Hi Ville, thank you. I agree this is a central concern. If retiring 100 allowances leads the government to issue an extra 20, the climate effect is just 80%.
I also agree that politicians benefit from raising the cap in response to high allowance prices (ultimately driven by large-scale retirements). Raising the cap
pleases the polluting industries, which can reward politicians (e.g. via fundraising).
lowers the polluting industry’s (private) costs, expanding supply and lowering consumer prices. And lower prices = more votes.
My point is that politicians also face significant costs of raising the cap:
Political capital. Changing caps requires legislative or regulatory amendments (such as EU directives or RGGI state regulations), which are politically costly and resource-intensive.
Judicial risks. Financial institutions hold allowances as assets. They would initiate lawsuits against arbitrary cap increases, which lower allowance prices. A notable example is the Acid Rain Program (the world’s first cap-and-trade), where states and polluters sued over an arbitrary cap reduction and won in 2008, ultimately contributing to the end of the program (Schmalensee and Stavins, 2013).
Revenue impact. Governments generate revenue by auctioning allowances. A policy of raising the cap when allowance prices are high would trigger investor sell-offs, depressing prices and government revenue. Rather than being a threat, third-parties who retire allowances are useful to politicians: they raise taxes for them.
Historically, the political problem in cap-and-trade has been lowering, not raising, the cap. For instance:
The federal government’s attempt to tighten the cap in the Acid Rain Program failed.
In RGGI, caps have been systematically lowered by removing “banked” (unused) allowances. Retired allowances are considered banked allowances, so the cap reductions have amplified allowance retirements. For example, retiring one allowance in 2013 would have resulted in the effective retirement of three after adjustments: a tripling of the effect (see the second and third cap adjustments for banked allowances).
Your point that the cap is endogenous to allowance prices is well-taken. Historically, what politicians want is lower caps and higher prices—exactly what retiring allowances delivers. For current and moderately higher allowance prices, my sense is that the risk of politically motivated cap increases remains modest.
Lastly, you can retire allowances without causing cap increases in cap-and-trade programs where the relationship between the cap is an increasing and publicly known step function of the price of allowances. For example, RGGI employs a uniform-price auction and releases additional allowances only if the clearing price exceeds a publicly-known trigger (it’s called the cost containment reserve). To make sure that your bidding does not inadvertently raise the clearing price and raise the cap, you just bid below the trigger price. If the auction clearing price surpasses the trigger, your bid is below the lowest winning bid, so you don’t affect the outcome.
Hi Ville, thank you. I agree this is a central concern. If retiring 100 allowances leads the government to issue an extra 20, the climate effect is just 80%.
I also agree that politicians benefit from raising the cap in response to high allowance prices (ultimately driven by large-scale retirements). Raising the cap
pleases the polluting industries, which can reward politicians (e.g. via fundraising).
lowers the polluting industry’s (private) costs, expanding supply and lowering consumer prices. And lower prices = more votes.
My point is that politicians also face significant costs of raising the cap:
Political capital. Changing caps requires legislative or regulatory amendments (such as EU directives or RGGI state regulations), which are politically costly and resource-intensive.
Judicial risks. Financial institutions hold allowances as assets. They would initiate lawsuits against arbitrary cap increases, which lower allowance prices. A notable example is the Acid Rain Program (the world’s first cap-and-trade), where states and polluters sued over an arbitrary cap reduction and won in 2008, ultimately contributing to the end of the program (Schmalensee and Stavins, 2013).
Revenue impact. Governments generate revenue by auctioning allowances. A policy of raising the cap when allowance prices are high would trigger investor sell-offs, depressing prices and government revenue. Rather than being a threat, third-parties who retire allowances are useful to politicians: they raise taxes for them.
Historically, the political problem in cap-and-trade has been lowering, not raising, the cap. For instance:
The federal government’s attempt to tighten the cap in the Acid Rain Program failed.
In RGGI, caps have been systematically lowered by removing “banked” (unused) allowances. Retired allowances are considered banked allowances, so the cap reductions have amplified allowance retirements. For example, retiring one allowance in 2013 would have resulted in the effective retirement of three after adjustments: a tripling of the effect (see the second and third cap adjustments for banked allowances).
Your point that the cap is endogenous to allowance prices is well-taken. Historically, what politicians want is lower caps and higher prices—exactly what retiring allowances delivers. For current and moderately higher allowance prices, my sense is that the risk of politically motivated cap increases remains modest.
Lastly, you can retire allowances without causing cap increases in cap-and-trade programs where the relationship between the cap is an increasing and publicly known step function of the price of allowances. For example, RGGI employs a uniform-price auction and releases additional allowances only if the clearing price exceeds a publicly-known trigger (it’s called the cost containment reserve). To make sure that your bidding does not inadvertently raise the clearing price and raise the cap, you just bid below the trigger price. If the auction clearing price surpasses the trigger, your bid is below the lowest winning bid, so you don’t affect the outcome.