To Trade or not to Trade: Climate Change in the Marketplace

VANCOUVER, August 8, 2007 (GLOBE-Net) – Most policy makers and business leaders now recognize the need for action to reduce greenhouse gas emissions to mitigate climate change. The challenge, however, is in implementing a system which results in real emissions reductions, while still allowing for economic growth and private sector innovation. Increasingly the debate revolves around whether a ‘cap and trade’ emissions trading regime or a carbon tax is the best mechanism to achieve real reductions in carbon emissions while maintaining economic growth. An eclectic group of advocates are lining up on each side of the debate with no clear winner in sight.

As the 2006 Stern Review of the Economics of Climate Change succinctly puts it, “Climate change presents a unique challenge for economics: It is the greatest and widest-ranging market failure ever seen.” Left alone, the world’s economies would likely continue to consume fossil fuels and produce escalating greenhouse gas emissions which could precipitate a potentially disastrous rise in global temperatures.

The market failure referred to is simply that when there is no cost to the discharge of greenhouse gases into the atmosphere, individual entities will continue to consume emissions producing fossil fuels when it is convenient or cheaper to do so. In doing so, we damage the greatest public good we share, the earth’s relatively stable and comfortable climate.

To correct this failure, several approaches have been proposed including issuing permits to emit greenhouse gases and allowing trading of such permits; placing a tax on greenhouse gas emissions to discourage that behaviour; or enacting regulations that restrict emissions producing energy consumption.

While setting a ‘carbon price’ is a necessary aspect of any climate change policy, how that price is best applied is still a subject of much debate. The two main options are ‘cap and trade’ systems, or carbon taxes.

Cap and Trade Systems

Legislated carbon credit markets operate under the principle of a ‘cap and trade’ policy regime. Governments first specify a total amount of greenhouse gas (GHG) emissions allowable for certain sectors or companies, and those covered by the cap are issued permits or allowed to purchase such permits by auction. Companies that reduce their emissions can sell excess credits to those who need them.

The rationale is that carbon trading allows emissions to be allocated in the most efficient manner, reducing emissions where it is cheaper to do so and allowing those facing higher costs to purchase less costly credits. This provides incentives to cut emissions while offering a range of options for compliance. Proponents of the cap and trade system argue that it is the most efficient flexible market mechanism available on an international scale.

The most extensive cap and trade system is the European Union’s Emissions Trading Scheme (ETS), which covers most major industrial sectors. The EU’s flagship climate change policy has been the driving force that has spurred the worldwide carbon trading market to an estimated value of over $22 billion annually. But it has experienced severe price volatility due to over-allocation of credits by some countries. The EU is currently reviewing the system and likely will tighten the caps, add additional sectors (such as forestry and transportation), and move to auctioning credits.

Other cap and trade systems include the Regional Greenhouse Gas Initiative which brings nine U.S. states together to limit emissions to current levels beginning in 2009. A group of western US states plus British Columbia have expressed interest in linking to the eastern scheme with a regional carbon trading bloc of their own. In Australia, the New South Wales Greenhouse Gas Abatement Scheme is already operating at the state level, and Australian state premiers have made initial proposals for a national cap and trade system starting in 2010.

Canada will require large industrial emitters to reduce GHG emissions per unit of output by 26 percent by 2015, with emissions trading as one of the compliance options. Japan has also taken preliminary steps towards emissions trading, possibly linking to the EU market.

With this momentum, it is possible to envision the creation of a global market for greenhouse gases with the EU ETS as the initial nucleus.

Carbon taxes

Many economists and a surprising number of business leaders believe that the simple application of a tax on greenhouse gas emissions is a more efficient method for reducing emissions generating fossil fuel consumption. Such a tax would send a price signal to fossil fuel consumers directly. Ideally this signal would be calculated on a per tonne basis of greenhouse gases produced. In its most explicit form for example, a carbon tax could involve a levy per litre of gasoline purchased, based on the emissions that will result from its combustion.

It is argued that with a direct cost placed on emissions, companies will be encouraged to invest in cleaner technologies and increase energy efficiency. Efficient companies will be rewarded with tax savings while laggards will be penalized. Revenues from such penalties could be used to lower other taxes or be used as investments in energy efficient environmental technologies. Consumers also would adjust their spending patterns to avoid higher costs. Instead of taxing ‘good’ behaviour such as generating wealth, a carbon levy taxes ‘bad’ behaviour, namely greenhouse gas emissions. This philosophy can be applied to other areas as well, in what is called a ‘green tax shift’.

Carbon taxes are already levied in many jurisdictions, usually in the form of direct charges on fossil fuels, such as gasoline. Germany levies an “ecotax” on gasoline and electricity, while the United Kingdom places a charge on all flights from British airports. Norway has perhaps the most extensive carbon tax in place, directly impacting the country’s economically important oil and gas industry. This taxation policy helped make CO2 capture and storage at the Sleipner gas field in the North Sea economically attractive. However, it was not enough to support Shell and Statoil’s plans for the world’s largest CO2 capture and storage project involving an 860-megawatt gas-fired power plant and offshore oil fields, which was recently declared not commercially viable.

For the most part existing ‘carbon taxes’ are not directly linked to greenhouse gas emissions, but are rather broad attempts to raise revenue by increasing the prices of commodities such as electricity and gasoline, thereby decreasing consumption of these goods. Comprehensive carbon taxes tied explicitly to greenhouse gas emissions and set high enough to achieve substantial emissions reductions have so far been avoided due to their perceived unpopularity among businesses and the general public.

Regulatory restrictions

Also under consideration or being implemented in some jurisdictions are regulatory measures which place limits on emissions or which prohibit certain activities. These measures are not considered ‘market-based’ as they may impose inflexible requirements rather than creating incentives (or disincentives).

Some purely regulatory measures to reduce greenhouse gas emissions include fuel economy standards for cars, emissions standards for power plants, building energy codes and renewable energy requirements for public utilities. For example, British Columbia has pledged that all new electricity projects developed in B.C. will have zero net greenhouse gas emissions, while existing thermal generation power plants will reach zero net greenhouse gas emissions by 2016. Any coal-fired electricity generation will have to reach zero GHG emissions.

Alberta has taken a hybrid approach by adopting regulations which require companies that emit more than 100,000 tonnes of greenhouse gases a year to reduce emissions intensity by 12 percent annually. Companies which exceed the limit must contribute $15 per excess tonne to a technology fund or invest in projects to offset their excess emissions elsewhere in Alberta. This regulatory strategy is meant to provide similar incentives to a carbon tax or carbon trading in encouraging firms to meet their targets. However, the key difference is that firms will not be encouraged to go below their target, because they will be unable to sell excess emissions credits.

Virtually every jurisdiction in the world has some regulations which indirectly or directly reduce greenhouse gas emissions, and it is certain that such legislation will continue to be developed in the future.

The difficult questions

The key question is which approach would work best to reduce greenhouse gas emissions? Are market-based measures sufficient? Can regulation alone accomplish this formidable task? Would it be advantageous to combine regulation with carbon trading or a carbon tax? Or will the world need all three?

The answers will vary depending on who is asked, as each approach brings certain advantages and disadvantages.

Cap and Trade Systems are favoured by some businesses for their flexibility, and because (theoretically) they allow resources to be allocated to most efficient reductions across sectors and across countries. Carbon credits have become hot commodities and are seen as an entrepreneurial market mechanism that can be readily adopted by many in the business community. A cap also implies a firm, absolute emissions target, which is easier to understand and to predict than most other methods.

However, cap and trade systems cannot cover the entire economy, and may not be applicable for significant emissions sources such as transportation. The decision on which sectors to include can leave some business interests footing the bill while others may emit freely. Transaction costs can be also be high as credits require brokers, verification and regulatory support.

Carbon credits are also susceptible to the claim of ‘hot-air’- the idea that some credits don’t represent real reductions in emissions and are therefore an expensive way of achieving absolutely nothing. In the emerging international carbon credit market, there have been some undesirable collateral developments which cast doubt on the effectiveness of emissions trading. Unfortunately, theoretical efficiencies offered by carbon trading have not always emerged in the real world.

As the EU ETS has demonstrated, carbon markets remain vulnerable to price fluctuations and will only be effective when optimally designed, a task which may prove challenging on an international scale. However, the booming worldwide carbon market is now worth more than $30 billion annually, and further development schemes should bolster its effectiveness while encouraging clean energy and efficiency projects in many countries.

Carbon taxes offer a broader scope for emissions reductions, and can be easily applied with little transaction cost. Over time, carbon taxes offer a permanent incentive to reduce emissions, and are not susceptible to technology or market changes which can undermine carbon credits.

Carbon tax advocates generally point to the simplicity of application of a tax, and the attractiveness of cutting taxes on ‘goods’ such as income, and shifting it to ‘bads’, such as pollution. Overall taxes paid would remain the same, but those who emit large amounts of greenhouse gases would be more heavily taxed than those who employ cleaner forms of energy, causing a long-term trend towards low emissions technology.

Taxation of any sort does not normally appeal to anyone. The idea of trading emissions sounds more like a free market instrument, something which businesses can easily respond to. While a carbon tax is also market based because it sets a price for emissions and allows companies to respond however they wish, the idea of credit trading seems easier to swallow for many.

Setting a carbon tax at a high enough level to reduce emissions significantly may require a charge of $30 - $50 per tonne initially, and may increase over time as demand for some emissions-intensive goods may be difficult to curb. Such a tax would likely be poorly received, particularly as it would be impossible to tie it to a firm target for emissions reductions.

Even so, many studies indicate that a carbon tax would have little negative impact on the economy and impose limited costs on consumers while reducing emissions substantially, leading to substantial support for this approach over emissions trading.

Regulatory options are already well established in so many areas that they will most certainly be a part of any climate change strategy in Canada or elsewhere. Fuel efficiency standards, building energy codes and renewable energy requirements are three main areas in which legislative progress may be significant.

Such regulations essentially mandate what a ‘carbon price’ would attempt to accomplish over the long term. High fuel prices or high energy costs would encourage a shift towards fuel efficient cars, efficient buildings and low-carbon energy, but regulatory instruments can jump-start the process and set a new baseline upon which other policies will build.

The main debate therefore is whether to trade or tax carbon. While each side has its supporters, many acknowledge that both could accomplish the same important goal, which is to reduce greenhouse gas emissions. The details of implementation will vary, and certainly there will be bumps on the road, but the key principle is to create an economic incentive and market conditions which encourage businesses, individuals and governments to hasten the transition to a low-carbon economy.

Many governments are reluctant to impose additional taxes and at the same time are opposed to the notion of buying ‘hot air’ credits. The likely outcome is that we will see both carbon trading regimes and carbon taxes in various forms on a regional scale and unlikely to see an international trading regime or global carbon tax in the near future.

While the central imperative is to take effective action on climate change, be it a carbon tax, an emissions trading system, or promotion of alternative energy and environmental technologies, the reality is that climate change is a global phenomena and we need a truly global regime to deal with emissions reductions to have maximum impact.

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