Option Value and the Non-Equivalence of Cap and Trade with Carbon Taxes
By Arnold Kling
Julian Robertson, the legendary hedge fund manager, has placed a big bet on the long-term decline of the U.S. economy. Additionally, Robertson is invested in the nuclear energy industry and in Chinese biofuels. He’s also launched an aggressive lobbying campaign to pass federal legislation instituting mandatory caps on greenhouse gas emissions.
…GE is deeply invested in alternative energy sources that have little demand absent government mandates or restrictions on effective sources of energy such as coal and oil. The firm has already bought up “greenhouse gas credits” — worthless goods until Congress actually caps the gases. DuPont, Goldman and dozens like them have also positioned themselves to get rich from government action on this front.
Pointer from Will Wilkinson, who adds this interesting question:
why have all these big players lined up behind cap and trade and not a tax? Wouldn’t the equivalence thesis predict indifference? I suspect that the answer is that their expected competitive advantage given a tax is lower than their expected advantage given cap and trade. In which case, that’s a pretty significant real-world failure of equivalence, no?
Suppose that you invest in green energy, and that the price of your output will go up 10 percent if people are induced to shift away from carbon-based energy. If we are certain about the 10 percent increase in price, then we should not care whether it comes from a tax or from a permit system.
Under uncertainty, the story changes. With uncertainty, we do not know whether the value of a permit will be higher or lower than the value of a tax. But the upside is much higher than the downside. The value of a permit cannot drop below zero. But if substitution away from carbon proves difficult, the value of a permit could turn out to be tremendous.
For a green energy speculator, the permit acts like a call option, with limited downside and nearly unlimited upside. A tax lacks that option value.
Again, think about the scenario in which substitution away from carbon proves unexpectedly difficult. With a tax, this surprise results in less carbon reduction than what was originally intended, but not much additional profit to green energy producers. With a cap, the carbon reduction has to take place, and the green energy producers score an enormous gain. It is that scenario, and the fact that there is no offsetting scenario in which the permits have negative value, that makes cap-and-trade a better lottery ticket for the energy producers.