Getting rid of carbon 6 - emissions trading

I finished my last post, Getting rid of carbon 5 - problems with measurement, with this comment:

The difficulty that I have had with discussions on emissions trading schemes lies not in the underlying economic concepts, but in the difficulty I have had in tracing through just how the schemes might work in practice on the ground.

In this post I want to trace through some of the issues involved in emissions trading working from first principles. I am approaching the question in this way because I am myself seeking to understand how such a scheme might work in practice.

Before going on, for the sake of simplicity I am using carbon as a short hand term to cover all green house gas emissions.

Both emission trading schemes and the alternative tax based schemes work by placing a price on carbon. The more carbon you produce or use, the more you will pay.

This increase in production costs is then passed on to customers in the form of higher prices. This reduces demand for the now higher priced goods and services. Production falls or increases more slowly than might otherwise be the case and especially for the higher carbon goods and services. This reduces or at least slows the growth in emissions. Producers have an incentive mean time to invest in more carbon efficient means of production and distribution.

Because adjustment takes time, most schemes provide for progressive, known, increases in carbon prices. This aids adjustment and provides a greater degree of planning certainty.

In what are known as cap and trade schemes, an initial cap is set on emissions that then falls with time. Firms producing below the cap gain credits that can then be sold to firms exceeding the cap, thus rewarding lower carbon activities, penalising higher carbon ones. Activities that directly reduce carbon may receive credits that can then be on-sold, thus providing a reward for those activities.

The economic modelling that has been done to measure the impact of such schemes necessarily has to make assumptions.

First and most critically, they have to assume that carbon can in fact be reduced. If carbon cannot in a general sense or in the context of particular critical activities, then there may be severe price effects for very little results.

On of the reasons I began this series by looking at some of the green house reduction possibilities in an Australian context, was simply to test whether or not carbon reduction was in fact possible and, if so, to start to sketch out some of the things that might be done in combination.

A second key assumption used in the models relates to economic growth. Faster economic growth increases emissions, but also compensates for the negative effects flowing from carbon reduction.

While I can understand in a general sense how how the economics is meant to work, there are a number of specific issues that I do not properly understand, nor do I think that they have been fully discussed.

The first is the effect of carbon pricing along the production chain.

To this point, most discussion on price effects has focused on energy and especially electricity pricing. However, the effects are far broader than this because every stage of the production process will be affected in terms of both the carbon embedded in inputs and its own emissions.

I am not sure how the price effects were measured in the various economic modelling exercises, but I have a feel that they are going to be greater than expected.

Consider building costs. Each input used in the building process will increase in price by the combination of the carbon costs for the various things required to make that input plus the costs of any carbon emitted during the production process itself for the input and then the final construction process itself. Higher building costs in turn mean higher rents.

The exact pattern of price increases will not be uniform across the economy. In the short term, some producers may be able to absorb higher prices. Others where the demand is less elastic may be able to pass them on in full. Where lower carbon products are substitutable for higher carbon products (wood for steel or cement for example), then price increases may be constrained by that substitution.

Price and consequent production effects will be affected by each sector's exposure to international trade. If each country introduced identical emission trading regimes, the impact of emissions trading should be (in theory at least) broadly equivalent between countries. More precisely, perhaps, between industries in different countries with similar production patterns.

This seems highly unlikely. Each country is likely to have its own targets, its own exemptions or exceptions, thus increasing uncertainty as to results.

The presence of carbon offsets such as soil sequestration or forestry creates a new set of uncertainties over and beyond measurement difficulties.

From a global viewpoint, it is in everybody's interests that carbon offsets be created to the maximum possible extent. This seems unlikely to happen under present proposed arrangements.

Further, just because an industry emits carbon, even large amounts of carbon, does not meant that that industry should be phased out. We are concerned with overall effects. Here it may in fact make sense from a global or national perspective to continue a particular activity even though it does involve substantial carbon emissions. Many of the very particular responses to particular industries are not of themselves especially rational.

Keeping things very simple and looking just from a global perspective, it seems to me that we need to break the nexus in national targets between emissions and offsets.

The starting point needs to be the calculation of the reductions in carbon that need to be made at a global level, taking growth into account. The next step is to estimate major known offsets on a global basis.These offsets will have an economic value that will flow to the creating country, but should not be taken into account in national targets. Rather, they should go into a global pool.

A formal structure would need to be created for measuring and recording these offsets to provide an effective market base. Further, part of the agreement should be agreed action by countries to try to ensure that the offsets are in fact achieved.  

The overall carbon reduction target would then form the base for the calculation of country targets. This means that the overall approach rests on two legs: carbon reduction targets set to address the problem combined with carbon offsets. The two in combination would actually exceed the required cuts. That surplus is central to making the whole thing work.

The core problem in setting the targets remains the best way to find an equitable solution acceptable to all. This may in fact not be possible.

One of the points that Professor Garnaut made in an Australian context is that schemes need to be universal; the more exemptions you have, the greater the risk of distortions. As a broad statement, I think that the Professor is right. However, at a global level, there are great variations in levels of income and in per capita emissions.

Poorer countries with low per capita emissions argue, with justice, that a universal scheme would penalise them. Not only would their development be constrained directly, but they also lack the cash to buy offsets.

There are different ways of handling this.

One would be to make a clear distinction between the emission targets and subsequent redistributive compensation. This would be sensible in theory, but is likely to strike practical problems including trust. Wealthier countries do not always have a good record in delivering on commitments!   

A second way would be to build a bias into any emissions trading scheme that recognises lower development. How might this be done?

One simple way would be to break countries into three groups based on current per capita emissions.

The lowest emitters could have targets set at current levels plus, say, 20%. The second group would have targets set at current levels. Then the third group would have the per capita emission target reductions set at the level required to bring about the required reduction. This is likely to involve quite sharp cuts.

This is where the carbon offsets pool comes in. We do not need to achieve the full global targets, simply the target minus offsets. Countries would be able to buy from the offsets pool to help manage their emission targets.

In my next post, I will look at how all this might work in practice at national level.