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.