“As the U.S. develops a carbon policy, it may make sense to, as you suggested earlier, implement some sort of tax. That wouldn’t necessarily be an attempt to price the entire cost of carbon emissions. However, it would put some price on carbon price on carbon emissions above zero. Then, we’d work out the kinks with cap and trade in the longer term later on.”

I understand there have been some things put in the Kerry/Boxer bill (for more, see Senate climate bill: ag unimpressed) to keep a potential carbon market from being manipulated. Do you see anything like that working?

“There are two things to say here.

“When you try to prevent the cap and trade market from working – which is what these provisions do – you no longer get the benefit certainty that’s the hallmark of cap and trade. Markets provide very harsh incentives whether for ill-designed contracts or mispriced goods. And those harsh incentives are what we’re relying upon to give us the benefit certainty of a reduction of X amount of carbon.

“Some of what you see evolving in the (congressional) bills to try and staunch arbitrage plays or other types of what the Hill likes to call ‘market manipulation’ is, to me, a realization that a lot of the cap and trade policy ideas that have shown up are holdovers from how we viewed the central banking 10 years ago – for instance, under Alan Greenspan, who was a great central banker. But we now know he made it look way easier than it really is.

“Engineering and managing a market, whether for central bank reserves or carbon permits, is a tremendously complex task. But 10 years ago, Greenspan made it look simple, like ‘gee, pull this lever and the market reacts. We can just construct this carbon market and it’ll work.’

“Success isn’t a foregone conclusion when you have (numerous) traders critically reading your bill on the details of the market design that are ready to profit off any loopholes or incentive features. The fact of the matter is it’s very difficult to design such markets.

“If we didn’t have to have the central bank operating this market for bank reserves in order to stabilize the value of the U.S. dollar and how that relates to U.S. economic growth, we wouldn’t walk into doing it willingly, today. (Even though) that’s exactly what we’re doing under cap and trade.”

Common misperceptions on this?

“A big one is what I just described: overconfidence in the ability to manage financial markets.

“But the biggest misperception involves the bills, as they mount, keep moving toward using the central banking feature to stabilize the price of carbon. Whether you express this in theoretic economic terms, or in plain common sense, once you stabilize the price of carbon using institutional design and convoluted contracts, you get the same effect as a carbon tax.

“Why not just take the stabilization target price and make that price the tax? Why bother to use the carbon offsets, the institutional framework, the government agencies, the laws, the convoluted market design and the rest?”

So, why not? You mention there are some environmentalists now coming to the carbon tax side. Why didn’t they start there in the first place? Was that mistake from the get-go or was it by design because they know the carbon tax won’t be passed?

“I think it was a mistake made at the beginning when thinking about carbon policy. I think it’s a mistake from which the Greens are gradually retreating, but which Capitol Hill remains wedded to.

“The mistake has to do with the application of cap and trade from an economic perspective. A few months ago, the Wall Street Journal ran a piece quoting the economist who came up with the initial theory of cap and trade. He said, ‘Don’t do it.’ The reason he said that is it comes down not just to the convoluted marketing but the fundamentals.

“The economics of cap and trade – and I said this before the Senate Energy Committee a couple of weeks ago – works for an externality that’s easily identified and quantified. It relies on an ability to say ‘I want 100 million tons of carbon dioxide reduced. And I can identify exactly where those are.’

“If you can do that, you can set the value to be purchased. A price can then evolve.