Daily Score Blog

Worries about “gaming” or market manipulation sometimes crop up as an objection to cap and trade, often with reference to recent shenanigans in the financial markets. Some fear that a cap-and-trade system could be manipulated to artificially raise—or lower—permit prices to generate profits for a few at the expense of consumers. While distrust and concerns about scamming a carbon market are understandable, they’re not warranted.

To put some of these fears to rest, it’s informative to look at existing cap-and-trade programs. Neither of the two programs regulating greenhouse gases nor a third controlling acid rain pollutants has been corrupted by gaming or market manipulation.

The European Union’s Emissions Trading Scheme (ETS) was the world’s first cap-and-trade program restricting carbon dioxide releases when it started in 2005. The system has succeeded in creating a Europe-wide carbon market and trading program. There have been hiccups in the ETS, including an initial overallocation of allowances to polluters and some price volatility. Yet the problems are fixable and are already being addressed as the program evolves. The challenges are not attributable to a fundamental flaw in the policy or to lack of regulatory oversight. And the market has grown more robust as the number of traders has increased, making price manipulation difficult. Partly thanks to the ETS, the EU is on track to meet its emissions reduction obligations under the Kyoto Protocol.

The Regional Greenhouse Gas Initiative (RGGI), with a membership of 10 Northeastern and Mid-Atlantic states, held its first auctions in September 2008. Additional auctions are scheduled. While still in its early days, RGGI appears to be off to a good start, with low permit prices and no evidence of gaming.

The US Acid Rain Program has a track record dating to 1995. The program regulating power plants has exceeded expectations, beating the SO2 emissions cap years ahead of schedule and costing only one-fourth of what was expected. After more than a decade, analysts have concluded that the SO2 cap-and-trade program has also been free of gaming.

In short, cap-and-trade programs are already up and running with no evidence of sinister manipulation. That’s no surprise to specialists who study markets.

I've got an emerging obsession: the risk of market manipulation in cap and trade programs. It's something you hear about all the time, at least in carbon policy circles, but the details about "gaming" always seem to be in very short supply. Still, it's something we should take a close look at because the alleged consequences are so severe.

So at the moment, I'm gearing up to read everything important that's been written on the subject. (If you know of good stuff, please send it my way.) In the meantime, I want to share this recent short brief written by economist Laurence DeWitt at Pace University.

He takes a look at how the RGGI carbon cap and trade system has fared:

So far there have been no discovered instances of even attempts to exercise market power--and there has been great vigilance in searching for such actions. In addition to the careful scrutiny of Potomac Economics, which serves as RGGI’s official market monitor, the federal Commodity Futures Trading Commission (CFTC) has already become active in monitoring and analyzing the exchange traded RGGI derivatives. 

And a look at how the national SO2 and NOx cap and trade programs have gone:

It should also be noted that we have several decades of national experience with SO2 and NOx cap and trade programs with no indications of any significant effort, successful or otherwise, to manipulate the market. SO2 and NOx programs are relatively small markets—and thereby offer more potential for manipulation--so this experience to date is very relevant.

In fairness, DeWitt's piece is much too short to do justice to the subject matter. I plan to dig into the details further in the coming weeks, but I thought it provided a nice high-level expression of the basic facts of the case.