Ch 5: Theory and Practice and the Case for ‘Silver Buckshot’

5.6 Theory and practice and the case for ‘silver buckshot’

In Figure 5.1 above, the simple case of a negative pollution externality was presented in the context of energy production, which we also noted has important positive production externalities. Theoretically we created a framework for looking at the costs and benefits of alternative policy approaches, placing emissions trading in the context of alternative policies such as taxation and regulatory bans standards.

In practice, climate change is a far more complicated externality involving multiple sectors and jurisdictions each with their own economic, cultural and political realities and histories. For example, while it does not matter where CO2 is emitted when assessing a firm or nation’s contribution to global warming, the impacts in terms of storms, floods and droughts are distributed differently. Low-lying areas are most at risk from sea level rise (eg Bangladesh, Denmark and various small island states) and temperatures will rise most pronounced in the Arctic and Antarctic regions, which may in the long-run actually be positive for some (Russians in Siberia) but negative for other reasons (for wildlife such as polar bears). This means the slope of the MDC curve varies across geographic regions.

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Perversely, the wealthier states most responsible for the historical stock of greenhouse gasses are the ones most able to adapt through sea defences, new technologies for growing drought resistant crops and so on, where poorer states will have trouble to access adaptation capital and technologies exacerbating damage costs in those regions.

There are also many, many more externalities at play, in addition to the negative pollution externality and those around energy security. For instance one of the most important is due to oil supply being set by the collusive behaviour of the Organisation of Petroleum Exporting Countries known as OPEC. This leads to tighter supply and higher prices than would otherwise be the case and makes it difficult to assess how ‘the market’ will respond to higher carbon prices. It is also interesting to note that this oligopolistic behaviour by OPEC reduces supply (Q) and pushes up prices, in a manner similar to a carbon tax (Tietenberg, 2004).

On the one hand, OPEC may decide to increase production and cut prices in response to higher carbon prices in order to maintain market share and slow technological change away from fossil fuels thus negating the net change in the price of fuel at the pump and any change in emissions.

Alternatively, OPEC may tighten supply pushing up prices even further to maintain profits and creating political and economic instability in the face of extraordinarily high fuel costs and hoping that democratically elected governments will loose their appetite for imposing higher carbon prices.

Note the outcome of this struggle between OPEC and the oil consuming nations (mainly the OECD states) largely comes down to who gets the economic rents from higher fuel prices – the OECD taxpayer in the carbon pricing scenario, or the OPEC member states in the higher price and collusion scenario. In each case the implicit carbon price could be the same, but the distribution of income from higher fuel prices drastically different.

Table 5.2 shows us that every $20 (USD) increase in the price of a barrel of oil has the same impact on producer prices as a $50 increase in carbon price.

The presence of these and other market failures and barriers to change means that while carbon pricing is necessary it is unlikely to be sufficient to effectively reduce emissions.

These practical problems have prompted Steve Rayner at the James Martin 21st Century School at Oxford University to argue that there is no silver bullet solution to carbon policy and that what is needed in practice is ‘silver buckshot’. Such an approach would integrate the different carbon pricing strategies with industry policy, research and development in

Figure 5.6 Oil prices over time

Oil prices over time

Table 5.2 Oil prices and the Carbon Price Equivalent

Oil prices and the Carbon Price Equivalent

clean technologies through to technological demonstration experiments and early market support with targeted subsidies.

By integrating active industry policy, this approach attempts to address concerns that households and firms, especially in the short term, do not always respond to price signals. Reasons for this include system complexity and lack of information about low carbon technologies, the long-term nature of energy investments, difficulty financing projects with large upfront costs and the slow pace of cultural change that is required to underpin a low carbon economy. These problems result in what is called path dependency, that is once a particular technology or process (such as energy from fossil fuels) is entrenched it takes a concerted effort beyond just sending price signals to shift the system, for example to a world based on renewables.

According to Brian Arthur, small past decisions can lead to path dependency or the notion that technologies become ‘locked-in’ even though better alternatives exist, simply because once investments are made it makes similar, supportive investments more attractive. There are five main forces that Arthur identifies as driving this process of ‘increasing returns to adoption’ (Arthur, 1994).

Firstly, learning by doing suggests the more often a technology is used the more it is developed and improved (Rosenberg, 1982). For example, the use of petroleum-based fuels in the internal combustion engines of cars has led to large improvements in performance of those engines and fuels, compared to the competing technologies of electric-battery or hydrogen motors. Secondly, network externalities mean that often technologies are advantaged by the number of adopters (Katz and Shapiro, 1985). For example, the vast number of petrol cars limits the diffusion possibility of battery-electric or bio-fuel cars due 269 to the lack of alternative refuelling infrastructure in the case of the former, and the ability of the engine to handle ethanol or bio-diesel in the later. Thirdly, economies of scale mean the more a technology is used, the lower its cost.

Electricity production is one of the classic examples of natural monopoly where the average costs of a large power plant fall with the amount of electricity produced making them competitive, but only at very large outputs (and levels of market concentration). Fourthly, increasing returns in information mean that often the more a technology is adopted, the more it enjoys the advantage of being better known and understood. This means that the risk of adopting a new technology falls as it becomes more widespread. Finally, technological interrelatedness suggests that as technologies become diffused, other sub-technologies and products become part of its infrastructure and help bring down its costs (Frankel, 1955).

For example, petroleum-based technologies have a huge infrastructure of refineries, distribution systems, filling stations, car manufacturers and so on that rely on them, further underpinned by an education system that trains engineers, geologists and chemists in the required skills for the industry in addition to political organisations that have grown in order to secure the legislative and subsidy frameworks that support the industry.

However, proponents of market-based solutions to climate change may argue that the industry policy elements of the ‘silver buckshot’ approach constitute ‘picking winners’ as the government may be put into a position of having to choose one technology over another. For example, the decision around significant new investment in nuclear energy is one such case. While a high carbon price helps the economics of nuclear energy, without substantial additional state support such as an efficient and supportive planning and approval process and the state insurance or subsidization of nuclear waste disposal, it would be very difficult for nuclear investments to take place.

Michael Grubb (2004) outlines a useful framework to consider these competing schools of thought on climate policy (illustrated in Figure 5.7 below).

Figure 5.7 Main steps in the innovation chain

Main steps in the innovation chain

Here technological change is mapped as a series of ‘steps in the innovation chain’. Accelerating this process for low-carbon technologies requires not only well designed policies and investments on the supply-side (technology-push) but also on the demand side (technology-pull) policies. For technology-push the focus is on research and development programmes and demonstration projects of new technology, while for technology-pull policies are mainly through the use of economic incentives such as carbon pricing (Doornbosch and Knight, 2008).

The alternative to ‘picking winners’ is to set the carbon price high and let ‘the market’ ‘choose’ the winners, rather than politicians. In theory, this choice emerges out of a competition between new clean technologies and fossil fuels, as the costs of new mitigation techniques comes down due to learning and carbon prices rise penalising the old fossil fuel systems. It is argued that such market approaches help avoid the danger of political decisions being captured by vested interests through lobbying.

When considering the nexus between ‘picking winners’ (technology-push) and letting solutions to CO2 mitigation emerge through the price signal (technology pull) there is a trade-off between the danger of political capture (and a bad decision) on the one hand and the time it takes for the price signal to work its effect on the other due to path dependency and behavioural reasons. In practice, where the line is drawn in the innovation process will come down to each country’s perspective of the role of the state in organising economic activity and the policy tools and institutions available to it, such as public finance.

In an economy riddled with market failures, and already subject to various (and competing) policy interventions and political rent seeking, the choice of policy approach – ‘to tax or to trade’ or regulate in some other manner is in practice perhaps best described as one of guiding principle than of strict practice. Nevertheless, as in politics, such principles can form a useful basis to signal a general approach in the face of complexity and uncertainty.

5.7 The essential elements of an Emissions Trading Scheme

There are two basic types of emissions trading scheme: cap and trade and baseline and trade schemes.

Cap and trade sets out a system where the government defines a new set of property rights to use the atmosphere base on an emissions limit or cap. Then, after the distribution of the allowances between actors involved in the scheme, it allows trade in these allowances so that actors can choose to conduct abatement or by additional allowances. Finally at particular times, actors covered by the scheme are required to surrender the allowances that that correspond to their level of emissions – this may be above or below what they originally were allocated depending on the costs of CO2 abatement they are faced with. The European Emissions Trading Scheme, and Sulphur Dioxide Trading Schemes in the United States, are examples of a cap and trade scheme.

The baseline and credit schemes involve establishing a baseline level of emissions for a sector (such as proposed plans for deforestation) or a project or company (e.g. the Clean Development Mechanism or the NSW Emissions Trading Scheme). Under this scheme no overall emissions cap is set, however actors are encouraged to reduce their emissions below this baseline (usually defined as the business as usual scenario) to generate emissions credits which can then be traded – although some base line and credit schemes have no, or limited trading. This approach is the basis for ‘White Certificate’ schemes that governments are using to encourage energy-efficiency measures such as those in Connecticut, USA (George et al., 2006), Flanders (D’haeseleer et al., 2007), the UK (DEFRA, 2007a), France (Monjon, 2006) and Italy (Pavan, 2005).

5.8 Cap and trade schemes

As a first step, the establishment of a cap and trade emissions trading scheme involves the definition of a cap on emissions in a specific area. The definition of the scope is based on several parameters including geographical coverage, temporal range and the gases covered. This is usually referred to as the scheme’s coverage.

The carbon price, or price of emissions permits in an emissions trading scheme, is shaped by the forces of demand and supply. On the supply-side, the legislator sets the desired level of pollution (the cap) ex ante – that is before the emissions occur, at the fixed amount Q*. This cap is generally made to a carbon reduction target for that sector.

Demand is driven by the polluters who must operate within the proportion of the cap that has been allocated to them. As each unit of pollution from their business must be offset by an equivalent emissions right, as soon as they exceed the amount they have initially been allocated, they have to enter the market to buy emissions permits thus creating demand for permits.

Demand for allowances will depend on the severity of the cap but also on the level of actual emissions from involved agents. If the reduction target is small, demand for emissions rights will be weak. Similarly, if the involved agents (states or companies) are able to significantly reduce their emissions, to perhaps within their cap, then demand for permits on the ETS will also be week and prices will remain low to moderate. This can occur either due to the employment of mitigation technologies, such improving energy efficiency, or due to a fall in demand for the firms actual output (as in the case of the economic recession of the former communist bloc countries following the collapse of communism and transition towards market economies in the 1990s and early 2000s).

The monitoring and reporting of emissions is the next critical element. The precise achievement of the environmental target is known only after the calculation of actual emissions at the end of the commitment period. Therefore, the definition of clear rules and standardized methods for calculating emissions are a prerequisite for the credibility of any emissions trading system.

Emissions are fungible, therefore it is important that these measurement methods are reliable and consistent so that a tonne of carbon dioxide means the same thing between different agents, potentially across different sectors and from different countries. For example, in the United States, industry is required to use continuous measurement equipment to monitor flu gasses to account for CO2 to a high degree of accuracy.

Reliable registries are also needed to ensure that emissions and corresponding emissions rights (allowances) can be traced. Registries ensure the booking of transactions of emissions rights. They are similar to a general ledger where all accounting transactions are posted.

In existing schemes, such transfers of ownership take place in real time. This means that registries do not account for future transactions (futures or forward), only spot transactions can be registered. Registries only provide an inventory of traded quantities; therefore they do not contain any information on agreed prices. Their function is to ensure traceability of the allowances and thereby guarantee the environmental integrity of the system. At the end of the accounting period reconciliation between actual emissions and emissions rights held by the participants is performed using the data booked in the registry.

Finally, in order to ensure environmental integrity of the system regarding the cap, the regulator must set sanctions to penalize agents who can not offset their emissions by an equivalent number of allowances. A system of fines encourages polluting entities not to emit more than the number of allowances they hold. For instance, under the first emission trading scheme, the US sulphur dioxide market, the government established a penalty scheme in case of shortage of allowances: if a company did not have enough allowances to cover its emissions at the annual reconciliation, it was liable to pay a fine of $2,000 per uncovered tonne.

However, fines alone are not always enough to ensure environmental integrity. Take for example the case where there is a substantial over demand for permits due to an unusually cold and long winter which meant more energy was used to heat homes, than the regulators might have expected when they set the cap. The price of emissions permits in these circumstances may rise so high that the polluter may choose to pay the fine, rather than attempt to buy emissions permits.

To avoid this pitfall, governments may institute that the payment of a penalty not release the agent from the obligation to reduce emissions. Therefore the entity in default must also redeem the rights missing during periods of subsequent compliance. This approach was chosen under the EU Emission Trading Scheme.

Next Page – Ch 5: Setting the Cap and Commitment Period

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