Liebreich: Why Cap-and-Trade Will Continue to Hold the Aces

By Michael Liebreich
Chairman and CEO
New Energy Finance

Anyone who was underestimating the ferocity of the high-stakes card game being played in the run up to Copenhagen in December should be doing so no longer, thanks to the fate of this month’s official negotiating sessions in Bonn. Work on a draft negotiating text will now have to continue in further rounds of discussion in Bonn again in August, then Barcelona and at Bangkok in the autumn.

The issues are difficult enough to overcome as Copenhagen’s key players engage in bluff and brinkmanship. However, there is also an ongoing background debate over the design of mechanisms used to deliver a global deal on emission reduction. Among the negotiators and those closely following the talks, cap-and-trade is the only game in town, but some of those further from the action are still exercised by the merits of alternatives that have no chance of being implemented.

Playing cards in the great carbon game

In the international card game called Copenhagen, only the EU has so far decided to play its hand face up, revealing its negotiating position in advance including its planned response to other nations’ initiatives. In December 2008, the EU approved its energy and climate package, committing it to a 20% reduction in CO2 emissions by 2020 from a 1990 baseline – using 20% renewable energy to help it get there – and increasing that to 30% if other major nations followed suit. By 2050, the EU says it will have cut emissions by 80%.

The US election cycle and its system of political checks and balances have rendered its position far more opaque. However, they now look to be dealing President Obama a very strong hand for Copenhagen. Some variant of the Waxman-Markey Bill, which currently contains a commitment to cut emissions to 17% below a 2005 baseline by 2020 and 80% below by 2050, looks set to pass the House of Representatives before the meeting. The President should therefore be able to lay out the US’s commitment in detail, but he will also be able to point out that it will only get through the Senate if others – especially China – are seen to respond in kind. Australia recently caused howls of protest from both environmentalists and industry by tightening its emission targets but deferring the introduction of cap-and-trade to 2011. This positions their negotiating team on the same tack as the US, that is to say “here is what we can deliver, but only if we get a fair deal ourselves”.

For China, India and other large developing country emitters, there are two tricks they are absolutely determined to win. First, any commitments they make – and they are prepared to make quite a few – cannot take the form of absolute emission caps, and secondly, a large part of the bill will have to be sent to the developed world.

The smaller developing countries are not themselves major emitters, so in practice they are not really needed for a deal; however, they are disproportionately affected by climate change and will aim to extract the maximum possible funds for adaptation as a reward for not disrupting the proceedings.

At the same time and in parallel with the Copenhagen process, these negotiations are being mirrored in microcosm at the national and regional level. No leader in his or her right mind wants to make a commitment in Copenhagen that has not been essentially pre-sold domestically. What we are seeing is a festival of card-playing in capitals around the world, with winners scooping the jackpots and losers leaving the tables, ashen-faced, as the implications of shifting to a carbon-constrained economy begin to come into focus.

Confusion over mechanisms

Although clarity is starting to emerge on the trajectory of future emission reductions and how they may be divided up, a startling level of uncertainty appears to reign over the mechanisms that might be used to deliver them – especially given the lateness of the day and how long it takes to set up administrative institutions.

At one extreme are the Kyoto hardliners, arguing that anything other than rolling over the existing mechanisms would be a betrayal of years of effort and would nullify all progress to date. At the other extreme are those arguing for a completely fresh start, and who would discard all the baggage of Kyoto and search for a new consensus. An increasingly influential group is backing a move to sectoral approaches, although others have worried that these risk “overlaying the flesh of one nightmare on the bones of another”, in the words of one minister involved in the negotiations. One thing seems certain: around the world, both in the major emitting regions and internationally, much of the heavy lifting will be done by cap-and-trade systems.

The fact that cap-and-trade has gained almost unstoppable momentum appears to have passed by some otherwise astute commentators (including the editorial writers at the Economist). While it is to be assumed that only the most internationalist of dreamers could hold out hope for a single global carbon tax, there is in theory nothing to stop each country making whatever commitment it is prepared to make in Copenhagen, and then using domestic taxation to achieve its targets. But it is not going to happen, at least not in any of the major economies, and there are good reasons why not.

The debate may end up being fairly academic. In economic terms cap-and-trade and a carbon tax pretty much converge if you assume the following: the level of any tax-based system would be appropriate to achieve the desired volumetric reductions; large swathes of economic activity in the developing world would remain exempt from either system; all credits in any cap-and-trade-based system would eventually be auctioned; measures would be implemented to reduce carbon price volatility; and competition drives down the cost of administration – all fairly reasonable assumptions.

The fundamental difference between a carbon tax and cap-and-trade is that a tax defines the cost of emitting a tonne of carbon, but leaves uncertainty about the volume of adjustment it will achieve, while cap-and-trade defines the volume of emission reductions, but leaves the market to decide the associated costs. There is something inherently elegant about a carbon cap, since the scientists can – with increasing levels of accuracy – tell us what levels of emissions are allowed if we want to avoid the worst climate outcomes. A carbon tax, however, looks on the surface to be easier to implement because it is not volatile and so can more easily be priced into investment decisions and collected from a small number of providers of fossil fuels.

The case against cap-and-trade

There are three main arguments against cap-and-trade: that it is pointless if it covers only half the world; that it is complex and imposes significant administrative costs; and that it is open to abuse and fraud. All three are powerful arguments.

We are unlikely to see a single global carbon price for the foreseeable future, for the same reasons we don’t have a single global currency: it would result in massive flows of capital from countries with good carbon productivity – i.e. rapid rates of improvement in emissions – to those with poorer performance. Buyers would be concentrated in the West, sellers in the East. This may be optimal from an economic viewpoint, but politically and geopolitically problematic.

What we will see instead is a growing network of carbon markets – each covering different geographic regions or industries – which look set to cover more and more of the world’s emissions, and which will be increasingly linked. At present the main linkage is via project-based credits from the developing world and economies-in-transition, which can be sold via the CDM and JI Kyoto mechanisms into the EU-ETS, or into the emerging US voluntary market. Nations can also trade directly through allowance-based credits such as AAUs. If, as seems increasingly likely, Copenhagen results in the adoption of sectoral agreements covering steel, aluminium, paper and so on, then it should be possible to sell the resulting credits into any of the regional systems. This arbitrage will tend to drive carbon prices closer together. And as the network of carbon markets expands to cover more of the world’s emissions, so we move towards the elegant outcome – whereby we directly translate the world’s greenhouse gas emission targets into concrete local caps.

In any case, the Achilles Heel of the cap-and-trade-based system – the ongoing refusal of the big developing world economies to accept any caps – would be no different under a tax-based system. The Chinese and Indians would argue on exactly the same grounds that they should not suffer the same costs as western economies which have been responsible for most emissions to date, so we should impose a tax, but not on them.

A much more serious problem is the administrative cost of cap-and-trade. Estimates of the administrative burden of the Kyoto mechanisms vary – from a few percent of project costs to 10 or 15% for smaller projects. But that is missing the point: some three-quarters of trading in the world’s carbon markets occurs under the cap-and-trade scheme of the EU-ETS, not the CDM. As the scale of clean energy projects worldwide grows, as programmatic methodologies are refined, and as sectoral agreements yield credits from far larger industrial projects, the administrative cost of cap-and-trade, as a percentage, will come down.

The final major criticism of cap-and-trade is that it is open to abuse and fraud. There are stories – none as far as we know verified – of Chinese entrepreneurs building refrigerator factories only to collect CDM credits for destroying the resulting HFCs. There is no question that the CDM project mechanism puts the levers of a cash printing press in the hands of a few lawyers, verification agencies and mid-level bureaucrats in some of the world’s most corrupt economies. There will be fraud. But can the proponents of carbon taxes honestly say that taxation is not equally open to abuse?

But is a carbon tax any better?

Any carbon tax proposal has its own weaknesses. The objection most frequently raised by those on the right of the political spectrum, is simply that taxation distorts the functioning of the markets. In this case, the objection is self-defeating: the whole purpose of an emissions policy is to price in the externality cost of emissions and hence to distort economic activity from what it would otherwise have been. A much more persuasive argument is that governments will inevitably fritter away the proceeds of a carbon tax. Perhaps true, but that could equally be said of the proceeds from the auctioning of carbon credits under cap-and-trade.

One minor argument against a carbon tax is that the very process of reporting emissions, managing compliance and having prices reported in the media stimulates more action than a tax would. Although, as we have seen, tax and trade mechanisms give the same abatement incentives, in practice human nature plays an important role. We get worked up about targets, prices and metrics that we have to reveal in our annual reports. A tax is something we can live with once we get used to it.

More significantly, however, a carbon tax is not able to flex with the state of the economy, whereas a market price for carbon, as we are currently seeing, clearly does. There are those who find the recent collapse in carbon prices in the EU-ETS disturbing – they shouldn’t. Europe set its emissions goals. If it turned out, because of the recession, to be easier to hit them than expected, why should industry not get the benefit? At times like this it is worth remembering that the market is the worst way of allocating resources in an economy – except for all those other approaches that have been tried, to paraphrase Winston Churchill. What is needed, it must be said, is increased transparency over future prices and reduced policy risk, so that market participants can make properly informed decisions.

The high volatility in European carbon prices results directly from exceptionally high levels of policy risk in the current environment. If you look at the long-term shortfall in carbon credits and the ability to bank from one commitment period to the next, there is absolutely no reason for the price to be as low as it is. However, if you believe there is a real risk the system might not be around in its current form for the long term, then you should discount the ability to bank credits, the system is long and carbon prices even now are too high.

If reducing volatility in carbon prices is important, the current debate about mechanisms to achieve this goal – for instance by imposing a floor on the price at which credits will be sold at auction – is wholly misguided. Setting a floor on the price at auction is not the same as setting a floor on the actual price. If the actual price drops below the floor, all that happens is that the next emission auction will fail. That is highly unlikely to drive the price up in the short term – in fact the exact opposite: the resulting damage to confidence from a failed auction is much more likely to drive prices down.

If we really want to reduce volatility in carbon prices in Europe, then we have to look at more profound changes. Five-year commitment periods are a problem when projects to produce credits have 20-year asset lives. Of course a system based on 20-year commitment periods would be impractical and have no feedback mechanisms, but a rolling commitment period would help. Another way to reduce volatility might be to create a “European Carbon Central Bank”. There is a cognitive gap between the level of the emissions reductions to which Europe has committed and the carbon price that business expects to see. Any analysis of Europe’s marginal abatement curves shows that by 2020 the carbon price will need to be in the EUR 40 to EUR 60 range; yet businesses balk at putting figures like this in their investment plans, preferring to ignore the carbon price altogether, or at best to use a lower figure. A strong carbon central banker could have a material impact in reducing volatility by consistently communicating the expected trajectory of carbon prices. And if you really want an orderly progression in carbon prices, give the Carbon Central Bank the ability to tweak the credit creation tap and a decent-sized fund with which to undertake open market activity.

Political realities

The real roadblocks for carbon taxes, however, come not from the realms of economics, but from the realm of politics – or Realpolitik.

Unlike a carbon tax, the burdens of cap-and-trade can be fine-tuned. You can choose between giving industry an easy time (handing out free credits), filling your national coffers (auctioning credits with no tax rebates), or buying off tax-payers (auctioning credits and giving 100% rebates). And you can change the mix over time, in response to circumstances. A carbon tax has no such flexibility: it simply falls first on industry, and is then passed on to consumers, angering both and making any deal that much harder.

Cap-and-trade has the additional benefit of creating a currency which can be used to buy off stakeholders outside the system – international partners, the developing world, those focusing on the issue of deforestation, pressure groups and so on. More importantly it gives the funders something in return – emission reductions in developing countries.

Finally, cap-and-trade creates a whole new set of influential stakeholders who hate taxes but love the opportunity to create new, complex and profitable instruments from which to derive rent. This is the flip-side of the compliance cost argument mentioned above. Reducing carbon emissions will cost money, and although the public may be for it in principle, when it comes to footing the bill, there are bound to be strong objections. Creating an influential, articulate and wealthy constituency that supports the system in good times and in bad may prove a wise investment.

Killer blows for carbon taxes

Ultimately, however, there are two killer blows for carbon taxes, which should disqualify them from even making it to the table in the great carbon card games now being played around the world.

First, regional and supra-national bodies, such as the European Union, have no right to impose taxes, but can roll out cap-and-trade regimes. Second, hard-pressed voters during a recession are particularly allergic to new taxes. Having given government a mandate to address climate change, they will tolerate any system which works while obscuring the cost of reducing emissions.

Step forward cap-and-trade, it’s your turn to deal.

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