Senators John Kerry and Barbara Boxer have introduced a "green" price collar on carbon under their draft climate bill that should be applauded by emitters and environmentalists alike. A green price collar that will; 1) maintain the integrity of the carbon cap, 2) lower price volatility, 3) put a limit on emitter costs, 4) better ensure the program's long term viability, and 5) help to tighten the carbon cap. Best of all, the Kerry-Boxer bill is able to do this by putting market participants to work defending the price collar rather than fighting it.

The Market Stabilization Reserve (Sec. 726 of The Clean Energy Jobs and American Power Act ) would amend the strategic reserve language used under the ACES bill in the following three ways:

First, the Market Stabilization Reserve replaces the ACES price trigger formula with a pre-determined ceiling price that starts at $28/ton in 2012 and rises by an inflation adjusted 5-7% annually. Using this fixed ceiling price in combination with the ACES fixed floor price (which starts at $10/ton in 2012 and rising 5% per year thereafter), the Kerry-Boxer bill looks to create a trading band or "price collar" on carbon allowances values over the life of the program (see graph below):

Second, the Market Stabilization Reserve nearly doubles the number of allowances available to defend the price collar. While the ACES bill limited the strategic reserve to providing an additional 10-15% of allowances established under the cap in a given year to fight price spikes, the Kerry-Boxer bill would increase this amount to 15-25% of the total number of allowances established. An amount of allowances large enough to create a high degree of certainty that the carbon prices will remained contained within the price collar band (see graph below): 

And finally, unlike under the ACES bill, the Market Stabilization Reserve may purchase domestic and international offsets to supplement the number of allowances available in the reserve pool. These changes in the strategic reserve language under the Kerry-Boxer bill are expected to lower carbon price volatility and give emitters greater assurance that their carbon costs will be contained within the price collar band.

Furthermore, the Kerry-Boxer bill creates a market based mechanism that encourages market participants to actually work to defend the price collar. A dynamic that is expected to make the Kerry-Boxer price collar truly "green" as this would enable a higher percentage of allowances from the Market Stabilization Reserve to be retired from the program instead of used to fight price spikes. 

To illustrate, let's suppose carbon prices in the year 2020 were trading at a price of $43.75, just 5 cents below the $43.80 collar price ceiling. From a market participants point of view, these market conditions create a strong incentive to not only stop buying allowances but actually begin to sell them in the hope that they will be able to buy them back later at lower prices (once market  speculators have been driven out of the market). 

The reason for this is that at a carbon price of $43.75, a market participant knows two things; 1) that the risk/reward of buying allowances is lousy given the amount of allowances on offer under the Market Stabilization Reserve to defend the $43.80 level* , and 2) the risk/reward of selling carbon allowances is quite good, as market participants also know that the allowances they sell to help reverse the supply/demand imbalance in the market can be covered with minimal cost in the Market Stabilization Reserve auction.  

As a result, a market participant is likely to act in a way that protects the price collar from being triggered, creating  not only a programmatic benefit by keeping the Market Stabilization Reserve largely in tact, but an environmental benefit as well as more of these allowances can eventually be retired from the program over time.

In sum, the Kerry-Boxer draft climate bill should not only be commended for moving up our target on emissions reductions from 17% to 20% by the year 2020, but for also creating a "green" collar on carbon. A green price collar that will create better cost and program certainty for emitters, while still maintaining the program's long-term environmental integrity under the cap.

* The 1.2 billion allowances available to defend the price collar in this case (the equivalent of 25% of the 4.8 billion allowances established in 2020) is roughly the equivalent of six times the largest annual change in our emissions output over the past two decades. The average change has been around 70 million tons or around 6% of allowances on offer in the Market Stabilization Reserve.