A market that provides nothing more than a spot price for a
\ngiven commodity is only a market in name. To have a real market of the kind that brings about all the good things
\nthat economic theory describes, we need a much richer, more complex suite of
\ntransactions. In particular—and especially for capital-intensive industries—the length of a contract can be as or more important than the price. Tell me that widgets are selling for 15 cents
\neach 10 minutes from now and the only decision I can make is whether to buy,
\nsell or hold my stock of widgets. Tell
\nme on the other hand that I can execute a 30 year contract for widgets at 10
\ncents each and I might just build a widget factory. Between those two extremes lies a tremendous
\namount of financial sophistication that policy makers too often fail to appreciate.<\/p>\n
Of African food and california power markets<\/strong><\/p>\n Perhaps the best evidence that price alone isn’t sufficient The common cause in Africa and California was the absence of In both cases, the presence of a price signal led to “economically-rational” Lessons for the U.S. power market<\/strong><\/p>\n When U.S. power markets deregulated in the late 1990s, there Some say we shouldn’t doubt market omniscience, and that the Again, Africa offers a parallel. U.S. food aid has depressed prices in African Lessons for CO2 markets<\/strong><\/p>\n So is market efficiency predicated on a 20-year wait for My guess is that it has something to do with the fact that Meanwhile in the U.S., we are in the midst of a large and Related Links:<\/strong><\/p>\n Michael Pollan chronicles rise of the food movement(s)<\/a><\/p>\n Kerry-Lieberman climate bill: The details<\/a><\/p>\n Cap-and-dividend: the worst possible way to regulate GHG emissions<\/a><\/p>\n
\ncomes from places where that argument has spectacularly failed. In Roger Thurow and Scott Kilman’s excellent book
\n“Enough<\/a>,”
\nthey outline how the wholesale replacement of government subsidies with
\nprice-only markets led to the waves of mass starvation in Africa in the
\n1980s. Closer to home, the deregulation
\nof California power markets begat the California power crisis. In both instances, the creation of a price
\nsignal was followed shortly thereafter by a shortage
\nof supply<\/em>. A spot price is a
\nnecessary precondition for a functioning market, but clearly it is not
\nsufficient. <\/p>\n
\nliquid, sophisticated capital markets. The
\nChicago Board of Trade did not magically appear, fully formed the first day a
\nWisconsin wheat farmer pulled his barge down Lake Michigan. Similarly, when African farmers suddenly had
\nto sell grain at a market rate come harvest time, they didn’t have the benefit
\nof futures contracts, swaps and puts to hedge their risk. Rather, they had a commodity to sell at the
\nsame time that all their competitors had the same commodity to sell. Supply shot up, price collapsed and the next
\nseason the farmers responded (perfectly rationally) by growing less food. In California, generators realized that they
\nearned a lot more for their power on hot days, to the extent that it was in
\ntheir economic interest to hoard fuel and withhold power supplies in advance of
\na heat wave.<\/p>\n
\nbehavior, and yet that behavior ran exactly contrary to the social benefits
\nthat economically-informed policy makers predicted. The
\ncommon cause was the immaturity of capital markets, which were not deep enough
\nto get beyond the immediate short term buy\/sell decision. In a more sophisticated market, Africans have
\ngranaries, silos, and futures contracts, and Californians have short-sellers and
\nother financial arbitrageurs to limit the market power of a small number of
\ngenerators. But that sophistication does
\nnot come overnight. <\/p>\n
\nwas a temporary construction boom in natural gas power plants by a number of
\ncompanies who grossly misjudged the pace of further deregulation. Most of those companies ended up in
\nbankruptcy. Since then, virtually no new
\npower assets have been built in response to wholesale electricity market
\nsignals—for the simple reason that wholesale markets haven’t provided a power
\nprice or contract tenure sufficient to attract capital.<\/p>\n
\nfailure to build new power plants proves that we don’t need them. The problem with that argument is that we
\nhave seen new generation built during that period external<\/em> to deregulated markets. Regulated utilities have continued to make investments subject to utility
\ncommission approval. That approval
\neffectively provides (very) long-dated contract for any power they produce at
\nprices that are guaranteed to be high enough to recover all operating costs and
\ncapital. There has been a concurrent
\nboom in wind turbine construction, driven by a combination of wind-specific tax
\nsubsidies and wind-specific RPS contracts, both of which combine to provide
\nlong-dated contracts for power, provided that it comes from wind. In both cases, these assets are procuring
\nlong-term contracts at prices that are well above clearing prices in wholesale
\npower markets, distorting markets even as they are bypassed.<\/p>\n
\nfood markets, slowing the maturation of the very markets that are required to
\nmake Africa self-sufficient, and increasing the continent’s dependence on
\nfurther food aid. The deployment of
\nextra-market generation in U.S. power markets is comparably slowing the
\nmaturation of U.S. power markets, making it ever harder to break free of our
\nantiquated, top-down regulatory paradigm.<\/p>\n
\nsophisticated markets? Not necessarily—and Kyoto-compliant CO2 markets are a noteworthy exception. They are about as old as U.S. electric markets,
\nbut are vastly more sophisticated. I can
\nlock in a 15 year strip for CO2 sales in a CDM-compliant country today that
\ngives me price certainty, and even gives me a buyer who is willing to take the
\npost-2012 regulatory risk after Kyoto expires. On just about all relevant measures, these markets are deeper, more
\nrobust and more sophisticated than U.S. electric markets. How come?<\/p>\n
\nthese markets were created from whole cloth. There is no equivalent to the commission-sanctioned power plant in Kyoto
\nthat gets built outside of the market but affects prices within the
\nmarket. Regulated parties have to meet
\nin a single market and that single market became the magnet for capital. While far from perfect, good things have
\nlargely followed.<\/p>\n
\nunderstandable backlash against complex financial markets. Without question, there is a need for greater
\nregulation and oversight of financial instruments. However, we cross a line when we ban their
\nuse—and we should be very careful about efforts mooted to do so in current
\nCO2 policy proposals. That ban makes for
\na good populist sound-bite, but only amongst those who don’t understand what
\nthose “complex financial instruments” do. If we want people to invest in capital to reduce CO2, we need to give
\nthem a way to enter into long-dated contracts for CO2 reduction at firm prices. A spot market for CO2 doesn’t provide that
\nfinancial product—but a vibrant participation in that market by
\nfinancially-sophisticated players will. That means hedges, swaps, collars, puts, and—dare I say it?—derivatives. Some financial institutions
\nwill make a lot of money on those transactions and others will lose. Such is the nature of a functioning financial
\nmarket that prices and allocates risk through the system. And while we absolutely need a regulator to
\nensure that those booms and busts don’t put the functioning of the market at
\nrisk, we cannot forget that the purpose of a CO2 market is, first and foremost,
\nto reduce CO2 emissions. That in turn
\nwill require capital investments and the long-dated contracts necessary to
\nbring that investment forward. Price
\nalone won’t cut it.<\/p>\n
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