Paper Recommends Ways to Lower CO2 Price Volatility

The Brattle Group has assessed the likely extent and potential impact of CO2 price volatility on carbon abatement investments and recommends strategies to reduce volatility to protect consumers and investors, according to a Jan. 22 press release.

In the discussion paper "CO2 Price Volatility: Consequences and Cures," economists Metin Celebi and Frank Graves evaluate current U.S. climate policy proposals that involve a cap-and-trade mechanism with increasingly tight caps on carbon emissions over time. They found that the extent of volatility of CO2 prices under these types of proposals could be substantial and is likely understated even by the current wide ranges in CO2 price forecasts.

This high level of price volatility, exceeding that of natural gas prices, will likely deter investors' willingness to undertake long-lived, capital-intensive, and low-CO2 technologies. By increasing investors' hurdle rates, making debt financing more difficult, and creating an option value for waiting to invest, CO2 price volatility will cause carbon abatement technologies to be deferred for 10 years or more, until CO2 prices are perhaps double the levels needed to justify these investments, absent the volatility.

The paper recommends several ways to help reduce potential CO2 price volatility. The most direct way to mitigate CO2 price volatility would be to use a carbon fee rather than cap and trade, although that approach appears less likely to be adopted in United States. If cap and trade is used, there should be a safety valve mechanism that includes a slowly evolving price "floor" to protect investors, as well as the more commonly-discussed "ceiling" to protect customers. Tax benefits, development subsidies, and partial investment guarantees could also reduce risks and CO2 price thresholds for investment.

"At this time of economic uncertainty and as the new administration readies itself for energy policy planning in the U.S., it is critical for companies and policymakers to carefully consider how various climate and carbon initiatives will affect needed investments in the coming years," said Graves.

The discussion paper can be found at www.brattle.com.

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