Jessica Green in Nature: Don't link carbon markets

In a new Comment at Nature, NYU political science professor Jessica Green argues against the prevailing theory that emerging carbon markets can and should link together to pursue a coordinated global carbon pricing policy. Citing problematic interactions between the EU Emissions Trading System (EU ETS) and Clean Development Mechanism (CDM), as well as California's cross-border electricity emissions accounting woes, Jessica makes the case that governance challenges limit the viability of linked carbon markets

Many policymakers argue that the next logical step is to combine cap-and-trade efforts into one global carbon market. According to prevailing economic theory, linking markets together should promote trading, smooth financial flows and lower the overall cost of reducing emissions. A global price on carbon emissions would emerge without the need for long and fractious diplomatic negotiations.

But reality is more complicated. Initial attempts to join up trading schemes in Europe and in California and Quebec have led to price crashes and volatility, not stability. It is becoming clear that cap and trade works only under special circumstances — when one entity controls the market and parallel initiatives do not undermine it.

Personally, I wouldn't make the general argument that market links themselves have led to low and volatile prices. Those are common outcomes in all emissions trading systems, not necessarily a product of the market links themselves—though the presence of a market link does mean that volatility in one system is readily transmitted to another, so the distinction I'm drawing is perhaps a minor one.

Sometimes the link itself is a driver of low prices, such as in the EU ETS / CDM link. CDM offset credits contributed to the oversupply of compliance instruments in the EU ETS; when EU regulators banned problematic CDM credits in Phase III of the EU ETS they nevertheless allowed allowance banking in between Phases II and III, with a large quantity of allowances from Phase II made available for banked use in Phase III as a result of CDM credit used in lieu of allowances in Phase II. Hence, the connection between the EU ETS / CDM market link and persistent low carbon prices is a direct one. 

In contrast, the California-Québec market link has little to do with causing the ongoing anemic allowance auctions and low market prices that followed. However, this link illustrates an important governance challenge I documented in an earlier paper that Jessica cites. On the eve of California's formal market launch, last-minute reforms to cross-border electricity trading rules led to significant reductions in expected market demand without acknowledgement in the public regulatory process whereby California and Québec linked carbon markets. Analytically, it is possible to show that either: (1) California regulators told their Québécois counterparts about the expected consequences that they denied in the public regulatory process in California; (2) California regulators were aware of the expected consequences but neither disclosed them to their Québécois counterparts nor in the public regulatory process; or (3) that California regulators ignored the findings of their own expert advisers, believing that no consequences would follow from their internal market reforms.   

Whatever the case, the California-Québec experience highlights how administrative and oversight requirements are much higher in linked markets where all participants seek to share governance responsibilities and not just let one jurisdiction become the de facto group regulator. This also reinforces Jessica's main point, which is that the consequences of regulatory reforms in one jurisdiction necessarily affect all of the linked jurisdictions as well—especially when one jurisdiction is much larger than its smaller trading partners. On that basis alone the concerns she raises are important to consider, even though I tend to describe market links primarily as vectors for volatility, rather than drivers. 

If linking carbon markets turns out to be too difficult to pursue in practice, does that mean carbon markets won't be effective as a means to some future coordinated climate policy? Not necessarily. Carbon markets can be designed to achieve specified price trajectories, using price floors and ceilings (or together, a price collar to ensure that market prices stay within a specified range). In this application it is actually quite simple to coordinate carbon market prices with carbon pricing policies in other jurisdictions—by comparing and negotiating carbon price trajectories across instruments and jurisdictions, just as in tax policy coordination. 

Update: on a second read, I realize my post might come off as critical of Jessica's work. That wasn't my intention. I'm very happy that Jessica has published this important essay and hope it will lead to more conversations within and between the social science communities that research climate policy.