Carbon trading: saving the environment by monetising it?

''The Arctic seems to be warming'' announced a newspaper headline. ''Reports from fishermen, seal hunters, and explorers...all point to a radical change in climatic conditions, and hitherto unheard-of high temperatures in that part of the earth's surface.'' The story ran in the Monthly Weather Review... in November 1922. Since those days we learnt a lot about the environment, started using the term anthropogenic climate change, and increased the total measured yearly CO2 emission s tenfold – from 3100 Mt to 32,000 Mt.

 

Carbon dioxide and global warming

 

The scientific community has walked its own climate change road: from disbelief and scepticism to heated arguments and finally consensus. By now 97% of climate scientists agree that global warming is a real trend and human beings account for a large part of it. The main way we cause climate change is by emitting greenhouse gases (mostly CO2) which stay in the atmosphere and cause the so-called greenhouse effect.

 

Earth's surface is warmed up by sunlight which allows vegetation to grow and travellers to show off their holiday tan. But the incoming sunlight provides only about half of the energy absorbed by Earth – the rest comes from the greenhouse effect. After receiving light from the Sun Earth's surface re-emits energy in the form of infrared radiation which is then ''caught'' by clouds and greenhouse gases and is once again re-emitted in all directions. Since the layer of greenhouse gases around our planet is quite thick, only a tiny part of the re-emitted energy from the surface escapes to the outer space – most of it comes back to the surface to warm the Earth once again. Think of a Turkish steam sauna which is always filled with steam (warmth) but there is only a small input of steam per minute (sunlight), and only a tiny amount of steam dissipates through the crack in the door (the energy re-emitted back to space) – that is Earth's system.

 

The problem with increased greenhouse gas emissions is that without corresponding measures of decarbonisation (e.g. larger areas of forests which could balance CO2 concentration through photosynthesis) more and more energy gets trapped in Earth. Increased CO2 concentration in the atmosphere makes it harder for infrared radiation to escape the atmosphere and thus Earth is warming – to continue the analogy, it is as if somebody covered the crack in the sauna door with a towel and the room is becoming overfilled with steam. While the spike in CO2 emissions is largely the result of growing industrial production and thus improvement in daily lives of the most destitute, politicians have realised that it cannot continue at the price of the planet and started searching for effective sustainable growth policies.

 

Command, tax or trade?

 

The three policy responses to skyrocketing CO2 emissions were command-and-control laws, carbon tax, and cap-and-trade systems. Command-and-control refers to the military-style management of greenhouse gas emissions: government officials decide how much pollution is acceptable, the same officials are in charge to choose the best way to reach the target, and bureaucrats are entrusted with implementing their policies. Such policies have fallen out of fashion because of their slow decision making process, costly implementation, and meagre results. Governments moved on to market-based mechanisms.

 

Carbon tax recognises the basic problem of fossil fuels – those who use it do not get to bear full costs of the ensuing CO2 pollution. In economic theory such a phenomenon is called negative externality. Since consumers of fossil fuels do not take into account full costs of their carbon emissions and the consequential global warming, they tend to overconsume, that is, burn more fuel than the optimal level at which societal (not private) benefits from using fuels are equal to costs. Carbon tax mitigates the situation by imposing a higher price on fossil fuel consumers and thus reducing quantity demanded to the optimal level. In practice, the advantages of carbon tax are, first, relatively simple implementation as existing tax collection mechanisms can be used, secondly, stable income for the government which can be directed towards environmental projects, and finally, political appeal as it can be supported both by progressivists who want to tackle climate change and conservatives who prefer market-based approaches. However, there are worries that carbon tax places an unfair burden on low-to-middle income families who tend to commute more or live in less energy-efficient houses. Carbon tax can also cause offshoring as it raises the price of energy for domestic businesses. The deepest worry though is that an increase in fuel price will not necessarily slow down climate change if people simply prefer to pay more to ride their huge SUVs. A more stringent yet flexible market-based approach was needed, and found in cap-and-trade systems.

 

The main idea of cap-and-trade policy is captured in its name – the government caps, that is, limits CO2 emissions, and then allows the emitters to choose the way they are going to meet their quotas. Coal plants and gas burning facilities can then decide if they want to reduce their emissions by, say, implementing cleaning technologies such as scrubbers, or by buying more pollution allowances from those who have some left (thus the policy is also known as carbon trading). In others words, the government just decides the amount of CO2 emissions which is set to decrease year-on-year thus slowing down climate change, and market players are free to choose who, how, and when is going to implement cleaner technologies. The upside of cap-and-trade systems is that emission reductions are supposed to happen where they are cheapest: if reducing emissions at plant A are more expensive than at plant B, it will be beneficial for plant A to pay money to plant B for implementing new technologies. After all, we do not care who exactly reduces emissions as long as overall CO2 concentration in the atmosphere is decreasing. In theory cap-and-trade is the most economically efficient way of bringing CO2 emissions down, but there have been some hiccups in implementing it in practice.

 

Carbon trading around the world

 

Kyoto Protocol Article 17 laid out that developed countries which agreed to reduce their emissions ''may participate in emissions trading for the purposes of fulfilling their commitments''. The Conference of the Parties drew inspiration from the US Acid Rain Program which successfully reduced sulphur dioxide emissions by introducing pollution allowance trading. However, the Kyoto agreement ran into bureaucratic obstacles, ratification issues (e.g., the US), and the lack of national measurement, reporting and verification (MRV) mechanisms. Governments did not start trading carbon emission allowances immediately, even though countries like Russia and Ukraine which had an oversupply of allowances due to economic downturn in energy intensive industries were eager to do so. Potential buyers of allowances (each permitting to emit 1t of CO2) - for instance, Japan, Spain, Austria – expressed their intention not to buy hot air – allowances from the Post-soviet countries which were not acquired through planned emission reduction efforts but instead piled up as a result of the fall of the Soviet industrial production. The consensus was the development of Green Investment Schemes (GIS) – basically an agreement to ensure that all money received from sold allowances will go towards increasing energy efficiency and environmental protection in the Post-soviet sphere. Emission trading started in its earnest around 2008, reaching the peak of 150m units of allowances in 2012. However, only the countries which met all the requirements of the Marrakech accords (which outlined the details of Kyoto emissions trading) and GIS schemes were permitted to sell their allowances. Poland, Czech Republic, Estonia and Ukraine emerged as the main suppliers. The price of allowances fluctuated from €14 at the beginning of trading to €0.03 in 2012 when the future of Kyoto became unclear. Inter-governmental emissions trading all but ceased with the end of the first Kyoto commitment period in 2012.

 

The spirit of carbon trading carried on in the form of subnational, national, and transnational schemes. The Californian cap-and-trade system, for instance, covers 85% of the state's emissions and has an ambitious challenge to reduce them by 80% by 2050. There are pilot projects in China, India and elsewhere too. By far the biggest carbon trading scheme has been operating in Europe since 2005. The EU Emissions Trading Scheme (EU ETS) covers over 11,000 power stations, industrial plants and airlines (45% of total emissions) in 31 country. It has the target of reducing emissions by 21% by 2020 and the proposed target of 43% by 2030 (relative to 1990 emission levels). Despite the success in reducing CO2, EU ETS has had its share of problems. Because of the 2008 crisis and the initial oversupply of allowances the carbon market crashed in 2009 and the price plummeted to €1 by 2012. Companies continue to receive free allowances from the European Commission which coupled with low price on the market makes emissions virtually costless. EU ETS experience showed that cap-and-trade schemes, while theoretically superior, in practice are costly to set up and administer, and their success depends crucially on the correct initial allocation of allowances and sufficient pace of tightening the cap (currently EU ETS reduces allowances by 1.74% per year).

 

Unsurprisingly, some have backpedalled or criticised carbon trading. Australia, for one, had been considering introducing an emissions trading scheme and even linking it with EU ETS, but finally decided against it. The main reasons were the already mentioned administration costs and complexity relative to a carbon tax. Pope Francis has decided to join the critics with the Encyclical Letter On Care of Our Common Home where he described carbon trading as a system which '' seems to provide a quick and easy solution under the guise of a certain commitment to the environment, but in no way does it allow for the radical change which present circumstances require .'' Some environmental NGOs have also been lobbying strongly against EU ETS on grounds of inefficiency and complacency, but often they fail to provide convincing arguments against the hard fact of successfully reduced CO2 emissions in the EU. Despite the criticism, EU ETS keeps growing, inspiring other pilot projects around the world which could in the future become a single global carbon trading market.

 

The future of carbon trading

 

Emission trading as an environmental policy is relatively new and in its short age has seen both successes like in the US Acid Rain Program and failures to an extent exemplified by trading under Kyoto Protocol. It is definitely more efficient than command-and-control bureaucratic management of emissions, but faces another potent market-based alternative – carbon tax. However, emissions trading is more flexible in its application and puts the main burden on the emitters, not the low-or-middle-income consumers. As an economically superior and distributionally just emissions control mechanism, carbon trading should be developed in light of the early lessons of allowance oversupply and market crashes. Its future will depend largely on the development of the largest trading scheme – EU ETS – which will either inspire more pilot projects, like the ones in India and China, or prove once and for all that monetising carbon dioxide cannot stop global warming. If we are serious about slowing down anthropogenic climate change – and we should be if we care at all about potential food crises, water shortages and extreme weather events – we have to reduce CO2 emissions. Correctly implemented carbon trading is currently the best option we have.