

In this way it is possible to monetise the energy value of carbon, which is intrinsically valuable, rather than CO2 which is intrinsically worthless, and derives its value, as do Fed IOUs aka dollars, from political and administrative fiat. We may then raise global energy prices – particularly in those producer countries wasting energy on a cosmic scale – through a carbon levy into ‘carbon pool’ funds, which would then be deployed in direct local investments in renewable energy and energy savings. Populations would then be compensated with an energy dividend of Units, redeemable in payment for energy use. They could either choose to redeem their Units in payment for continued profligate carbon energy use, or more likely, they would invest them in energy savings, or exchange them with a willing counterparty for something else they would rather have.

I outlined in Rotterdam recently how unitisation might work in enabling a global gas market,

http://www.slideshare.net/ChrisJCook/gas-market-presentation-03-12-2009

and for electricity here

http://www.slideshare.net/ChrisJCook/energy-pools-scottish-energy-institute-11-11-2009

I agree with your views professor. It was really nice to read a synopsis of the bill from an expert’s viewpoint.

The real failure of cap and trade as a market mechanism in allocating resources, from my perspective as a financial participant in power markets for a long time now, is that carbon prices will not send durable, or rather bankable price signals relative to the underlying capital investment decisions they supposedly are designed to impact.

And they never will, because as soon as prices become large enough and liquid enough, the market will yelp at abusive profits, speculators, etc and restrict the market and scare off any long-term financiers. Thus it will always be doomed to failure as a defensible policy tool–as in, nobody will defend it when people are making a killing at the expense of poor customers. But even more critically, why do we accept that products that largely fulfill a public utility function are ever worthy of episodes of way-above average rates of return, at great expense to everyone, as the ‘efficient’ capital allocation tool, when some careful and rational planning could achieve the same function without the financial drama? I realize that right here, Professor Pirrong is shaking his head, how could anyone, let alone a former pupil believe forsaking the free market for the madness of central planning could be a reasonable proposal. I’ve just watched too much disastrous abuse and tinkering in ‘free markets’–and not episodically, really more structurally abusive by incumbants–vs. some actual decent policy evolving

Yes, man is apt to make errors in planning, corruption exists and the free market has been (thought) to be a better capital allocator in the long haul. But it seems to me, incentivize not marginal pricing, but marginal efficiency. Short-term carbon pricing is totally inadequate to establish that ‘value’. Use sticks and carrots to achieve efficiency and let the market decide how to get there, within reason.

If one examines the sulfur-dioxide allowance market, which worked splendidly at its outset due to available substitutes that required only modest capital investment, even when there were very large price signals over $1000/ton, it was never sufficient to go out and monetize for several years and fund the capital equipment needed to build scrubbers and reduce SOx in the free market–that decision more often than not ended up back in the regulatory purview where ratepayers paid for some long-term rate adders, and in return maybe got some discounted power or perhaps a share of above-market prices earned as a result of having a more efficient plant operating post-capex (though to be clear, almost all scrubbers cause de-rates, thus its just a theoretical expansion of headroom on margins ex-emission cost and usually pretty short-term).

Ironically, it seems the EU policy initiatives focused on automobile carbon emissions might be the winning ticket, in terms of bang for buck. Here, the government simply sets out a forward looking, staggered, declining emission rate threshold for new auto sales, in terms of carbon/km (efficiency). The auto manufacturers all bellyached, but low and behold, they are largely complying (and certainly now competing to comply with bragging rights); the failure to comply is producing unimaginably high fines and pushing the laggards (like Porsche) off the edge to join the efficiency party. And the manufacturers with the most attractive and efficient new products–not highest domestic carbon prices!–have seen market share wins globally.

The best trait? Clarity. Automakers can see the threshold levels ahead, can make incremental investments and improvements to adopt and manage compliance. No misallocation of credits, depressed prices pushing out investment, blah blah blah.

No easy answers, but as usual, Professor Pirrong offers the most clarity and a voice of reason of how free markets are supposed to work when designed well. I wish I had the same faith in observation of the reality.