Twenty-first Century Skill: Trading Carbon Credits

Cap and trade has become an increasingly popular mechanism used by governments to induce green behavior among corporate polluters, with news emerging almost daily. Just recently New Jersey Governor Chris Christie withdrew his state from the Regional Greenhouse Gas Initiative in the Northeast even as several states in the West were planning a new joint program.

So clearly it's important for business managers in many industries to understand how cap and trade—a complex, market-based process with many moving parts and permutations—really works. A carbon trading simulation designed by Harvard Business School professor Peter Coles gives students the opportunity to experience firsthand the pressure-packed decision-making process and uncertainty involved.

"I'm a believer in interactive learning," says Coles, who has used the simulation in the elective course Managing Networked Businesses and the doctoral course Market Design. "The goal was to provide a classroom experience that would allow students to really see the impact of different design principles in the cap-and-trade mechanism."

The basic concept is straightforward enough: A cap is set on carbon emissions. Companies can then buy and sell a limited number of emission permits, which allows them flexibility in their pollution levels, and at the same time creates a market price for carbon pollution. But how well does the system function when it's implemented in the real world?

For the exercise, the class is divided into groups of five students. Several days before the exercise, each student receives private information regarding his or her role in the simulation, including an initial allocation of permits. Four of the students are assigned roles as managers of large cement manufacturers (simply designated White, Brown, Black, or Green Cement). A fifth student, who represents an environmental activist organization, is assigned the goal of purchasing as many permits as possible within a designated budget in order to reduce the total allowable pollution levels for the cement firms.

Students are instructed to try to maximize profits and not, for example, install clean technology because they think it is morally responsible.

Trading begins
In class, a year of trading is condensed into a 21-minute exercise with several decision points. At the 7-minute mark of trading, each firm decides whether to invest in clean technology, which ultimately could save the company money by reducing emissions, but comes with up-front costs. At 14 minutes, each firm sets cement production quantities for the year. After 21 minutes trading halts, and students submit their permits. They are obliged to pay a fine of $40 per ton of pollution exceeding their permit holdings.

"Putting the students through that decision-making process reinforces the role of uncertain prices in a cap-and-trade mechanism," Coles says. "It contrasts with a simple command-and-control approach to regulation that specifies maximum pollution levels allowed by industry, or a carbon tax with a known cost for each ton of carbon. Those methods don't generate as much uncertainty in future prices, so it's easier to recognize what the return will be on an individual investment."

At the beginning of the exercise students are in the dark. No one knows what an appropriate permit price is, but they try to get signals to help them make a somewhat savvy decision. "Those who make poor choices feel the consequences of price uncertainty most deeply," Coles says.

One of the cement factory managers begins with no permits. While that may seem unfair, it's a condition that mirrors real life. "Typically, these permits are grandfathered," Coles says. "They go to incumbent firms with the best lobbyists, while the new guy faces an uphill battle."

Sometimes groups will find that the price drops to zero, upsetting students who are stuck with suddenly worthless permits. In other instances, the price rises dramatically. "Both extremes offer useful discussion points," says Coles, noting that the Europe Union experienced a price collapse in 2006 that called the stability of the entire market into question.

"As a class we can talk about whether a price collapse is really a problem, and if so, what can we do to fix it. A simple solution would be to not issue so many permits, which is easier said than done. Another is to allow unused permits to be banked for future periods, while a third would be to establish a government-imposed floor or ceiling on trading prices that would protect firms from those extremes."

The profit point
The profit-driven behavior of the cement factory managers eventually creates a clear "aha!" moment.

"No one is thinking about efficient reduction of pollution during the exercise, and that is really the whole point of the cap-and-trade scheme," Coles says. "A property right is assigned to produce a certain amount of pollution and then market principles go to work. Afterward, in discussion, we look at what's happened and see that we've held pollution to the cap level incredibly efficiently." In the discussion, he adds, it's possible to go through the math behind the dynamic and the role of marginal cost of abatement in reaching this point.

Students consider other market design factors during the debriefing session, such as determining how to set initial permit allocations. As mentioned, grandfathering would give incumbent firms an advantage; other options include auctioning permits to the highest bidders, or assessing each firm's operations by size and industry and then estimating benchmark pollution levels; if a firm exceeded those levels, it would need to buy additional permits.

Trading in the United States
While the United States hasn't taken part in global carbon cap-and-trade schemes, Coles notes that it has long had trading programs for sulfur and nitrogen oxides, the emissions that cause smog and acid rain. "Our 'SOx' and 'NOx' markets are well functioning. It's an easier problem to solve because it's a more local pollution. By contrast, if China, the United States, and India decide not to join a global carbon trading scheme, Europe's efforts may appear insubstantial in reducing global warming. Worse, if cap and trade puts European firms at a permanent disadvantage in the global market, this may further erode European industry support."

Using a simulation to grasp the mechanics and economic efficiencies of cap and trade is one matter. But factoring in the complexities of global politics? Coles has been thinking about an extension of the simulation, in which the United States joins the European Union's carbon market as a means of testing what happens when markets are linked.

There will probably never be a simulation that captures and accurately predicts the intricacies of geopolitics—but it's a start.

This article was provided with permission from Harvard Business School Working Knowledge.