Formal chaos?

Recent price fluctuations have led to soul-searching about the EU ETS and its wacky governance. I remember that when I was at university there was a lot of excitement about chaos theory. Someone showed me a simple system with wheels, where there were regular inputs but totally wild and theoretically unpredictable outputs.

I wonder if the EU ETS is a similar system.

Imagine phase three of the ETS and think of 2020; assume there is a cap of 1.77 billion units.

Imagine that the expected emissions are around 1.77 billion units. If the system has any power to influence emissions, then we should expect emissions to be around that level.

If the market agrees that actual emissions will be 1.76 billion, then we would expect, everything else being the same, that the price of EU Allowances should be zero, because there would be no demand for them.

But if the market agrees that actual emissions will be 1.78 billion units, then the price would reach the level of the “marginal abatement cost” of the 1.78 billionth unit. Let’s say, for the sake of argument €40.

Let’s say that the level of emissions depends on … the weather. So if we expect much rain and full lakes in Norway and Spain, then the price will be zero. And if we expect little rain, then the price will be €40.

So without banking of EU Allowances, we would expect the price to flit between €0 and €40, depending on the level of expected rain.

It might not just be the rain. Think of Germans or Greeks. Germans are good at doing what they are told to do; Greeks don’t really give a toss. So if at the margin of the power system, you have a German, you know that he will cut his emissions dutifully, and the price should be zero. If you’ve got a Greek at the margin, then you can bet on the €40 price.

That image of the price flitting between €0 and €40 reminded me of the chaotic system someone once described to me.

But remember that EU Allowances can be banked and used in the next trading period. So the price between 2021 and 2028 should also affect the price in 2020. Well, then there might be a cap of 1.2 billion units (for the sake of argument). By then the marginal abatement cost of the 1.2 billionth unit is expected to be even higher. Perhaps €75 (for the sake of argument).

So the expected 2028 price should jump between €0 and €75, depending on our expectations of the weather.

Again, we have to ask whether it will be sunny or rainy in 2028 and whether we’ll have a German or a Greek at the margin of the system. Or whether someone comes up with a cool technology to cut emissions, which they are supposed to do.

I can’t think it through (so probably lots of other people can’t) but it seems like the price could end up swinging between €0 and €75. That’s even more chaotic than swinging between €0 and €40. So as time goes on, the price fluctuations seems to get wilder and wilder. You might as well just call it Gene. And this is all influencing our 2020 price. Which is influencing the price today.

Whether this is formally chaotic or not, I don’t know, but the price is clearly born to be volatile. Small changes in expected circumstances can lead to massive swings in the price. Did you say “volatile”? As policy measures go, it is a highly strung kid, abused by its alcoholic dad, does a lot of drugs at university, works as a hedge fund trader, is addicted to cocaine, suffers violent mood swings, has an anger problem and supports Millwall.

So if I am planning investment in low carbon and trying to figure out the expected price of carbon based on price signals (which is one of the reasons we have cap and trade), I’m not sure I want that kid as my trusted financial advisor. I have no idea whether the price of carbon will be very small (aka “zero”) or very big. I would just know that the price would be whizzing up and down like some feverish subatomic particle. This is not likely to encourage much investment in low carbon technology. Perhaps this is the definitive case for taxes instead of cap and trade.

I don’t know if the carbon price is formally chaotic or what that implies. One thing is certain, however. The price itself is less chaotic than the governance of the EU ETS.

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