This week representatives from over 190 nations began gathering in Copenhagen to try to hammer out a global treaty to handle the problem of man-made global warming. As a long-time reporter on environmental issues, I, for many years, doubted the severity of the issue, but as the various temperature data sets (satellite, surface, balloon) began to converge, I became persuaded that man-made global warming is real and a potential problem. Global average temperature trends in recent decades suggest that the planet is warming up at a rate of about 0.13 per decade. (Interestingly, recent temperature data finds that while the last decade has been the warmest on average in modern records, global average temperatures have not been increasing since 1998.) So the question is: If global warming is a problem, what are the smartest policies to address it?
Unfortunately, the current model for controlling the global emissions of greenhouse gases like carbon dioxide is a cap-and-trade scheme devised under the Kyoto Protocol. To comply with its obligations under the Kyoto Protocol, the European Union implemented with its European Trading Scheme (ETS) back in 2005. The ETS covers the output of about 12,000 big emitters, whose CO2 amounts to roughly half of the European Union’s total emissions.
Under cap-and-trade schemes, governments set a limit on how much of a pollutant, in the case of man-made global warming chiefly carbon dioxide, utilities and other enterprises can emit and then allocate permits to them. The permits can then 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 sell their extra permits to other enterprises that find it more expensive to reduce their emissions. In this way, a market in pollution permits is supposed to find the cheapest way to cut emissions.
Carbon Market Follies
That is the ideal, but implementing the ETS has been far from ideal. For example, in May 2006, an audit showed that several EU governments had issued permits for 66 million tons more CO2 than was actually being emitted. Traders immediately realized that the supply of permits was not scarce, so the price of carbon dioxide allowances 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. European governments later tightened limits on carbon dioxide emissions and permit prices recovered in the second trading period until the advent of the financial crisis in 2008 forced a dramatic economic slowdown.
The steep decline in economic activity has lowered CO2 emissions, producing a surplus of carbon permits among companies in the EU's emissions trading scheme. Consequently, as carbon dioxide emissions fell, so too, did permit prices, reaching a new low of under 10 euros per ton in February, 2009. Since then carbon dioxide permit prices have recovered slightly to over 13 euros per ton.
The main point is that such price volatility means that companies have great difficulty in planning their infrastructure investments. There is very little evidence that the ETS has driven large-scale capital investments in energy production aimed at reducing the emissions of greenhouse gases among firms and facilities subject to the system. If carbon dioxide trading does not induce those kinds of investments, then it clearly has failed.
So if carbon trading has really been an effective tool for encouraging investments in low-carbon and no-carbon energy production technologies, German electric power utilities would not have announced plans in 2008 to build more than 20 new coal-fired electric power plants. And just before the financial crisis hit, The New York Times reported in 2008 that European countries were planning to build about new 50 coal-fired plants over the next five years. It is true that the planning for and construction of many these plants are now on hold due to the global financial crisis, but those construction projects will likely revive once economic growth resumes. The main point is that European carbon dioxide trading is not working as intended because it has not noticeably encouraged utilities to invest much in alternative low-carbon energy technologies.
In addition to being ineffective at encouraging investment in low-carbon energy technologies, the way that permits have been distributed has provided billions of euros in windfall profits to polluters. How does this work? Beginning in 2005, the ETS cap-and-trade scheme handed out nearly all of its emissions permits gratis. Hold on, you might say: If the emitters are getting permits for free, why don't they pass along the lower costs to their customers?
Think of it in terms of an analogy put forward by left-leaning economists James Barrett and Kristen Sheeran: Tickets from scalpers for the last World Cup Soccer championship games were going for more than 200 euros, about double their face value. Would the price have been lower if a scalper had found them on the ground? No. "The supply and demand for tickets is the same no matter how much the scalper paid for them, and so the price he charges you will also be the same no matter how he got them," note Sheeran and Barrett. Or think of it this way, if someone gave you a bundle of cash worth a thousand euros, you would not be inclined to sell them to another person for less than a thousand, would you? The same thing is true of carbon dioxide emissions permits.
Giving away permits for free is largely equivalent to a carbon tax in which the tax revenues are given to energy company stockholders, not spent on behalf of consumers and taxpayers. Before the carbon market collapse in April 2006, the consultancy IPA Energy estimated that permits granted to British and German utilities fattened their bottom lines by 1 billion euros and 6 to 8 billion euros respectively. And British and German consumers paid more for their electricity on top of that.
One way to correct the most egregious flaws in current cap-and-trade schemes (including the one proposed in recent Congressional legislation in the U.S.) would be to adopt cap-and-auction instead. Auctioning permits is very much like imposing a carbon tax. In this case, the government sets an overall emissions limit and emitters have to buy allowances from the government every year. The chief difference between a cap-and-auction scheme and a carbon tax is that the price of the allowances will vary from year to year. Once again, this variability in permit prices introduces uncertainty in the infrastructure planning of firms.
Why Not A Carbon Tax?
Many economists think that a better option for rationing carbon would be a gradually rising tax on fuels that emit carbon dioxide. As the tax increases, industries and consumers would cut back on their use of more expensive fossil fuel energy and switch to using energy produced by low-carbon and no-carbon technologies. This process would lead to lower carbon dioxide emissions over time.
Leading economists like Harvard University’s Gregory Mankiw and Yale University’s William Nordhaus advocate imposing a tax on all kinds of carbon-base fuels at the wholesale stage, as far upstream as possible. Utilities and refiners who take raw coal, oil, and natural gas as inputs would pay a tax on these fuels. The extra cost would get passed downstream to all subsequent consumers. Thus carbon taxes would encourage conservation and low-carbon energy innovation. Since the tax is levied on how much carbon a fuel contains, it would make fuels like coal less attractive compared with low-carbon fuels like natural gas or even renewable energy like solar and wind power. Ideally, carbon tax revenues would be used to cut individual domestic income taxes, thus offsetting some of the pain of higher energy prices.