Some members of Congress recently tried and failed to pass a bill tackling global warming. In California, a landmark climate change law is already on the books, but before the year is out, state regulators may approve a "cap-and-trade" system.

It's a popular strategy for reducing emissions but a bit tough to understand. Here's how it works: Regulators set mandatory limits on various kinds of industrial emissions. Firms that need to exceed their limits, or "caps," can buy permits from firms with allowances to spare. Hence the phrase "cap-and-trade."

The concept was put to the test at the Haas School of Business at the University of California, Berkeley. There, professors Severin Borenstein and Jim Bushnell teach a class called Energy and Environmental Markets, the crowning glory of which is a computer simulation of an electricity market.

Competing groups of classmates, each with different "portfolios" of power-generating plants, vie with each other to get the best price for their power during a three-week period.

Borenstein says the simulation was inspired by real-world events. A few years back, California deregulated its electricity market, and soon after, energy traders figured out how to game the market, nearly bankrupting the state's biggest utilities.

"We first introduced the electricity strategy game during the electricity crisis, so students would have a better understanding of what went wrong in the California electricity market by actually putting them in the position of firms deciding how much to produce and how much to charge," Borenstein says.

He and Bushnell predicted California's energy crisis. They were ignored at the time. But in the classroom, it becomes clear as students put in a position to manipulate the market do so all on their own.

The professors updated the simulation to account for carbon trading. So after a first round of straight-up power trading, the teams have to reduce their carbon output by 10 percent and trade permits.

"Now, in Game A, these guys bought up most of the credits, and they announced 'We're tearing up half the credits, and so you got to pay a high price if you want to get carbon credits from us.' Was anybody surprised by this? … You guys were? Yeah, you guys were kind of upset, as I recall," Bushnell explains as students laugh.

The lesson? In any market, social concerns — even broader economic stability — take a back seat to making money as efficiently as possible.

Borenstein says it's critical to stress-test your market design before you ring the opening bell.

"What's going to happen in the real world when some people are out to make as much money as they can?" he asks.

He isn't just talking from the sheltered confines of the ivory tower. Borenstein and Bushnell have experience as electricity regulators in California. It's a fair bet that some of their students will go on to serve as carbon trading regulators.

After the class is over, Greg Croft says he also was taken aback, but not by his classmates gaming the market. His concern reflects the second big worry public policymakers have about carbon trading: "It hugely increased the electricity prices," he says. "I mean, this is the only example I've seen, [but] we had two different games in the class and it happened in both games."

Cap-and-trade is not the only strategy under serious consideration by economists, environmentalists and public policy wonks. Some of them would prefer to simply put taxes on emissions.

But taxes are widely considered a much harder sell politically. California regulators could decide to opt for cap-and-trade, as well as taxes. Whatever strategy they go for, the state should prove a handy test case — a simulation, even — for the rest of the nation.  Source

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