A Symmetric Safety Valve

How to set policy in the presence of uncertainty has been central in debates over climate policy. Concern about costs has motivated the proposal for a cap-and-trade program for carbon dioxide, with a“safety valve” that would mitigate against spikes in the cost of emission reductions by introducing additional emission allowances into the market when marginal costs rise above the specified allowance price level. We find two significant problems, both stemming from the asymmetry of an instrument that mitigates only against a price increase. One is that most important examples of price volatility in cap-and-trade programs have occurred not when prices spiked, but instead when allowance prices collapsed. Second, a single-sided safety valve may have unintended consequences for investment. We illustrate that a symmetric safety valve provides environmental and welfare improvements relative to the conventionalone-sided approach.

A cap-and-trade policy with both a ceiling and a floor for allowance prices has significant advantages over a single side "safety valve" approach that only includes a ceiling, according to a new RFF discussion paper.

Under the traditional safety valve, a trigger price spurs the introduction of additional allowances into the system, guaranteeing the price never goes above a target value. In "A Symmetric Safety Valve", RFF Senior Fellows Dallas Burtraw and Karen Palmer, with Danny Kahn, propose a modification that would also guarantee allowance prices never drop below a certain price floor.

They note that the actual experience with cap-and-trade programs indicates that lower than expected prices are actually a more common outcome than price spikes. A one-sided safety valve that ignores low prices has two major drawbacks, they argue.

First, it is likely to weaken overall program benefits because additional emissions are allowed when costs are high without a corresponding adjustment for periods when prices are low. They estimate the inclusion of a price floor in the SO2 trading program would have improved economic welfare by $1.5 billion to $8.25 billion annually since 1995.

Second, the introduction of a price ceiling changes expectations about future allowance prices and emissions levels and thus affects investment decisions. Using a detailed simulation model of the electricity sector, they find that a one-sided safety valve results in lower investment in emissions-reducing technology and higher long-term emissions.

The effectiveness of a symmetric safety valve is linked to the use of an allowance auction for at least a portion of the allocation, which is a feature of most current climate policy proposals. Previous criticisms of price floors have assumed grandfathered allocations of emissions allowances, with the price floor being enforced through government purchases of allowances and therefore an explicit subsidy to firms. This problem disappears under an auction. From a practical perspective, an auction provides the simplest way to implement the floor. In fact, good design suggests that an auction should have a reservation price, which is a price below which allowances will not be sold.