Carbon Market Promises and Woes
Economists argue that the carbon market suffices to reduce greenhouse gas emissions and attack additional policy tools for increasing mitigation costs. Time to look at how the carbon market works in practice!
In my last blog I have pointed to the campaign of a few Norwegian economistsagainst climate policy tools such as the newly established green certificate market, which ensures a higher electricity price for renewable electricity. I published a similar critique in Dagens Næringsliv, a business daily. The prompt response by Professor Michael Hoel of the University in Oslo was that I did not understand the quota market. Professor Hoel lectured me on basic microeconomics, pointing to the fact that increased renewable energy would lead to reduced prices for emissions allowances and hence increased emissions somewhere else in the European Emissions Trading System (ETS). The emissions reductions achieved through subsidies for energy efficiency or renewable would necessarily be more expensive than the marginal emissions reductions in the ETS. The response did not my argument that technology learning required niche markets which the green certificates created, and that without new technologies we would not be able to reduce emissions sufficiently. Instead, Hoel suggests that Norway should buy large amounts of emissions allowances and retire them – just to drive up the price. Let’s have a look at how the carbon market really works to see what would happen.
The EU ETS has been in operation since 2005, and the market for project-based mechanisms has existed even longer. The experience with these markets provides a good basis for assessing the ability of carbon market to address the climate crisis. In the European carbon market, large industrial facilities and power stations require emissions allowances (EUA) for every ton of CO2 they emit. Allowances are distributed by governments to cover most, but in theory not all of the needs by industry. The problem in the first period 2005-2007 was thatsome national governments had given out too many allowances. Up until the EUA market collapsed in 2007, the price varied in the €10-30 per ton range (Fig.2.5 in Carbon 2008). In that period, it became obvious that power companies who had allowances for free passed almost all of the costs through to the customers – as if they had paid for the allowances. As a result, the carbon market generated windfall profits for power generators and redistributed tens of billions of Euros from electricity consumers to producers – apparent in the balance sheet of utilities. (BBC documents new examples of windfall profits.)
The overallocation of EUAs and the resulting collapse of the carbon market was an embarrassing for the European Commission, which responded by restricting the national allocation of allowances by member states for the 2008-2012 period. Estonia and Poland were not satisfied with the amount of allowances they were allowed to distribute and sued the EC in front of the European Court of Justice. In September 2009, the Court ruled in favor of Estonia and Poland. It said it was up to member states not the EC to set national emissions targets. It is uncertain how this wrangle will continue, but Eastern European member states have received a joker in the political tug-of-war about emissions rights.
The very political nature of the process by which emissions allowances worth billions of Euros are created and allocated was also apparent in the negotiations about the continuation of the European ETS for the 2013-2020 period. In a recommendable move to improve the system, the European Commission proposed to sell the emissions allowances instead of giving them away for free, something that would make the system a lot better. Industries which are exposed to tough international competition would continue to receive free allowances. Poland managed to negotiate an allocation of free allowances to its power sector – which certainly is not exposed to international competition from outside the ETS area! The argument was that Polish industry and households could not bear the high electricity prices. If experience with the ETS is any guide, Polish utilities will pass on the carbon costs to their customers and take the free allowances as a subsidy.
Now, one can imagine what the reaction of EU countries would be to a sudden purchase of a large amount of emissions allowances by the Norwegian government. Instead of allowing the carbon price to rise, EU governments would simply distribute more allowances, thus turning the Norwegian purchase into a subsidy for allowance-receiving industry. Polish coal-fired power stations are favored candidates for receiving these gifts of Norway.
There is plenty of documentation of phony projects and cheating at the heart of the project-based emissions reductions, especially Clean Development Mechanisms. It reminds me of the story of economic incentives for catching rats, which some Caribbean government had tried as a measure to control this pest. At first, it brought down the density of rats, but then it gave rise to organized rat breeding. The International Energy Agency has now proposed a different mechanism for providing incentives to emissions reductions in developing countries.
One may wonder how the carbon market would work if politicians managed to solve the problems with allocation and cheating. There is another aspect which is not normally reflected in the economists’ models: the variation of the carbon price in response to economic cycles, uncertainty and imperfect information. The economic risk to investors in energy technology posed by the medium-term uncertainty in the quota price is a significant deterrent to investments, as energy companies recently told a hearing by the UK House of Commons. It is totally unnecessary to generate such a varying price signal because we know already today that in the long run, polluting fossil power stations are not acceptable.
I agree with an increasing number of analysts that emissions allowances should be replaced by a pollution tax, which is simpler to implement, gives much less opportunity to cheat the system or achieve huge gains through lobbying. The problem with carbon pricing in general and a tax in particular is that it costs the public a lot, and that the amounts of money that needs to be rechanneled are much larger than the marginal changes in investment costs that are affected by this policy. The political price of carbon pricing is hence high. To limit that price, it is advantageous to also use more targeted, effective policy tools to achieve emissions reductions, such as energy efficiency regulations for houses, cars, and gadgets, subsidies for all sorts of technology development, information tools, and subsidies/niche markets for emerging low-carbon technologies.
Emissions allowances are funny money – a fantasy creation that works well in economists’ highly stylized model world, but unfortunately not (yet?) in reality. It is time that economists return to their forefathers’ understanding of “political economy” (which considers the interests of different parties) and observe real markets before intervening in politics.