Carbon Emissions Trading EU Environmental Policy

This 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?

Climate change – the biggest market failure the world has ever seen?

The 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 emissions The scheme operates through the allocation and trade of CO2 emissions allowances One allowance represents one tonne of carbon dioxide equivalent. Long term goal - de-carbonization of EU economy Carbon trading scheme began in January 2005 Now into 2nd phase – which lasts until end 2012

Pressure 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

20-20-20 EU Targets: 20% cut in greenhouse gas emissions by 2020, compared with 1990 levels 20% increase in use of renewable energy by 2020 20% cut in energy consumption through improved energy efficiency by 2020

Trading 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 allowed The cap creates the scarcity required for the market At 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

Carbon Trading – assets and liabilities Businesses in the EU-ETS must implement carbon management strategies in the medium term Assets: 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 allowances The 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.

Rewards and incentives? Reward efficiency – e.g. those businesses that are pollution efficient Reward action – e.g. capital investment in lower-carbon cleaner factories and production processes Reduce pollution without damaging the competitiveness of European businesses.

The 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

Weaknesses - Fools Gold? Government failure? Over-allocation of carbon quotas and national freedom to allocate Gave cash windfalls to some businesses Carbon price collapsed This 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 level The fool’s gold of carbon trading

Recession and carbon prices EU recession has caused reductions in output in steel, paper, cement and glass Has led to a sell off of carbon credits That has led to a big drop in the market value of carbon permits from Euro 35 to 9 There is less incentive for companies to stop polluting Fears for the future of many clean energy projects Is there a case for a minimum price on carbon emissions?

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Is a carbon tax a viable alternative?

Carbon taxation A Carbon tax is a specific tax on the consumption of goods which cause carbon dioxide emissions Case 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 price A 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 activities Incentive for firms to lower their emissions and for consumer behaviour to change Consumers 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

Negative Externalities and Market Failure Price Marginal social cost (supply) Marginal private cost (supply) Efficiency Loss Marginal private benefit (demand) Social Optimal Output Private Optimal Output Quantity

Supporters of a carbon tax

Problems 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 accurately What is the true economic cost of CO2 emissions and impact on climate change? Involves discounting the future Costs of compliance / risk of tax evasion Possible regressive effects on lower income households Less certainty about the effect on quantity of emissions Countries may free ride on others carbon taxes i.e. enjoy a reduction in CO2 emissions without imposing their own tax Unless introduced across many countries – would potentially damage competitiveness and jobs of countries that bring a carbon tax in Would countries be prepared to raise the carbon tax to reduce emissions? Low price elasticity of demand?

Evaluating the alternatives When evaluating consider some of these points: Which interventions are likely to be most effective? In changing behaviour In encouraging innovation and investment In reducing emissions at lowest cost What are the consequences for equity? Between rich and poorer nations Between rich and poorer within any one country Between current and future generations Between producers and consumers What 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