2This presentation covers Can carbon markets be part of the answer in controlling climate change?What is the basic economics of carbon trading?Is the EU system working?What are the alternatives / complements?Should carbon trading be replaced with a carbon tax?
3Climate change – the biggest market failure the world has ever seen?
4The EU-Emissions Trading Scheme EU ETS is a market-based mechanism to incentivise reduction of greenhouse gas emissions in a cost-effective and economically-efficient manner.Similar system trialed in the USA - US acid rain program employed a sulfur emissions cap and trade system and successfully produced a 50 percent cut in emissionsThe scheme operates through the allocation and trade of CO2 emissions allowancesOne allowance represents one tonne of carbon dioxide equivalent.Long term goal - de-carbonization of EU economyCarbon trading scheme began in January 2005Now into 2nd phase – which lasts until end 2012
5Pressure to reduce C02 emissions The USA has the highest per capita emissions of carbon but China and India and other Asian countries have huge populations – putting increased pressure on carbon emissions
6EU Targets:20% cut in greenhouse gas emissions by 2020, compared with 1990 levels20% increase in use of renewable energy by 202020% cut in energy consumption through improved energy efficiency by 2020
7Trading the right to pollute Market failure can occur with missing markets.In the past there has been no market to trade and enforce environmental property rights.Carbon trading seeks to create incentives to reduce pollution.A cap is set on the emissions allowedThe cap creates the scarcity required for the marketAt the end of each year installations are required to ensure they have enough allowances to account for their installation’s actual emissions.In Phase II increased penalties imposed on any excess emissions rise to €100 per ton of CO2
8Carbon Trading – assets and liabilities Businesses in the EU-ETS must implement carbon management strategies in the medium termAssets: If a carbon emitting business can under-use its initial allowance by better energy efficiency, it can sell its surplus on the market.Liabilities: If a business is faced by high costs to reduce its emissions, it must buy extra allowancesThe new carbon market should develop a price that reflects the cheapest ways of implementing emission cutbacks.As the market price of carbon emissions rises, so there is an incentive for businesses to invest in technologies that are more pollution efficient including carbon sequestration.
9Rewards and incentives? Reward efficiency – e.g. those businesses that are pollution efficientReward action – e.g. capital investment in lower-carbon cleaner factories and production processesReduce pollution without damaging the competitiveness of European businesses.
10The Clean Development Mechanism CDM: allows industrialized countries to invest in projects that reduce emissions in developing countries - as an alternative to what would undoubtedly be more expensive emission reduction programmes in their own country.The CDM scheme has been criticised – fraudulent use of it
11Weaknesses - Fools Gold? Government failure?Over-allocation of carbon quotas and national freedom to allocateGave cash windfalls to some businessesCarbon price collapsedThis has driven up the demand for coal fired energy! – a dirtier fuel! (law of unintended consequences)Uncertainty of future of the scheme makes it less likely that businesses will invest in greener technologies – all a question of incentives!Politicians unlikely to set emissions cap low enough to drive carbon prices to the right levelThe fool’s gold of carbon trading
12Recession and carbon prices EU recession has caused reductions in output in steel, paper, cement and glassHas led to a sell off of carbon creditsThat has led to a big drop in the market value of carbon permits from Euro 35 to 9There is less incentive for companies to stop pollutingFears for the future of many clean energy projectsIs there a case for a minimum price on carbon emissions?
15Carbon taxationA Carbon tax is a specific tax on the consumption of goods which cause carbon dioxide emissionsCase for a carbon tax:Cap and trade is like a tax so why not tax instead?Mandates a specific price on carbon – less uncertainty than the emissions-trading priceA way of internalizing externalities – the tax would raise the marginal cost of the CO2E-emitting activities, up to the point that the marginal social cost of abatement activities is equated to the marginal social benefit from these activitiesIncentive for firms to lower their emissions and for consumer behaviour to changeConsumers will respond … perhaps in surprising ways (behavioural economics has something to say here!)Revenue generated can be “ring-fenced” and then recycled – i.e. spent on environmental initiatives
16Negative Externalities and Market Failure PriceMarginal social cost (supply)Marginal private cost (supply)Efficiency LossMarginal private benefit (demand)Social Optimal OutputPrivate Optimal OutputQuantity
18Problems with a carbon tax What are the chances of agreeing a carbon tax across different parts of the world?How much to tax when emissions of carbon are difficult to measure accuratelyWhat is the true economic cost of CO2 emissions and impact on climate change? Involves discounting the futureCosts of compliance / risk of tax evasionPossible regressive effects on lower income householdsLess certainty about the effect on quantity of emissionsCountries may free ride on others carbon taxes i.e. enjoy a reduction in CO2 emissions without imposing their own taxUnless introduced across many countries – would potentially damage competitiveness and jobs of countries that bring a carbon tax inWould countries be prepared to raise the carbon tax to reduce emissions? Low price elasticity of demand?
19Evaluating the alternatives When evaluating consider some of these points:Which interventions are likely to be most effective?In changing behaviourIn encouraging innovation and investmentIn reducing emissions at lowest costWhat are the consequences for equity?Between rich and poorer nationsBetween rich and poorer within any one countryBetween current and future generationsBetween producers and consumersWhat approach offers the best chance of a global programme?Putting a price on carbon is a necessary but insufficient condition for achieving the required reductions in CO2