Are carbon trading schemes the best way to tackle climate change? Trading is central to meeting Kyoto targets. But the EU scheme, the world's biggest, has had a bumpy start and questions remain about the long-term viability of tradingby Matthew Lockwood / February 25, 2007 / Leave a comment
Published in February 2007 issue of Prospect Magazine
For a policy that is supposed to save the planet, there is surprisingly little public debate about carbon trading. The principle of buying and selling permits to emit greenhouse gases now dominates international thinking on climate change. The government’s recent energy review confirmed that carbon trading “will remain the central element of the UK’s emissions reductions policy framework,” a view strongly endorsed by the Stern review. The idea of nations trading emissions also lies at the heart of the Kyoto protocol. Carbon markets in some form exist across Europe, Japan and even in parts of the US and Australia. And while carbon trading has so far been the domain of big power companies and heavy industry, in future we may see schemes involving supermarkets, local government and even individual citizens.
Yet economists aside, most people have little interest in carbon markets. Since the subject is full of acronyms and obscure jargon like “grandfathering,” “bubbles” and “flexible mechanisms,” this state of affairs is understandable if undesirable. Given the urgency of the climate change issue, it is crucial that the policies we design to mitigate it are effective, and there are some very serious questions about carbon trading. As we shall see, the devil is in the details of scheme design.
Principles of pollution trading
The basic ideas underlying carbon markets are simple. A good way to understand them is to look at the precursor to today’s carbon schemes—sulphur dioxide trading in America. In 1990, the US government set up the acid rain programme to reduce annual emissions of sulphur dioxide by 10m tons below 1980 levels, a cap that has been subsequently tightened. One way of reaching such a target is to specify that each power plant or factory must reduce emissions by a set percentage. But where it is cheaper for some polluters to make cuts than others, a tradable permits scheme can in theory achieve the same outcome at a lower cost. This is the approach of the acid rain programme. Tradable permits create a market, requiring the polluter to pay for the right to pollute. The general idea is that the total amount of pollution allowed is allocated among polluters in the form of permits, mainly in proportion to each plant’s heat output. Each permit allows the holder to emit a ton of sulphur dioxide. In the first phase of the acid rain programme, over 400 power plants in the eastern and midwestern states were included. At the end of each phase, each participant had to have the correct number of permits for its actual emissions or face a fine ($2,000 per ton).
The theory is that those who can cut back their pollution cheaply do so, and sell their surplus permit allocation to those who cannot. The overall effect should be to drive pollution reduction at the lowest cost to the companies involved (and potentially to their customers in the form of lower prices). The acid rain programme is widely seen as successful. Emissions in the first five years fell by 50 per cent, more than the cap required, and it is estimated that the programme has saved $3bn compared to the costs of alternative sulphur dioxide reduction schemes.
Evolution of trading schemes
So pollution trading had a sufficient track record to appeal to negotiators devising international climate change policy in the 1990s. Under the Kyoto protocol, governments will be able to meet their emission reduction targets either by cutting national emissions or buying credits from other countries. Credits can also be earned by investing in offset projects that cut emissions in developing countries, which have no Kyoto targets, through the “clean development mechanism” (discussed below).
In 2002, the British government gave the City of London a first-mover advantage by setting up a voluntary carbon emissions trading scheme with some energy-intensive industrial companies, who were persuaded to take part with sweeteners in the form of large subsidies. The City has become the main global centre for carbon trading. However, the British scheme—which didn’t even cover the really important emitters, such as power plants—has been superseded since 2005 by the EU emissions trading scheme (ETS), which in principle is driving the EU’s attempt to meet its Kyoto commitment to cut carbon emissions by 8 per cent below 1990 levels by 2012. The EU ETS is hugely important because it is by far the largest scheme in the world—in terms of the value of permits, estimated at $37bn a year, it is between three and 20 times larger than the US schemes—and is the potential keystone for any putative global trading scheme.
In this European market, member states set a European commission-approved national cap on carbon dioxide emissions, along with a plan for allocating permits to installations. Permit-holders are then allowed to trade. The first phase of the scheme (2005-08) includes power plants and factories in energy-hungry industries (iron and steel, cement, glass, paper). Actual carbon emissions are measured by how much oil, gas or coal is used in each location. In 2005, these sources between them produced 362m tonnes of carbon—almost half of the EU’s emissions. From 2008 more industries will be covered, including the airline industry from 2011—these together will account for up to a further 9 per cent of emissions.
Such schemes, involving electricity generators and heavy industries, are remote from consumers and voters. But in Britain various other existing or proposed trading schemes get closer to direct use of fossil fuels by households. One of these is the government’s “energy efficiency commitment.” Conceived as a way of getting the six biggest domestic energy suppliers to speed up energy efficiency improvements in our homes, this scheme is funded by a levy on our gas and electricity bills. The £400m or so raised every year is given to the utility companies to pay for energy savings by customers, mainly through offering subsidised cavity wall insulation. To offer the companies flexibility in meeting their targets, they are allowed to trade a proportion of their energy efficiency target with one another, although none has done so to date.
The government has also made quite detailed proposals for a mandatory British emissions trading scheme, to be introduced in 2009, for 5,000 large companies and organisations not covered by the EU scheme but that are still responsible for about 10 per cent of British carbon emissions. These include supermarkets, local authorities and large office-based companies.
Perhaps the most intriguing proposal is for carbon markets to reach down to individual citizens. The idea of giving every adult in the country an equal allocation of carbon and then allowing trading was first proposed by the environmentalist David Fleming in 1996. Every time we buy fuel at a garage, pay a gas or electricity bill or get on a plane, carbon would be deducted from our account (most versions envisage an electronic system similar to credit card transactions). The idea has slowly gathered momentum, and is now being seriously investigated by a range of organisations from the Environmental Change Institute to the Royal Society of Arts. Even David Miliband, the environment secretary, has recently called personal carbon trading a “compelling thought experiment.”
Will carbon trading work?
From the point of view of mitigating climate change, the key question is whether carbon trading will actually reduce carbon emissions. Radical critics, such as Larry Lohmann of the environmental and social NGO the Corner House, argue that trading itself adds nothing to emissions reductions efforts. Certainly, what emerges from closer examination of air pollution trading schemes in general is that their effectiveness depends heavily on scheme design. (A recent report by the IPPR, “Trading Up,” reviews the European scheme.)
One issue is the strength or weakness of the underlying curbs set on emissions. In the case of the EU scheme, Cambridge economist Michael Grubb makes the point that its sheer scale means that member states are subject to intense lobbying by economically strategic industries. In the first phase of the scheme, lobbyists across Europe pushed successfully for weak caps. In April 2006, when it became clear that 20 of the 25 member states had set caps for 2005 that were so generous that they were above actual emissions the carbon price immediately collapsed from €25 to around €4 per tonne, where it currently languishes.
Industrial lobbyists also argued successfully for “grandfathering”—for allocations to particular installations to be based on their emissions in a reference period rather than on an overall carbon target, as under Kyoto, or on best practice in the industry. If this is repeated in subsequent phases, it will create a perverse incentive for companies to increase emissions, because this will give them a higher allocation in the next phase. In the run-up to the second phase, industrial lobbyists are also arguing for the right to carry over excess credits from the first phase. Member states have placated these interests by adopting complex non-transparent procedures, and in many cases simply by stalling on submitting plans—to the point where the commission was threatening legal action in late 2006.
How disastrous is this experience for the EU ETS? Defenders of the scheme say that many of the concessions made to industry—weak caps, grandfathering, and other weaknesses like the small fines for non-compliance—are politically necessary to get the scheme launched. Once it is running, caps and other features can be tightened. It is true that the first phase of the European scheme was seen as a trial period. But is it credible that the second phase will see a tougher stance? Late last year the commission sent back all the member states’ proposals (with the exception of Britain’s) because they were too lax, but it remains to be seen if governments and their industrial lobbies will play ball.
Similar issues of political credibility would also apply to personal carbon trading. Will people believe a government that says it intends to progressively cut the personal carbon allowance would actually carry out such an unpopular policy (or stay in power if it did)?
A second concern about the European scheme is that the cap is not only weak but also leaky. Companies that need extra credits to cover their carbon emissions can not only buy them in the market, but can also acquire them by investing in clean development mechanism (CDM) projects—the offsetting scheme set up under the Kyoto protocol. How many reduction credits can be acquired in this way varies from country to country, but it is expected that they will make up the majority.
In theory, the CDM is just an extension of the flexibility approach. A tonne of carbon dioxide emissions abated has the same effect anywhere in the world. So if it is cheaper to do this in India or Africa than in Europe, why not do so, especially if, as originally advertised, the CDM also helps transfer renewable energy technologies to the south?
In practice, renewable energy is involved in only 2 per cent of CDM projects. More typical is the deal announced last September, where Centrica (the parent company of British Gas) is investing in technology for capturing emissions of the very potent greenhouse gas HFC-23 from a Chinese chemical company. Some 70 per cent of CDM credits arise from capture projects like this one (arranged by the London-based carbon trading investment bank Climate Change Capital), mainly involving large industrial plants in China, India, Brazil and Korea.
CDM projects are supposed to represent real carbon savings compared with what would have happened in their absence. In the case of HFC-23 projects, it is difficult to assess whether they make any difference over and above what would happen under the Montreal protocol, which is designed to phase out ozone-destroying hydrofluorocarbons. The chemical company DuPont has accused its rivals of overstating emissions reductions from such projects. The fact is that there is no framework for establishing such facts and no assurance that emissions really are being reduced as much as claimed. A gold standard for CDM projects, with tighter criteria for the transfer of renewable energy technology, has been set up by the World Wildlife Fund and others. However, unsurprisingly, these credits are much more expensive than ordinary CDM credits, and make up only a tiny proportion of the total.
Perhaps the biggest problem with carbon markets like the EU ETS is their lack of long-term certainty. In permit schemes, because the supply of permits is stable, small changes in demand can lead to large changes in price, as in the case of the carbon price in the European market in 2006. In a nitrous oxide trading scheme in Los Angeles, permit prices rose from 13 cents to $37 within two years. Even in the sulphur dioxide scheme, prices had a monthly volatility of 10 per cent. This volatility is bad enough, but in industries such as electricity generation, where plants may last decades, investment decisions—especially innovations involving big up-front research costs—depend on knowing the price for carbon emissions over that time.
Although there is European legislation in place for carbon trading after the end of the Kyoto agreement in 2012, the long-term future of the EU ETS is not assured. According to Vincent de Rivas, CEO of EDF Energy, “the long-term price of tradable emissions allowances is too uncertain to be a driver of systematic technological change in an industry whose generating capacity investments must be planned over 30-year periods.” For economists such as Dieter Helm of Oxford University, this lack of a long-term framework for innovation and investment is carbon trading’s biggest failing so far. Poor design often leads to a final paradox: in many carbon trading schemes there is little actual trading. In many early US schemes there was hardly any. Even in the EU ETS, only 1-2m tonnes of carbon dioxide were traded daily at the peak of the market, in comparison with the hundreds of millions of tonnes of permits held by participants.
Do companies benefit too much?
The other big question about carbon trading is whether it is fair. For trading schemes between large industrial companies—like the EU ETS—the equity concerns are less about fairness between participants and more about the potential for those companies to make windfall profits at the expense of consumers.
Although there is good evidence that, except for the aluminium sector, the emissions trading scheme involves no serious loss of competitiveness with countries outside the EU, company lobbyists have successfully pressed for emissions permits to be given away free. Thus while a participant company may have to buy a few permits in the market to match its actual emissions at the margin, in most cases the bulk of its permits will cost it nothing. Despite this, a number of studies confirm that companies increase prices to consumers as if they were paying for all their permits. UBS Investment Research calculates that the first phase of the EU ETS has added around 1p to each kilowatt hour of electricity.
DTI consultants said that British electricity generators were expected to make windfall profits of around £800m in 2005. Consultants for the commission looking at the inclusion of aviation in the ETS recently estimated that airlines could make up to €4bn in windfall profits, depending on the emissions permit price.
There is surprisingly little public outcry about giving away free what is effectively a kind of property right to parts of the atmosphere. Although it is British policy that more permits should be auctioned to the highest bidder, an absence of public debate across the EU means that this is unlikely to change soon.
When it comes to proposals for trading between individuals, fairness between participants comes to the fore. On the face of it, an equal free ration of carbon permits for everyone from the prime minister to the dinner lady has enormous appeal, particularly as an alternative to taxes on energy, which are highly regressive. The carbon-spewing rich, it is argued, would have to pay extra for their 4×4 lifestyles compared to the cleaner-living poor, who would stand to benefit financially.
However, closer inspection reveals a more complex picture. Many poorer people live in old, hard-to-heat houses, and can neither afford to move nor upgrade their homes. Poorer people living in rural areas without public transport are heavily dependent on cars. Research by the Policy Studies Institute suggests that of the poorest fifth of households, about 25 per cent have above-average emissions, and so would lose under a personal carbon trading scheme. (At the IPPR, we will this year be undertaking a more detailed assessment of the pros and cons of personal carbon trading.)
The future of carbon trading
Given all its limitations, should we be pursuing carbon trading as the central policy for tackling climate change? Almost everyone—from radical anti-capitalist critics to mainstream economists—agrees that the current schemes have problems. They differ on whether those problems can be solved. Proponents of trading, including the government, argue that design flaws in the EU ETS are teething troubles, which can be resolved. In January, for example, the European commission recommended changes to the ETS, including more predictability for investors, more auctioning of permits and wider coverage of emissions (although it is unclear whether member states will embrace these). At the international level, trading advocates argue that although Kyoto is far from perfect, we cannot afford to start again from scratch and must build upon the slow development of trust and institutional commitment that is already there. By contrast, critics such as George Monbiot see these flaws as fatal, and carbon trading as a “red herring.”
However, it is not clear that the alternatives—which include carbon taxes, increased regulation, and investment in carbon-reducing technologies—would be any better. The underlying political realities—that economically crucial industries will lobby ferociously to protect their interests, that voters will not back governments threatening their cars, flights and plasma television sets—apply equally to other potential solutions. Thus while governments are reluctant to tighten caps, or insist on the auctioning of permits, they are also reluctant to increase fuel duty.
From this perspective, the political invisibility of trading schemes involving large companies may be their weakness. The hope is that emissions can be cut cheaply by large corporations with the public virtually unaware that this is going on. But this lack of public awareness is the very thing that makes schemes vulnerable to industry lobbying, resulting in schemes that are ineffective and unfair.
Individual trading may be an alternative—it would certainly make carbon trading more visible—but it would also be politically difficult to introduce, as well as potentially costly in administrative terms. A middle way through this dilemma may be greater public involvement in and scrutiny of corporate schemes. This would require more engagement from NGOs and the media. It is also a challenge to government to put the politics of carbon markets out in the open. It may be the only way to make them work.