Thursday 4 February 2016

Saving The Planet: Why Cap-and-Trade Is Not Fit For Purpose

Guest post by Tadhg Ó Laoghaire 

"It's not easy being green"
                                                                       -Kermit the Frog

A consensus is finally shaping up among international policy-makers. Market-based emissions trading has become the modern world's primary pollution control mechanism, forming a key part of various national and international bodies' commitment to climate change mitigation. The largest such market is the European Union's Emissions Trading System, which accounts for over 90% of the world's carbon market volume, but market trading systems are also a key part of the Kyoto protocol under the Clean Development Mechanism, and looks set to be adopted in China in the near future. Unfortunately cap-and-trade emissions systems are structurally incapable of delivering us from climate change.

To understand why the emissions-trading regime has come to dominate, it is important to understand its appeal. The first step is a government's imposing of a cap on carbon emissions within a country for any given year. Permits are then created up to the level of this cap, with one permit representing 1 tonne of CO2. These permits are then allocated to businesses, which can then trade the permits amongst one another. This trading amongst permit users puts a price on pollution, incentivising businesses to reduce their carbon footprint so as to be able to sell permits to businesses which are more carbon-dependent, which in turn strive to reduce the number they must buy. Thus, the social goal of reducing carbon emissions is internalised into the profit motive. By ensuring that companies can trade permits, the emissions trading system ensures that the emissions reductions will happen at the lowest possible cost. How so?

Let's say there's a shortage of eggs in my village, and the village leader decides to allocate the reduced supply equally amongst the inhabitants. While it may seem fair if everyone in my omelette-loving village has to cut back their egg consumption to 2 per week, this will not affect everyone equally. For example, I would have to close down my pancake house, which caters for both villagers and foreign travellers passing through. A cap-and-trade mechanism would incentivize some people in the village to reduce or cut out their egg consumption entirely so as to sell their egg ration to me. Since the eggs are worth more to me than to others (being the source of my livelihood) this ensures that the total reductions already imposed are achieved at the lowest social cost.

It is easy to see why economists would be drawn to a cap-and-trade mechanism for pollution control. It has that wonderful counter-intuitive feel to it that economic reasoning so often engenders, and it is breathtakingly simple and obviously efficient. With governing agencies setting a limit to emissions per year, businesses can ensure that the most cost-effective way of meeting this limit will be found. Then, year on year, the number of permits can be lowered, ensuring that the economy's total carbon footprint is reduced. Allowing us to continue our energy-intensive consumer lifestyle as well as mitigating climate change, this economic mechanism allows us to have our cake and eat it too.

At least, that's how the story is supposed to go. The problem is that the effectiveness of the carbon markets which have been initiated so far has been…well, let's go with ‘questionable'. In the first phase of the EU's Emissions Trading System there was actually a rise in emissions, whereas in the second phase, the price of carbon credits fell to a level whereby there was little incentive for businesses to adapt their polluting activities. Oscar Reyes, of the Institute for Policy Studies, notes that for the UN Clean Development Mechanism, a combination of the financial and economic recessions linked with poor management of emissions trading "resulted in a 99% percent decline in carbon credit prices between 2008 and 2013". Perhaps ‘questionable' wasn't the right word.

Indeed, very few people today would suggest that emissions trading is fit for purpose. Still, the logic of cap-and-trade seems sound, and indeed there are many explanations for the failure of specific carbon markets which lie outside its economic logic. For example, too many permits were initially given out causing their price to plummet, exacerbated by the fact that permits were often given out free to major polluters as opposed to being auctioned off. Another issue is the creation of a carbon offsets market, which allows companies to gain and trade ‘carbon credits' for reducing expected future emissions. Granting credits based on counterfactuals naturally leads to difficulties and perverse incentives, such as buying a chunk of rainforest in order to claim a credit for not cutting it down. The offset market also allows developed countries to outsource their carbon reductions to poorer, underdeveloped areas rather than pursuing cleaner technologies.

These are all relevant points. But they don't tell the full story. The inconvenient truth is that while cap-and-trade could be designed so as to operate more efficiently, inherent in it are some problems which cannot be reduced to implementation issues. If we are serious about climate change mitigation we are going to have to rethink our policy consensus.

The problem lies in the nature of the incentives an emissions trading market introduces. It is true that businesses have an incentive to reduce their emissions, but it will not be clear how much of an incentive they have to do so. This is because we do not know how quickly or extensively prices will change as a response to fluctuating demand. Fixing the quantity of emissions within an economy will necessarily lead to such price volatility, as we cannot have both price certainty and quantity certainty in a carbon market. This should be relatively clear after a moment's thought. Given a fixed quantity of permits, the price of those permits will depend upon how many people are willing to purchase them, and how much they are willing to spend, i.e. matters outside businesses' control and foresight such as the availability of clean-energy technology and the state of the economy. In short, if supply is fixed, prices will adjust based on changing demand.

This is important, as price signals are hugely significant for businesses when making medium to long-term investment decisions. Investing in green technology and radically reducing one's carbon footprint could be one such investment, but the cap-and-trade system fails to give any clear, stable signal as to whether doing so would be a financially prudent investment. If a business must invest for example 5% of its annual profits for 10 years in making the shift to a low carbon business model, it must have good reason to believe that this money is not being wasted. This cannot be the case today, since no one can say what the cost of carbon emissions will be in 10 years time.

It may be said that the ever-reducing cap on permits will lead to a rise in the price of carbon, as this should (if correctly designed) lead to increasing scarcity. This will result in businesses bidding against one another for fewer permits each year, gradually raising the price in the market. While this is basically true, it misses the point, or rather, two points. The first is that it is not whether it will prove profitable in the long-run to operate with clean technologies that matters - the decision problem for businesses is that they cannot predict how profitable it will be, and when it will start becoming profitable.  Certainly there is some vague, long-term incentive to reduce emissions, but the price signal is not precise enough to be action-directing in the way that climate change mitigation requires. This is especially disappointing since one of the very benefits of harnessing market mechanisms to combat climate change was supposed to be converting a general but diffuse global responsibility to change our ways into specific and calibrated incentives for key actors whose choices of technologies and outputs determine the climactic effects of our personal and social lifestyles.

The other point, or perhaps another aspect of the same incentive weakness, is a variation on the free-rider problem. If I look at the state of the economy while trying to make a decision as to whether to invest in expensive clean technologies, cap-and-trade does not provide me with any incentive to invest. If I think other companies will invest in these technologies, then I can simply wait for them to develop clean technologies at great cost and effort, and then either copy them or just buy the permits made cheaper by their carbon savings. Of course, if everybody acts the same way, carbon will remain expensive, perhaps so expensive that the system would collapse. In which case I still would not be damaged relative to my competitors by refusing to reduce my carbon emissions. As a polluting business it appears that my dominant strategy whatever my competitors do is to carry on as usual. Perhaps some easily and cheaply made reductions might make sense at the margin, but not the radical investments and restructuring that policymakers are hoping for.  

This gets at the heart of the fundamental weakness of cap-and-trade. It applies to the economy as a whole, but some industries, such as electricity generation, emit orders of magnitude more carbon than others, and it is precisely these industries that are least incentivised to adapt their business practices. By explicitly targeting the low-hanging fruit first, cap-and-trade advocates suppose that once the cheapest to remove emissions have been addressed there will be a smooth and automatic progression to removing more entrenched sources of emissions such as air travel or cement production.

The difficulty with this is that the pursuit of minor, short-term reductions which have immediate pay-off may well lead the economy away from the path we need to take to achieve our long-term goal of preventing disastrous climate change. Small short-term gains may involve making adjustments to an existing technology whereas long-term solutions may demand scrapping that technology altogether. Think for a minute about the fixed capital in power plants, chemical refineries, airplane fleets, and so on with their decades long operational lives. Once built, their carbon emissions per unit of output are more or less fixed. Moreover, once they are built it would be very inefficient to build another greener version of the same plant. To succeed in preventing catastrophic climate change it is these large and irreversible investment decisions, not day to day production decisions, that policy makers must strive to influence. Yet cap-and-trade protects high polluters from the need to make radical reforms to their business models by allowing them to purchase permits from businesses that do not pose as grave a climate risk. Thus, cap-and-trade is locking in precisely those industrial technologies and business practices which most need to be changed. The high-hanging fruit will actually become harder to reach.

The question then is what can be done about any of this. We do not have to renounce market mechanisms as a key tool in climate change mitigation. Businesses can and should be incentivised to reduce their carbon footprint. A price on carbon is still necessary – we just need a better of imposing one than that indirectly produced by cap-and-trade. A carbon tax is in some senses the mirror image of cap-and-trade, as it fixes the price of carbon emissions as opposed to theirquantity, thereby addressing the problems I identified. While we cannot guarantee precisely how much carbon would be emitted each year at any particular level of carbon tax, there would be a clear price signal by which businesses can forecast the financial costs and benefits of investing in low carbon technologies and business practices. If a straightforward carbon tax is politically infeasible, a hybrid policy which fixed a minimum price floor for carbon permits would at least be an improvement, by mitigating the uncertainty involved and perhaps the free-rider problem.

Of course, this analysis does not preclude the very real possibility that putting a price on carbon, by whatever means, will not be enough to keep climate change under control. We would be remiss not to use the other, more interventionist tools at our disposal, such as government regulations, punitive trade rules for free-riding countries, and technology development subsidies. We should not be surprised if we truly do face a choice between having our cake and eating it, between consuming our world and living in it.

Tadhg Ó Laoghaire is a graduate student in Philosophy, Politics and Economics at Leiden University. He can be contacted at