MBA Students to Regulators: Watch Your Back on Cap-and-Trade

 

Policy makers hashing out “cap-and-trade” systems to cut carbon emissions might gain some insight from this spring’s Energy and Environmental Markets class.


Berkeley MBA students competed in a carbon-trading simulation that suggested such regulations would get off to a rocky start. Given the chance, students quickly found ways to manipulate the market, as the instructors expected.


“The idea was to demonstrate how far real markets can diverge from predictions, especially when the market intersects with policy instruments,” explains Lecturer James Bushnell, who co-taught the course with Associate Professor Catherine Wolfram and developed the game with Professor Severin Borenstein.


“Cap-and-trade” is a strategy to limit greenhouse gases through market forces. Polluters who cut emissions can sell or trade excess carbon permits to dirtier producers. President Obama is pushing legislation to create such a system in the US.


The Haas carbon-trading game opened with an electricity auction, modeled on California’s failed deregulation. After the class split into two groups that competed in parallel, smaller teams bid on seven diverse portfolios of power plants. The teams generating the most juice quickly figured out what California regulators didn’t anticipate: Their megawatts were pivotal to meet peak demand, allowing them to charge exorbitant prices.


Then emissions were capped at 90 percent of the total produced by the power plants. Teams re-bid the portfolios, and carbon permits were divided equally – regardless of actual emissions. This ensured some teams would have to cut emissions or buy permits, while others could sell.


Uncertainty about permit prices led to power plays. The average price was $25 per ton in one group and $85 in the other, underscoring potential price volatility. Two teams became locked in a fruitless price standoff.


Another team took selfserving action to prevent a permit glut – as happened in Europe, where prices dropped to nearly zero.


“We figured if people hadn’t polluted enough by the end, we’d start destroying permits,” says Brian Farhi, MBA 10, who has worked 11 years in the solar industry. “We helped to reduce overall emissions, but we weren’t being graded on saving the earth. Our goal was maximizing profits.”


His conclusions for the future of the carbon-trading industry? “There will be a lot of risk early on, along with the opportunity to make a lot of money … and it’s the energy users who will pay for it all.”

 

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