Economic Markets and Political Markets

Published October 5, 2007

Former Tribune editor and publisher, Jack Fuller, has described two markets for energy. One is political and the other is economic. He correctly describes how political markets often add substantial counterproductive costs on the energy markets. One example he offers is the electricity market in Illinois. A decade ago the Illinois Commerce Commission established a set of electricity prices that was deemed “just and reasonable.” The state legislature with the endorsement of Commonwealth Edison and the Citizens Utility Board rolled back those rates 20 percent in exchange for allowing the wholesale price of power to go to market levels at the end of ten years. This was an alternative to the system of setting rates based on historic cost.

We are now at the end of the decade and wholesale electricity prices have returned to the “just and reasonable” levels that prevailed before the deregulation process began. However, the state’s political establishment wants to give residential consumers a discount from market rates. Politicians have strong armed Ameren and ComEd into giving refunds and drawing out the return to market rates. The legislation that came into force on August 28, 2007 also eliminated the reverse auction of power and created a new Illinois Power Agency to take over the buying of electricity from generators.

My take as an energy economist on this agreement between electric utilities and the political establishment is that wholesale prices of power will still return to something close to market levels, albeit not until 2009. It is conceivable that a single government purchasing agency might exercise monopsony power. However, experience with a similar agency in California after the power market was reregulated there in 2001, indicates that such an institution might very well lock in prices that are above market levels. Moreover, generators in Illinois will no longer be locked in to the Illinois market. If instate generators do not receive near market prices, they will be led to sell power to neighboring states where market prices do prevail.

The substance of the change will be about the same under either regime. Namely, the prices paid to generators will be influenced by market forces rather than by historic cost as they were under regulation. This in turn means increased value of electricity from coal generating plants and, more importantly, power from nuclear plants operated by Exelon, the unregulated corporate parent of ComEd. While this means somewhat higher prices to residential consumers, it will also create investment incentives to build new plants and expand old ones which will moderate the rate increases in the future.

The regime of rates determined by historic costs worked tolerably in the period of stable energy prices. The cost-plus regulation served to create an extra margin of generation (and distribution) that came in handy when there was a surge in demand or a power plant had to be shut down for maintenance or other reason. Since generation and distribution were vertically integrated within the same corporate structure, a surge could be handled at either stage of production. The point here is that vertical integration is a hedge.

The effect of this new regime on the distribution and transmission grids is not so clear. As time goes on, power will increasingly flow across state lines. That means that transmission lines under the regulation of the Federal Energy Regulatory Commission will require expansion and improved maintenance to meet the new demands, including surges. It is not certain that the existing regional service organizations that manage, but not own, the grid will be able to coax the proper investment from the incumbent utilities. The generators and their large industrial customers that will make up the new interstate market ought to supply the capital for the enhanced grid. These are not necessarily the present grid owners. Unless the transmission grids are reorganized into joint ventures, like interstate oil pipelines and intrastate gas pipelines in Texas, the quality of the grid will deteriorate over time. The grid that is not a joint venture by users, will also be vulnerable to the gaming of capacity reservations like happened during the California electricity crisis.

Jack Fuller correctly argued that forcing electricity prices below market levels will divert generation from nuclear to coal and cause an increase in environmentally harmful emissions. What it will also do is channel power generated by nuclear power to consumers outside Illinois who are willing to pay the market price for electricity. This, in turn, will lead to brownouts and a reduction in the reliability of service in Illinois.

It is at this point that Jack Fuller’s analysis goes off the rails. He issues a call for a tax on emissions and/or a system of carbon credits in order to reduce energy consumption and its associated release of carbon dioxide. As for taxes it is interesting that the political establishment tends to favor raising them on activities that are assumed to be harmful rather than lowering taxes on beneficial activities like reducing emissions. Could it be that politicians would like the tax revenue to spend on their friends? In any event, taxpayers and their representatives would be properly skeptical that the tax rebates would be neutral.

The trading of carbon credits is equally troublesome. It presumes an underlying data base of emissions from millions of individual sources and a continuous monitoring of changes to the data base. This would be a huge increase in regulation, and flies in the face of experience with other deregulations. Take, for example, the 1944 Bretton Woods agreement on fixed foreign exchange rates that was abandoned in 1971 and replaced by seven contracts traded on a subsidiary of the Chicago Mercantile Exchange in 1972. Thus, a replacement of markets for regulation took place. This set the pattern for the subsequent establishment of energy contracts in 1975, 1981 and 1985 when the price controls were removed in the same order. The point of this experience is that regulation and markets do not coexist. Markets are substitutes for regulation, not complements.

The experience with other emission trading systems is also contrary to the conventional thinking. The model on which the national acid rain and the RECLAIM system for the Southern California Air Basin (SCAB) involves differences in abatement costs among emission sources. Under this theory, allowance prices would be stable. However, allowance prices do not behave this way. Allowance prices tend to follow the price of natural gas and as a result they are quite volatile.

The underlying logic is very appealing. Emission sources understand that the allowances are not property rights. For both the acid rain and RECLAIM trading schemes, potential traders (which are mostly electric utilities) were warned that the government agency could alter or eliminate the trading scheme at any time and not be subject to the takings provision of the Fifth Amendment of the Constitution. In the RECLAIM example, the trading credits were indeed suspended during the electricity crisis of 2001 when the FERC also revoked the “just and reasonable” status of wholesale electricity prices and imposed a cap.

Thus, the decision by an electric utility is tilted in favor of actually reducing emissions defined for it and buying allowances only for those peak periods when it is likely to exceed the permitted limits. The attractive alternative for a utility during such peak periods is to shut down its generators (that produce emissions as a byproduct) and instead buy energy from another utility. The generation fuel of choice during peak periods is natural gas. Thus, the price of emission allowances and credits ought to be closely correlated with the price of natural gas, and they are. Moreover, the quantity of sulfur dioxide allowances traded, for example, are much lower than expected. Of the allowances traded, about half is simply averaging among multiple emission sources. This behavior pattern is also consistent with the peak load model.

When the advantages and disadvantages of emissions trading are weighed against the trading of natural gas futures and options, there is no contest. Natural gas derivatives win hands down. First, gas derivatives are property and the takings clause of the Constitution fully applies. Second, the gas derivatives are orders of magnitude more liquid than allowances. Currently, monthly gas futures go out to December 2012 which is only two years less than the yearly SO2 futures.

But gas futures are not the only derivatives that are useful for hedging for peak load conditions. There are since 1999 weather futures which are based on heating and cooling degree days for 36 cities worldwide of which 18 cities are in the United States and six in Canada. In 2006, $21 billion of these weather derivatives were traded. Weather derivatives are traded on the Chicago Mercantile Exchange and have recently morphed from monthly to weekly contracts. This suggests future flexibility will be greater than the governmental market, with out making investors vulnerable to a government takings. Clearly, the weather futures offer a more precise hedging vehicle when compared with allowances and even the natural gas derivatives. Weather derivatives may also be useful for hedging electricity price risk. While these derivatives are not exactly tailored to electricity generation, they are close enough. It is not unusual for one product derivative to serve as a hedging vehicle for another closely related product. Jet fuel price risk, for example, is hedged using heating oil (distillate) derivatives. The reason is the greater liquidity of the substitute market.

There has been a lot of attention recently to the supposed superiority of a revenue neutral carbon tax over a cap and trade system. Both the American Enterprise Institute and the Resources for the Future have offered a preference for the carbon tax. Both have recognized that taxpayers are suspicious of whether the “neutrality” of the new tax will actually accrue to the individual taxpayer, or whether the tax will be tilted to powerful political constituencies. In addition, it would be difficult to estimate the proper tax level to be imposed.

Tax collectors prefer the tax on carbon emissions over the cap and trade system. George Osborne, the UK Conservative party’s shadow finance minister points out how the cap and trade system has serious transactions costs and subject to fraud in initial allocation among sources and in enforcement. (Financial Times, September 13, 2007) But benchmarking of emissions for taxation would also be required, as would monitoring and enforcement for each emission source.

Thus, it would appear that there is as much potential for fraud under a carbon tax as there is with cap and trade. The difference to a potential tax collector like Mr. Osborne is the revenue that would accrue to the government coffers.

Indeed, one of the modifications to the cap and trade is to charge emission sources it receives for the allowances it receives. It is reminiscent of the quaint Chinese system of execution where the family of the condemned person is required to pay for the bullets.

There are two ways of using taxes to abate pollution. One is to tax emissions and the other is to give a tax credit for the act of reducing emissions. The latter fits with a positive theory of taxation, namely that taxes are prices for government services. To assume that government is completely free to tax group A and distribute the benefits to group B. assumes that there is a free lunch for government. There are limits to such behavior, otherwise the economy would be totally occupied with such transfers. The tax price theory was advanced by James Buchanan in 1970 (Public Finance) and substantially enhanced by Earl Thompson in 1974 (Journal of Political Economy). The basic idea is that tax revenue in the 1970s was mainly spent on national defense. Thus, assets that were vulnerable to capture by an aggressor were subjected to a high rate of taxation. By contrast, when vulnerable assets were reduced in value, as with the producing oil field, then it was granted an oil depletion allowance to coincide with the reduced level of protection services by the government .

A tax regime that would give tax credits for emission reduction is like the oil depletion allowance in the Thompson positive theory of taxation. If the tax credit promotes a savings in the government budget, then is to be expected, not just recommended.

There has been precious little discussion of where a carbon tax would be levied. In the current effort to benchmark each carbon emission source, it is permitted to report the energy input as a proxy for emission output. If this is the way that the tax would be levied, then little credit would be given for reducing emissions after combustion or of energy used as feedstock for plastics and other products. Of course, taxing energy inputs would greatly simplify the administration. But the same could be said for a tax credit for reducing energy use.

In all this discussion of taxation and cap and trade, the command and control system of reducing harmful emissions and discharges has been largely ignored.

One cannot ignore that this system pollution abatement prevails in most places in the world. The question that arises is why? For one thing, the command and control system is simple, compared with the carbon tax and the tax and trade. Individual emission sources need not be monitored. For another, there is less chance for fraud in the initial allocation as happened in Europe. Moreover, the costs associated with emissions reduction are deductible from income taxes as an ordinary business expense. Finally, it is more transparent and less vulnerable to a government takings. From what has been revealed above about the nature of the trades taking place, there may be no substantial difference in abatement cost across emission sources and thus little to gain from averaging such differences by taxes or trading.

On a macro level, William Nordhaus has recently updated his estimate of the impact of the carbon abatement and predicts that the costs of reducing carbon emissions exceed the benefits of by a substantial amount. [Nordhaus, July 24, 2007] This is true for a cap and trade and a tax on carbon emissions and presumably the tax credit for emission reductions and the command and control system. This ought to make us pause to think through what we know about global warming and what we are guessing about. We especially ought to know the pace of warming from actual measurement rather that relying on opaque models that fail to explain the present changes, or lack thereof. It may be that the pace of change is so slow that adjusting to the change is less costly than trying to alter the laws of physics. We ought to understand the workings of the world before we set out to change it.

Jim Johnston ([email protected]) is an economist retired from Amoco Corporation and a policy advisor to the Heartland Institute.