Cap-and-trade market structure, lessons from the past

From an article in the JACF on Designing a US Market for CO2. Most interesting are the lessons learned from the US SO2 (sulphur dioxide)market, a successful cap-and-trade system that began in 1995. How did the market's design and structure affect trading and contribute to the massive price spike in 2005-2006 (see graph below)? Prices increased from $220/ton to over $1600/ton before declining back to $200/ton. One explanation points to a change in the EPA's regulations in 2005 (CAIR) that put a tighter cap on emissions starting in 2010 and tightening more through 2015. Since emissions credits can be banked, expectations of increased demand in the future should be reflected in the current price. However, this regulation was only supposed to increase the cost to ~$600/ton, and while it might explain the spike it cannot explain the subsequent drop. A second explanation relies upon a shortage of low-sulphur coal due to railroad outages. This shortage increased demand for allowances and correspondingly, the price. While the shortage might have increased demand in the short-run, credits were available that could have been drawn upon to reach a slightly higher price equilibrium rather than a massive spike. So why didn't anyone step in and sell their credits at a massive profit? The answer lies in the restricted float - a low number of credits available for trade - which is due to the way the market was designed.


First, the credits were initially distributed to natural shorts (e.g. a power plant that produces SO2) that expected to use them at some point in the future. Except for relative emissions reductions (a plant installs a better scrubber and thus needs fewer credits), most of the market participants will stay long the credits to offset their natural short exposure. Thus, incentives to trade are reduced and the market is less liquid. Lower liquidity means that small changes in supply or demand can have a magnified effect on price.

Second, the credits were distributed for free, and were held on the firms' balance sheet at zero tax basis. When a credit is redeemed, the increased value is recognized as a gain, but offset by the increased environmental liability from generating the SO2, so it's a wash for tax purposes. If a firm believed the price spike was temporary, it could sell some of its banked credits while prices were high, then buy them back once the market returned to normal, netting a profit. But this action creates a taxable gain today, while the liability is still off in the future. The potential gains from this arbitrage must be weighed against the acceleration of the tax liability.

Third, many of the firms with credits are publicly regulated utilities. If the firm were to profit from selling credits high and buying them back low, regulators might force the firm to pass the profits along to customers (rather than letting shareholders and management keep them). On the other hand, if the arbitrage failed and the firm lost money, regulators might view this as speculation and punish management for being imprudent.

Thus, the owners of SO2 credits failed to create a viable market for them. Note that financial intermediaries, such as the much maligned short sellers and speculators, could help provide liquidity to a market like this and thereby enable more efficient price discovery, reducing the risk of disruptive price spikes.