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An argument for emissions trading

February 20th, 2009

With resurgent debate over the relative merits of carbon taxes and emissions trading, attention has turned again to Europe where the market price of emissions permits has fallen sharply as a result of the financial crisis and recession. Most commentators have seen this as a strike against emissions trading, but actually it’s a positive. The big concern about price uncertainty arises when we are very uncertain about the cost of reducing emissions. Under cost uncertainty, setting the emissions target too low could impose unexpectedly high costs on the economy.

What’s happening here is that we are uncertain about the rate of growth of the economy. An emissions target is countercyclical since it imposes a relatively high cost when the economy is strong, and a much smaller cost when the economy is weak. This is a Good Thing.

My view, for what it’s worth, is that a well-designed emissions trading scheme is the best available option. But given the weaknesses of the government’s proposed scheme, I’m prepared to consider alternatives.

Note also that different macroeconomic shocks give different outcomes. Warwick McKibbin has done some work showing that an upward shock to growth in one country will benefit other countries less (and perhaps not at all) under global emissions trading than with a price cap or hybrid policy. That’s because the growing country will demand more emissions permits, pushing up the global price.

It’s easy to see that McKibbin’s modelling result is consistent with the analysis here. By symmetry, a negative shock in one country will harm others less under emissions trading than under the price-based alternatives. And the same logic applies to sectors within countries. It’s easy enough to see then, that for any economy with a fixed aggregate target, or for the world as a whole, emissions trading will tend to reduce the benefits of booms and the cost of slumps.

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  1. February 20th, 2009 at 23:16 | #1

    IN the early 1990′s, Russia and much of eastern Europe has dramatic reductions in GDP and similarly dramatic reductions in emissions. These countries did not experience very significant changes in emissions per unit of GDP however. Of course these countries did not have any carbon pricing, if there was carbon tax it could have been more recessionary (but not necessarily, a carbon tax can be revenue neutral). But cap-and-trade would make no difference to the emissions intensity of Russia’s economy.

    Under the expectation that the world will be carbon constrained, any economy would benefit from being less emissions intensive. There would be some benefits to a price floor in recessions. This would also stop low emissions technologies from going out of business. It would also increase the benefits of green stimuli

  2. Kevin Cox
    February 21st, 2009 at 02:46 | #2

    I have argued before there is a better simpler approach to reducing emissions than increasing the price of polluting energy. That is to reduce the finance costs of infrastructure whose construction and deployment will reduce emissions. However given that we are going to be lumbered with emissions trading let us make it work.

    The Emissions Permits market as a cap and trade system cannot work because the laws of supply and demand with price as the controlling mechanism will not work with fixed caps. Such a market place will have unpredictable prices. Markets where you cannot make a reasonably accurate prediction of the price are useless with respect to the objective of achieving the most efficient allocation of resources. In the proposed emissions trading scheme the laws of supply and demand do not work because supply does not vary in response to changes in price. That is if there is a fixed cap that only varies at the whim of politicians then supply is effectively fixed. Demand for permits is independent of the market and for purposes of market operation is fixed. The simplest of modelling will shows that with fixed supply and demand a small price change in either direction will cause the price to continue to rise or fall depending on the initial perturbation. The price will go up until something external causes it to start going down and it will continue down until it reaches near zero and how long it takes to get there is indeterminant. Prices are unpredictable and the market is never in equilibrium.

    To fix this problem the government sets a target price for permits. If the price falls below a certain percentage of the target price the government reduces the supply of permits automatically. The size of the decrease will be a formula that depends on the price level. If the price rises above a certain level the supply of permits increases. The market in permits will now adjust itself and oscillate around the target price. The market can now be used by investors to make investment decisions.

    The second problem with the proposed implementation of Emissions Permits is compensation to the victims of price increases. There is a good case for compensation to the existing owners of coal fired power stations and perhaps to the owners of coal mines if they cannot find other markets for their product. There is a good case for compensation to the poor whose proportion of income spent on energy related goods is high. Given that we need to compensate people how can we do it in a way that also reduces emissions? We do it by taking the money raised from the sale of permits and distributing it ALL back to those who need compensation. However, we require the people receiving the money to spend the money in the market place of infrastructure in ways to reduce emissions. That is, in clean energy plants, in insulation, in better building design. The money is tagged and it does not attract interest until it is spent. This solves the problem of compensation and supplies the investment money needed to build a sustainable infrastructure. From the point of view of society as a whole it does not matter who gets the money – that is an ownership issue not an efficiency issue. What matters is that money is spent efficiently on ways to reduce emissions.

    Given that the amount of money collected from emissions permits is invested in ways to reduce pollution we know the target price we need to set to get emissions to a given level. This can be calculated by estimating how much investment we need to reduce emissions using known technologies. For Australia to get to zero emissions within ten years my estimate is around $20 billion a year.

    The above will work and will reduce emissions to whatever target we want to achieve. It is a roundabout way of solving the problem. It is much simpler and cheaper to print the $20 billion needed and distribute the money in whatever way is politically acceptable. The critical factors are that the money is zero interest and that it MUST be spent in the market place of ghg reducing technologies.

  3. ffrancis
    February 21st, 2009 at 04:34 | #3

    If the value of emissions permits rises during a boom and falls during a slump, is there a point in the slump where market value falls to zero? I’d replace them with a system of carbon credits – and not for reducing emissions, but only for actually removing carbon from the atmosphere. If it were mandatory to have enough credits to match your emissions, I think we could count on a significant boom in both emission-reduction and carbon-removal businesses. Not to mention non-carbon-emitting energy businesses.

  4. Hermit
    February 21st, 2009 at 07:51 | #4

    The argument that carbon charges would smooth energy price volatility may be evident in our own backyard. The Basslink underwater cable linking Tasmania to the mainland enables quick response hydro to power city air conditioners during heatwaves. The drop in dam levels is not so much of a problem since under the spot pricing scheme coal fired electricity can be profitably reimported to Tasmania. Actual spot prices don’t seem to be available from NEMMCO but they are believed to have hit the price cap of $10 per kwh recently while long term coal power can be as cheap as 3c.

    Now if there was a tough volumetric carbon cap this practice would be severely curtailed. Water in the dams would have to be conserved because there would only be so much coal power to go round. Thus an international carbon cap without grandfathered permits and bogus offsets would almost certainly force a regime of carbon austerity. If only there was the will to enforce it.

  5. hrgh
    February 21st, 2009 at 09:56 | #5

    Hermit @4

    Spot prices are here: http://nemmco.com.au/

    The price cap is closer to $10,000 p/mwh than $10, expect when the 7 day average hits a cap (I think around $300). This allows some volatility without allowing too much longer term exposure to high prices.

    Also, it is the contract price that is more relevant than the spot price, in reality there is very little exposure to the spot price because of the volatility.

  6. Hermit
    February 21st, 2009 at 13:16 | #6

    $10 and 3c per kwh are $10,000 and $30 per mwh. That’s a huge spread. I believe the line rental for the Basslink cable (owned by a Singapore investor) works out about $50 per mwh or 5c per kwh.

    Another issue we might have to face is paying more for aluminium. Why should one industry consume vast amounts of high carbon energy at giveaway prices? Perhaps instead of a can of soft drink we should fill up our water bottle at a fizzy drink dispenser. Under the ETS the special status of industries like aluminium seems to be non-negotiable. If the Chinese want to take over these industries perhaps we should have carbon import tariffs or cut back their coal. So perhaps these issues are negotiable after all.

  7. February 22nd, 2009 at 00:16 | #7

    I’ve written this here before, but people use the infrastructure that they have. Building new major infrastructure is what governments do. I don’t know of any emissions trading scheme that has actually reduced emissions beyond what appears to have been happening without the scheme (of course this is hard to prove).

    But the countercyclical nature of this is specifically a bad thing. When the economy is booming, people won’t do anything, because they’ll feel that they can afford high-priced permits — economizing isn’t generally what businesses do at such times. When the economy is in recession, people won’t do anything, because permits will be very cheap. And if the permits do begin to pinch at either end, politicians will simply either sell more of them or look the other way with regard to enforcement. The great advantage of de-building bad infrastructure and building new is that no one needs to look after permit levels or enforcement.

    Emissions trading is a relic of market worship. People want to do it in the same in which people in the U.S. really don’t want to nationalize banks. But they’re going to have to give up sooner or later.

  8. TerjeP
    February 22nd, 2009 at 04:52 | #8

    If the focus of the carbon emission policy is to reduce carbon emissions by ushering in new energy technology then the key business sector that needs price certainty from a carbon tax is the renewable base load energy sector. They are after all the ones in need of new capital and who must persuade investors and bankers that things will work out as planned. Most of the prospective renewable base load energy companies (eg Geodynamics with it’s hot rock technology or Enviromission with its solar tower concept) have a good idea what carbon price would make their alternative solution profitable (or at least investable). However dealing with the volatile carbon price that an ETS would deliver makes investment in such unproven high risk commercialisation a far less certain venture. In order for these investments to get off the ground price volatility under an ETS will need to be compensated for by a higher aggregate carbon price. In short an ETS is a more expensive way to get alternative energy investment. A carbon tax gives you much more bang for your buck.

    In short an ETS will mostly lead to speculative investment in permits whilst a carbon tax will mostly lead to speculative investment in alternative energy.

  9. Ikonoclast
    February 22nd, 2009 at 06:39 | #9

    I agree with TereP. A carbon tax is the way to go. For a carbon tax to work it must be combined with a policy of removing all the existing fossil fuels subsidies; both the direct ones like the diesel fuel rebate and the indirect ones like subsidising private cars by not making road users pay the full costs of road infrastructure.

    JQ, we couldn’t trust the markets to run a banking system. What in the world makes you think we can trust them to run a CO2 abatement program?

    A carbon tax system is always vulnerable to tinkering and pandering to special interest groups. If a government had the political will to implement a carbon tax, repeal all fossil fuels subsidies and stick to that policy then we might get somewhere.

    Trading with countries with a similar carbon tax would be straightforward. Countries which refuse to implement a carbon tax would simply see their goods get hit with the tax when their goods are imported. In other words, the only import tariff we need is a carbon tax on countries who won’t levy a carbon tax themselves.

    If they are playing games and using subsidies elsewhere in their system to negate their carbon taxes then they still get hit with the carbon import tax. The relevant minister makes the decisions and periodically reviews the status of each country through his department.

  10. Kevin Cox
    February 22nd, 2009 at 07:18 | #10

    A carbon tax is good because it gives stability and certainty. But if you implement emissions permits trading the way I have described it will bring sufficient certainty of price for investment decisions to be made.

    In Australia we have a government committed to fulfilling its election promises and they promised to introduce emissions permits trading. Making permits trading so the value of permits oscillates around a known value will be the equivalent of a carbon tax. Permits trading is a politically easier thing to get through because a carbon tax is called a tax and imagine the ads at the next election if Rudd introduced a carbon tax.

    In both cases the real issue is how the money from the tax or sale of permits is spent. We should make sure the money collected is spent on ways to reduce emissions. We can charge everyone for permits but compensate them by giving it back as permits money that has to be spent on infrastructure to reduce ghg emissions.

    For example we could give every motorist back the cost of permits on their petrol. At the moment we can give every motorist who wants it a discount so it is pretty easy to add giving everyone permits money and require them to invest permits money in infrastructure to reduce ghg emissions.

    It is how we spend money that is important – not how we collect it.

  11. BilB
    February 22nd, 2009 at 09:08 | #11

    JQ,

    You have pointed out the ETS mechanism adjusts with economic activity. Great. Now demonstrate that it is in fact reducing CO2 emissions at the rate required to mitigate climate change. Further demonstrate that the monies collected are being put to work to build a short solar cycle energy system. This being the ETS’s real purpose.

  12. TerjeP
    February 22nd, 2009 at 10:14 | #12

    Making permits trading so the value of permits oscillates around a known value will be the equivalent of a carbon tax.

    If there was zero oscillation around a known value then it would be equivalent to a carbon tax. However the half way house of having a price that oscillates within a price band based on market dynamics whilst also having a hard price ceiling and hard price floor seems to entail the worst of both systems. You still get less price certaintly than a tax so you need to have a higher aggregate price to compensate renewable energy investors for the uncertainty.

    They can switch to a tax and pretend to keep their core promise by simply issuing emission permits at a fixed price in unlimited quantity and allowing them to be traded. There wouldn’t be a whole lot of trading but so what.

  13. TerjeP
    February 22nd, 2009 at 10:22 | #13

    >blockquote>For a carbon tax to work it must be combined with a policy of removing all the existing fossil fuels subsidies; both the direct ones like the diesel fuel rebate and the indirect ones like subsidising private cars by not making road users pay the full costs of road infrastructure.

    It would work even without such measures. The higher number of hydrogen bonds mean that oil and petrol typically yield much less CO2 per Watt of energy than Coal, so even if the impact of a carbon tax was focused mainly on the electricty sector a carbon tax would still reduce emissions over time (relative to what would have been).

    In terms of the notion that fuel taxes don’t cover the cost of roads I’d love to see that argument defended with numbers. In fact I think that if we had a general carbon tax then fuel tax would be a prime tax we should look at abolishing (although payroll tax and income tax are very worthy targets for reduction).

    Permits trading is a politically easier thing to get through because a carbon tax is called a tax and imagine the ads at the next election if Rudd introduced a carbon tax.

    I don’t think the attack ads would get very far if the revenue was being used to remove income tax (eg by increasing the tax free threshold). Unless of course you did something stupid and decided to tax farting and the like.

  14. Hermit
    February 22nd, 2009 at 10:41 | #14

    It may be that the 45% emissions cuts by 2020 argued by climate scientists imply prolonged recession. Efficiency gains (eg roof insulation) may simply be unable to compensate for such cuts. Desalination and electric cars are possible new sources of demand increase, both controversial as to the net effects. Nuclear power can’t be ramped up that quickly even if it was politically acceptable or affordable. We could regard 25% carbon forbearance as a sacrifice to the future not that such voluntary cuts are likely.

    It may turn out updated coal statistics indicate emissions are slowing anyway. Less cement due to the building slowdown but more electricity for air conditioning in hotter areas. That’s why I like hard (no loopholes) targets; intervene if warranted but otherwise leave alone.

  15. BilB
    February 22nd, 2009 at 11:00 | #15

    All of this free market crap is sickening. Just so a hand full of people can get richer faster. What a crock. Those richer faster people have all cut and run, oh Sandford got caught along with Madoff but the rest are gone, and left the rest of the world with a bloody awful mess. A bit of a dynamic approach to GWA may very well have prevented the crash. Once technology is driven with enthusiasm then there can be dramatic improvements. Here is an example developed with public money not private

    http://www.abc.net.au/news/stories/2009/02/19/2496458.htm?section=australia

    If this works then my factory power needs are taken care of on my own roof.

  16. BilB
    February 22nd, 2009 at 11:38 | #16

    This looks like being a good read for those laissez fair folk out there

    The Anti-Economy: How the Pursuit of Private Fortunes is Destroying Community Wealth

    http://www.theoildrum.com/node/5121#more

  17. Ikonoclast
    February 22nd, 2009 at 13:43 | #17

    TerjeP raises some interesting points in post 13 and on a quick scan I think I agree with most.

    1. Coal yields less energy per unit of CO2 emission than hydrocarbons. Yes, agreed.

    2. Other taxes (like the fuel excise) should be removed if a carbon tax is implemented. Yes, agreed. The whole messy area of hydrocarbon taxes, excises and rebates should be rationalised. There should be no fuel excises and no fuel subsidies/rebates. Carbon and hydrocarbon fuels should simply attract a GST and a carbon tax each calculated separately (so there is no tax on a tax).

    3. Abolish payroll tax. Yes, agreed. Too many types of taxes mean too much (costly) administrative apparatus is needed. Given that we have company tax, personal tax and a GST, I can see no logical reason to have a payroll tax also.

    4. I would also be in favour of increasing the tax free threshold and indexing tax withdrawal rates to prevent bracket creep.

    5. On the other hand, I advocate a few things TerjP might disagree with. Tax breaks of the negative gearing type should be abolished along with the tax avoidance aspects of Trusts.

    A tax system should;

    (a) be as simple as it can be while still raising revenue effectively.

    (b) maximise tax revenue without causing significant disincentive and without making illegal activities too attractive.

    (c) contain NO rebates and NO tax deductions.

    (d) tax key negative externalities of production eg. a carbon tax is a tax on carbon pollution and thus a tax on athropogenic global warming, (a negative exteranality.)

    It would take quite a bit to spell out how (a), (b), (c) and(d) would be done. I might try it some time in a weekend reflections post.

  18. TerjeP
    February 22nd, 2009 at 14:16 | #18

    Ikonoclast – not that much disagreement then. I don’t know the details but in principle I agree with your position on avoidance via trusts.

    I would abolish payroll tax not because there are too many types of tax (although I agree that there is) but because it has a direct impact on the employment of labour versus the employment of capital. However same end point so no real issue. I would however prefer slightly to see payroll tax replaced with an alternate state tax on land (comparable to local government rates) or some such thing rather than a new federal tax.

    In fact about the only thing I really disagree with you on is the removal of tax deductability of interest on investment property, shares etc. However I’d accomodate such a reform if the extra revenue was funnelled directly into across the board reductions in income tax. Given that rents would rise (that’s what Keating found) I’d suggest that it would need to be focused on the low income brakets.

  19. February 22nd, 2009 at 16:25 | #19

    On the effectiveness of emissions trading:

    As soon as the government sets a cap (which is unlikely to be close to the target recommended by science), I can see no incentive for individual or community effort to further reduce emissions.

    International trading also seems fraught. If it works anything like CDMs do at the moment, it seems like just adding another dimension to the rich/poor divide.

  20. Ikonoclast
    February 23rd, 2009 at 09:21 | #20

    Rents did rise on the aboloition of negative gearing as Keating found. However, I would argue that the policy of negative gearing to create extra landlords (and reduce private home ownership) has hardly held rents down either.

    Witness the rises in rents over the last several years. The easy availability of credit and negative gearing practices has greatly inflated the price of housing. Rents have risen accordingly.

    Negative gearing is distortionary as are all tax breaks and perverse incentives. Remove them all from the economy and the market will be more able in general to allocate resources efficiently and effectively. I make that last statement with the caveat that we still need a mixed economy with government action on matters that the market clearly is not good at.

  21. TerjeP (say tay-a)
    February 24th, 2009 at 03:04 | #21

    More from me on the ETS versus carbon tax issue:-

    http://blog.libertarian.org.au/2009/02/23/penny-wong-gets-it-wrong/

  22. Gaz
    February 24th, 2009 at 15:40 | #22

    “Bradley Smith (@19): “As soon as the government sets a cap… I can see no incentive for individual or community effort to further reduce emissions.”

    And what a tragedy that would be – not.

    I mean it’s not as if individual and community efforts have made a jot of difference so far.

    Really, whether it’s a tax, a cap-and-trade or a hybrid scheme, the aim is to get emissions down, not make a handful of trendies feel good aout themselves.

    Penny Wong is right. If voluntary action is significant it will enable a faster reduction in the cap. But it’s insignificant, so it won’t.

  23. JoelP
    February 25th, 2009 at 10:11 | #23

    TerjeP @8

    “In short an ETS is a more expensive way to get alternative energy investment.”

    Yes, but there is also the RET at 20%. The idea being that this will help bring the cost of alternative energy down (through the establishment of new plants, expertise and technology) to a level where it will be encouraged by the CPRS by 2020.

    It’s just the 2020 time line that is questionable.

  24. David Douglas
    February 26th, 2009 at 14:36 | #24

    I am a long-term reader and first time commentator. Thanks for the work you do here. I now probably spend more time reading economists blogs than I do news Web sites.
    I have two concerns with a remark you have made: “Most commentators have seen this as a strike against emissions trading, but actually it’s a positive.”
    If projections for future growth are now lower given that the Great Moderation is undone, then the rate at which we discount future costs of climate change must also be lower. This inevitably means that more of the cost of climate change should be borne by the present generation.
    My other concern relates to price certainty. Investors in new, cleaner technologies face risks in bringing innovation to the market. These risks have been exacerbated as a result of market turbulence and uncertainty concerning future growth. These risks are unlikely to be ameliorated by the crippled derivatives market.
    These concerns may not undo your comment that the declining price is a positive. My argument is that these qualifications should raise concerns regarding the volatility of the carbon permit price.
    For a long time I favoured a carbon tax. During the year preceding the economic meltdown I became somewhat ambivalent with respect to the choice between taxation and trading on the basis that the market could deliver confidence in the future price. This appears to me to be no longer the case.

  25. Tushka
    March 12th, 2009 at 09:31 | #25

    In terms of finding a way to reduce the cap based on voluntary action, this site explores a way to calculate additional reductions without double counting.

    Given that taxes tend to be politically difficult to implement it may be worth exploring options to overcome cap-and-trade limitations:

    http://ghgblog.com/?tag=us-cap-and-trade

    It’s interesting to note that the EU didn’t seem to face the same ‘voluntary’ backlash, their citisens were most likely better satisfied with the more stringent targets they set.

  26. June 13th, 2009 at 17:29 | #26

    I suppose that an ETS can function like Keysnian fiscal stabilizers, in that they provide negative feedback dampening overall oscillations on the desired maximand. (Or minimand, in the case of carbon.)

    Keynsian fiscal ratings (tax and benefits) are a sort of “governmental price” which is counter-cyclically volatile. They top up income in a bust and tamp down income in a boom. Dampening oscillations in the quantity of income, although on a higher output trend line.

    Similarly an ETS is a carbon price which is counter-cyclically volatile. It cuts the carbon price in a bust and hikes the carbon price in a boom. Dampening oscillations in the quantity of carbon emitted, although on a lower output trend line.

    Always assuming that the ETS is effective. Big Ask.

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