Policymakers and businesses are now trying to figure out the best way to limit the emissions of greenhouse gases, especially carbon dioxide, which is produced by burning fossil fuels such as coal, oil, and natural gas. Why impose limits? Because accumulating scientific evidence indicates that the increased concentration of greenhouse gases in the atmosphere is causing average temperatures to rise globally. This increase could trigger significant disruption of the world’s climate by the end of this century. Although there remain serious uncertainties about the magnitude of the human role in climate change, there is a growing consensus that emissions need to be reduced.
The battle now is over how. The two leading approaches are carbon markets and carbon taxes. Surprisingly, a great many free marketeers favor higher taxes on carbon-emitting fossil fuels over a cap-and-trade carbon market, including former Federal Reserve chairmen Paul Volcker and Alan Greenspan, former chairman of President Bush’s Council of Economic Advisers Gregory Mankiw, and former Duke Energy CEO Paul Anderson. A Wall Street Journal Survey in February 2007 found that 54 percent of economists favor a carbon tax over all other approaches.
Earlier this year, ExxonMobil laid out a set of principles for reducing carbon emissions, including maximizing the use of markets, ensuring a uniform and predictable cost of carbon across the economy, minimizing complexity to reduce administrative costs, and providing transparency to companies and consumers. ExxonMobil’s vice president for public affairs, Ken Cohen, noted in a conference call with environmental and energy bloggers in January, “Most economists who have looked at this issue would come away saying a carbon tax makes the most sense. It’s the most efficient policy. The most sector-neutral. It doesn’t favor or disfavor one part of the economy over another.” Cohen added, “We do look seriously at carbon tax proposals, but…the devil is in the details.”
While carbon taxes are preferred by many policy analysts, proposals for carbon markets dominate Capitol Hill. For example, Senator John McCain, one of the leading Republican candidates for president, said in February that “any responsible climate change measure must have rational, mandatory emission reduction targets and timetables,” and it “must utilize a market-based, economy wide ‘cap-and-trade’ system.” McCain is a co-sponsor, with Senator Joe Lieberman, of the Climate Stewardship Act, which would establish a nationwide limit on greenhouse gas emissions and then issue permits to emit greenhouse gases. The McCain-Lieberman bill ambitiously aims to cut greenhouse gas emissions by almost 60 percent below what they would otherwise have been in 2030. Companies that have low emissions could sell their emissions rights to companies that find it expensive to reduce their own emissions.
Business leaders see the policy handwriting on the wall and are rushing to help shape the emerging greenhouse gas (GHG) emissions regulatory scheme to their own best advantage. A government-created market in emissions permits would be particularly responsive to this kind of gamesmanship. In January, the U.S. Climate Action Partnership, consisting of ten big companies with a total market capitalization of $750 billion, including DuPont, Alcoa, General Electric, and BP America, issued a “blueprint for a mandatory economy-wide, market-driven approach to climate protection.”
Also in January, the Electric Power Supply Association, the lobby group that represents competitive power suppliers that account for 40 percent of the generating capacity of the U.S., acknowledged that “regulatory and legislative processes are moving forward seriously and with speed.” In February, the power-industry lobby group, the Edison Electric Institute, came out in favor of “federal action or legislation to reduce greenhouse gas emissions that...involves all sectors of the economy, and all sources of GHG.”
Cap-and-trade schemes for reducing pollutants have a lot going for them. First, many businesses favor them. Second, we already have an American example of a similar market that works. Third, carbon markets are accepted under international treaties and already exist abroad. Fourth, most environmental groups like cap-and-trade systems because they set firm limits on actual emissions. And, fifth, in theory at least, the flexibility of carbon markets enables businesses to figure out the least expensive way to reduce overall emissions.
The United States currently maintains a robust cap-and-trade market in sulfur dioxide permits which advocates of a GHG market hold up as a shining example. Sulfur dioxide (SO2) is emitted by power producers when they burn coal that contains sulfur. Since SO2 is noxious to breathe and contributes to acid rain, Congress in 1990 enacted legislation requiring emissions from electric utilities to be reduced to 8.95 million tons by 2010 (emissions were 17.5 million tons in 1980). Each year, the Environmental Protection Agency issues permits that allow a smaller and smaller amount of SO2 emissions.
So far, those emissions are down to about 10.5 million tons annually. According to one estimate by the EPA, by 2010, the annual cost of the reductions to electric utility companies, their customers, and shareholders will be about $3 billion, while the annual benefits—including lower mortality and fewer hospital admissions from respiratory illnesses; improved visibility; cleaner soil, lakes, and streams; and reduced damage to buildings—will exceed $100 billion. Even if these figures are exaggerated, the SO2 cap-and-trade system appears to be a major success.
The American SO2 market served as the model for the European Union’s Emissions Trading Scheme (ETS), established two years ago to meet the EU’s commitment to reduce GHG emissions under the Kyoto Protocol. Countries set a limit on how much carbon dioxide businesses and participating enterprises will emit and then allocate permits to them. The permits can be bought and sold on an open market. Manufacturers, for example, that can cheaply abate their emissions will have some permits left over. The cheap abaters can then sell their extra permits to other emitters that find it more expensive to reduce emission. In this way, a market in pollution permits finds the cheapest way to cut emissions. “Innovators can invest in technology to produce and sell excess credits,” said Jonathan Lash of the World Resources Institute (WRI). “Cap-and-trade creates a market that chooses the best options.”
From the point of view of environmental activists, the greatest strength of a carbon market is that it sets an overall specific limit on carbon emissions. As Craig Hanson, deputy director of the People and Ecosystems program at WRI, notes, “What the environment cares about is the amount of emissions and the concentration of greenhouse gases in the atmosphere. Setting limits on emissions is a policy that addresses that problem directly.” Matthias Duwe, the director of the Climate Action Network in Europe, explained his group’s support for carbon markets by saying, “Environmental effectiveness is what counts. What we want is absolute reductions in emissions. Sending signals to business is secondary.”
Despite this enthusiasm, after more than two years of operation, the EU’s carbon trading market is not working. The ETS covers the output of about 12,000 big emitters, whose CO2 amounts to roughly half of the European Union’s total emissions. While the EU’s 25 governments individually determine the number of permits they will issue, the ETS system directs the handing out of allowances, based on historical emissions, for each factory or other enterprise. Initially, allowances to emit CO2 traded for around 10 euros per ton. A year later, the price for allowances had risen to 30 euros per ton. At that price the market was being widely hailed a success, as higher prices would be an incentive for companies to work seriously at cutting their emissions. Then, in May 2006, an audit showed that several EU governments had issued permits for 66 million tons more CO2 than was actually being emitted. Everyone realized that the supply of permits was not scarce, so the price of carbon promptly collapsed to less than 9 euros per ton. By February 2007, an allowance to emit a ton of CO2 could be had for less than a euro.
The woes of the EU’s carbon market are not over. In October 2006, all of the European Union countries forwarded their proposed National Allocation Plans for carbon dioxide emissions to the European Commission. It turns out that all of the countries, except the U.K., allocated permits for emissions that averaged about 15 percent above actual current levels. The EC’s environment commissioner, Stavros Dimas, warned: “If member states put more allowances into the market than are needed to cover real emissions, the scheme will become pointless, and it will be difficult to meet our Kyoto targets.” In other words, if there is no scarcity of carbon permits, then the permits are worthless, and there is no carbon market.
Many commentators argue that the last two years of turmoil are just the shakeout phase of a carbon market that will soon be robust. But the travails of the ETS highlight the fact that governments have every incentive to cheat. If they issue enough permits, their electricity companies will be able to generate power without adding to their costs—or the costs of their customers. And low energy costs give a nation’s businesses a competitive advantage over businesses in other countries.
Is there an objective, scientific way to allocate emissions permits? Not really. The process is inherently political. Chuck Chakravarthy and John Rhoads, energy consultants for Accenture, are blunt in a January article in Public Utilities Fortnightly. “Early winners will be the companies best able to shape regulations,” they warn. They urge utility executives to lobby now for emission allocations that will position them “for maximum economic value as compared with competitors.” There’s a huge amount of money at stake. At the height of the EU carbon market, for example, the allowances were worth about $50 billion.