We report on an economic experiment that compares outcomes in electricity markets subject to carbon-tax and cap-and-trade policies. Under conditions of uncertainty, price-based and quantity-based policy instruments cannot be truly equivalent, so we compared three matched carbon-tax/cap-and-trade pairs with equivalent emissions targets, mean emissions, and mean carbon prices, respectively. Across these matched pairs, the cap-and-trade mechanism produced much higher wholesale electricity prices (38.5% to 52.6% higher) and lower total electricity production (2.5% to 4.0% lower) than the \equivalent" carbon tax, without any lower carbon emissions. Market participants who forecast a lower price of carbon in the cap-and-trade games ran their units more than those who forecast a higher price of carbon, which caused emissions from the dirtiest generating units (Coal and Gas Peakers) to be signicantly higher (15.2% to 33.0%) than in the carbon tax games. These merit order \mistakes" in the cap-and-trade games suggest an important advantage of the carbon tax as policy: namely, that the cost of carbon can treated by rms as a known input to production.

To maximize environmental benefits from the rollout of its cap-and-trade program for greenhouse gas emissions, California should focus on achieving a positive demonstration effect from the program by doing as little as possible to harm the state's economy, as transparently as possible and as fast as possible.

^Abstract

This paper summarizes the lessons learned from implementing a realistic, game-based simulation of California’s electricity market with a cap-and-trade market for greenhouse gas (GHG) emissions and fixed-price forward financial contracts for energy. Sophisticated market participants competed to maximize their returns under stressed (high carbon price) market conditions. Our simulation exhibited volatile carbon prices that could be influenced by strategic behavior of market participants. General uncertainty around carbon price as well as the deployment of strategies that were privately profitable but adversely affected overall market efficiency resulted in total costs of electricity supply that were significantly higher than would have been observed in perfectly competitive allowance and electricity markets. 

We observed several striking phenomena in our game. First, all teams in our game found themselves in a position to prefer higher carbon prices, even those holding high-emitting power plants. This occurred both because electricity price rose faster with carbon price than the average variable cost of producing output for most teams and because the initial allowance allocations functioned as “free money” with a face value that could be increased through the unilateral actions of market participants. Second, teams exercised unilateral market power on both selling and buying sides of the carbon allowance market, with the net effect being a carbon price far above that which would have been expected based on allowance supply and demand in a perfectly competitive market. Third, disagreement among teams over the appropriate price of carbon allowances combined with the exercise of unilateral market power in both electricity and allowance markets dramatically increased electricity prices and often resulted in the use of a more expensive set of generation units to produce the electricity demanded.  Numerous authors have pointed out that electricity markets are extremely susceptible to the exercise of market power, and emissions allowance markets can exacerbate this problem, as demonstrated in Kolstad and Wolak (2008). Fourth, there was very little liquidity in the secondary market for carbon allowances until right before the final emissions “true-up,” with a flurry of trading at the last minute, which resulted in inefficient market outcomes as several trades failed to be completed before the deadline.

These findings have several important policy implications. First, policy measures that increase the transparency and liquidity of the carbon allowance market would make both the allowance market and the electricity market work better. In our simulation, all market participants showed a strong unilateral desire to limit the amount of information publicly available about conditions in the carbon market, much to the detriment of market performance. Second, guardrails that constrain market outcomes, such as price floors and ceilings, can play a valuable role by limiting carbon price volatility.  Third, position and holding limits can reduce the ability and incentive of market participants to attempt strategies that, while privately profitable, have a negative impact on overall market efficiency.