The principle of revealed preference, a cornerstone of economic thinking, tells us that if you want to know what something is worth, look at how much people are actually willing to pay for it. The cap-and-trade approach illustrates revealed preference in action. It is based on the idea that a tight cap on emissions will induce polluters to pay a relatively high price for carbon permits, thus giving them a substantial incentive to clean up. A more lenient cap, or uncertainty as to how tight the cap will be, will lead to low permit prices and weak incentives to control pollution.
Following this reasoning, the price of carbon permits under the European Union's cap-and-trade system for greenhouse gasses should provide a better measure of the success or failure of the recent Copenhagen conference on climate change (COP-15) than any number of newspaper editorials or political press conferences. Permit prices peaked at about 15 euros per ton as the conference started on December 7, reflecting optimism that the 193 participating countries would reach a relatively strong agreement to follow up on the expiring Kyoto Protocol. However, when the conference ended on December 20 with only the broadest agreement on general principles, permit prices dropped to under 13 euros per ton.
Commenting on the outcome of the conference, business executives most of all deplored the lack of certainty about the future direction of climate change policy. Until they have some indication of how serious governments are about climate change policy, they are likely to delay the huge investments that will be necessary to slow greenhouse gas emissions anywhere close to the targets environmentalists see as necessary.
To download a free set of PowerPoint slides summarizing the results of the Copenhagen conference and their effect on carbon prices, click on this link. If you find the slides useful, please post a comment or send me an e-mail.