CAP AND TRADE VERSUS CARBON TAX IN A RECESSION

The theory is that a cap-and-trade system is the most effective tool to fight global climate change because it harnesses the power of the marketplace to the purpose. Does that theory hold up in a recession?

Before answering that question, another one must be answered: Does the theory hold up at all? Does a cap abnd trade system fight climate change?

Answer: Nobody knows for sure yet.

A cap and trade system applies system-wide caps to emissions, then parcels out greenhouse gas emissions caps proportionately by region, by industry within the region and by business within the industry. Each business may sell “allowances” for the emissions its operations do not require or purchase more allowances for the emissions above its cap its operations require.

All caps are periodically ratcheted down, forcing the businesses, industries, regions and system to cut emissions by implementing economically advantageous methods. Allowances can also be obtained via offsets, with which a business pays for some form of emissions reduction elsewhere, most likely a New Energy project.

A cap and trade system, limited to a handful of big emitters generating specific pollutants, was reasonably successful during the 1990s in reversing acid rain.

The biggest and most important cap and trade system ever implemented is the European Union (EU) Emissions Trading Scheme (ETS). It began in 2005, implanted a 2nd phase with corrections in 2008 and is currently laying the groundwork for a 3rd phase scheduled to kick off in 2013. In the EU ETS, allowances (called European Union Allowances, EUAs) are traded at a price of euros per tonne (metric ton). Offsets, overseen by the The United Nations (UN) Clean Development Mechanism (CDM), are traded as Certified Emissions Reductions (CERs), also at a price per tonne.

Is the EU ETS working?

Answer: Nobody knows for sure yet.

In phase 1, EU allocation of EUAs was too generous. Prices fluctuated wildly and fell to almost worthlessness. Power companies figured out ways to game the system and profit without cutting emissions. Those problems were rectified in phase 2 and EUA prices stabilized, although a recent short supply threatened to push the price untenably high (which would drive the cost of electricity up).

Then the recession came along, production slowed and demand for EUAs dropped. Prices have dropped. Is this the beginning of new fluctuations? Was the market for emissions another bubble?

World Emissions Markets (from Reuters. click to enlarge)

Opponents of cap and trade – advocates of a potentially simpler, though possibly more politically difficult, revenue-neutral carbon tax – believe the EU ETS experiences during phase 1 are more likely to be the rule than the seeming stability of 2008. The impact of the current financial crisis on the system could affirm their point.

Bloomberg News, December 30: “EU carbon dioxide allowances for December 2009 dropped 10 cents, or 0.6 percent, to 15.71 euros ($22.18) a metric ton…The permits, which have fallen 32 percent this year, are influenced by oil prices because crude affects the cost of European natural gas, burned as a fuel in some power stations. Utilities in the EU emissions-trading program, the world’s largest, need about half as many carbon allowances to burn gas as they do to use dirtier coal…”

Bloomberg News, 3 days later, January 3: “European Union carbon dioxide permits dropped to their lowest in more than three weeks as natural gas declined. German power fell…”

Does this mean the EU ETS is fundamentally flawed? Does it mean the system will not serve in a recession, when climate change concerns might take a back seat to economic survival?

Not necessarily.

Reuters, December 18: “Recession will not lead to a repeat collapse in European carbon prices… companies can now use EUAs any time from 2008-2020, meaning they can save up -- or bank -- any surplus during temporary recession for use in later years, when there will be an expected shortage…That was not the case in the first trading cycle of the scheme -- now dubbed an expermiment -- from 2005-07…”

Implementing a global carbon tax could be simpler than a building a worldwide cap and trade system on the foundation of the EU ETS but it would require a careful, complicated adjustment of global revenues. How high should the tax be? How can it best be made neutral rather than regressive, with the burden falling disproportionately on those with fewer options? And new taxes have, historically, been politically out of reach. A little remembered failure of the first Clinton term was the carbon tax for which Al Gore prodded the administration to try.

In short, a tax sounds simple but would not necessarily be so. The other problem with a tax is that it does not guarantee any limits on emissions. Any business that discovers an energy source cheap enough to use without being hindered by the tax would be free to emit voluminously.

None of the complications of a global carbon tax is irresolvable. But they belie the argument that such a system is simpler to implement or more certainly effective.

The EU ETS proves a cap and trade system is a complicated affair and, though it is impossible to know how much the EU’s emissions would have gone up with no cap and trade system or with a tax, it is clear that EU emissions are only beginning – or only PERHAPS beginning – to show any improvement.

There is only 1 absolutely unequivocal and certain conclusion that can be drawn from a close study of the EU ETS: Any system chosen for the fight against global climate change will require vigorous monitoring and the flexibility to adapt. The EU ETS is an admirable example of both.

The U.S. system of government evolved over an extended period of time from the Articles of Confederation into the Constitution and the Bill of Rights. And it is still being perfected.

The marketplace presently in use by the U.S. and the world evolved throughout the 20th century. And, if the uproar about new regulatory measures to prevent the kinds of excesses that brought on the current financial woes is any indication, it is still in the process of evolving.

The global climate situation does not afford the luxury of time. A tax is the preferred mechanism of economists, conservative idealogues and purists who refuse, admirably, to acknowledge political limits. If they pursue a tax and capture momentum, let them have at it. Perhaps they can convince the public and the shortsighted politicians who lead them of their wisdom.

Climate change, however, will not wait long. If a consensus can only be built around a global cap and trade system, the EU has a model that has had and continues to have a lot of preparatory work done on it.

It is much more than the idea that the perfect must not be the enemy of the good. It is that there is no perfect solution and the challenge will not wait. World leaders must choose the most accessible potential solution and make it work.

Just like other world markets. (from Reuters. click to enlarge)

Slump means EU industry carbon caps no longer bite
Nina Chestney and Gerard Wynn (w/James Jukwey), December 18, 2008 (Reuters)
and
EU Carbon Permits Drop on Natural Gas; German Power Falls
Matthew Carr, January 2, 2009 (Bloomberg News)
and
European Union Carbon-Emission Permits Fall as Crude Oil Drops
Matthew Carr, December 30, 2008 (Bloomberg News)

WHO
The European Union (EU) Emissions Trading Scheme (ETS); The United Nations (UN) Clean Development Mechanism (CDM); EU analysts (Trevor Sikorski, head of carbon research, Barclays Capital; Alessandro Vitelli, carbon market analyst, IDEAcarbon)

WHAT
How does the current recession affect the crucial debate of cap and trade versus carbon tax?

Phase 1 results were a mixed bag. Continued below...(from Reuters. click to enlarge)

WHEN
- 2005 – 2007: EU ETS phase 1
- 2008 – 2012: EU ETS phase 2; CERs purchased but not used in phase 2 can be used to offset emissions in phase 3.
- 2012 – 2020: EU ETS phase 3
- Oil fell from a high near $150/barrel to below $40/barrel in 2008 and natural gas prices followed the pattern.
- The price of EUAs fell 32% in 2008.

WHERE
- The ETS is mandatory to EU member nations. Traders around the world invest and trade in EUAs.
- The UN CDM administers the CERs for New Energy and emissions reduction projects in developing nations. The country hosting the biggest number of CER projects is China.

WHY
- The recession in some ways makes cap and trade more economically appealing because a business’s investment in CERs at low prices now will offset emissions later, when economic growth returns and allowances are more expensive.
- As the price of oil drops, the price of natural gas also drops. When natural gas is cheaper, it is used more (and coal is used less) to generate electricity by European power plants. Natural gas requires has the amount of EUAs or CERs as coal.
- The fall in the price of German power is significant because traders include the cost of EUAs in power prices as a cost of generation.

...More mixed bag. (from Reuters. click to enlarge)

QUOTES
- Trevor Sikorski, head of carbon research, Barclays Capital: "From 2008-12 there's certainly enough CERs to balance the system, and going forward until about 2017 when you will need to get domestic European abatement…The expected EUA shortage has gone from 1 billion tonnes to about a quarter of that from 2008-12…It is putting off the day of internal emissions cuts…If you're meeting the (emissions) target through prolonged recession then the carbon price can be lower and you can meet your environmental goals more easily."
- Alessandro Vitelli, carbon market analyst, IDEAcarbon: "I don't really see a replay of Phase 1…The bankability of allowances means that future compliance obligations will set a carbon price going forward."