Can we save the carbon markets?

Written by Chris Huhne and published in Financial News on Thu 14th Jun 2007

For most business people beginning to put climate change on the corporate agenda, a key issue is whether there is going to be a strong, consistent and positive carbon price. If carbon emissions become a business cost that hits the bottom line, then carbon-saving technologies will be huge. There is, though a rising swell of criticism among environmentalists about whether the carbon markets can or will deliver. The World Wildlife Fund's report this week is one of many.

WWF is a reputable charity among the non-governmental organisations in the climate change field, but it has taken a good swipe at the workings of the markets. Unfortunately, its criticisms will feed a more general suspicion of markets as a solution to global warming. Neither the Kyoto market mechanisms nor the European Union's emissions trading scheme (ETS) are perfect, but they are the only show in town.

The EU ETS covers nearly half of the carbon emissions in the 27-member bloc, mainly from big emitters like power plants and steelworks. The first phase was such a flop that the price of carbon for permits to pollute this week was just 25 eurocents a tonne. Far too many EU member states adopted relaxed national allocations plans: too many permits meant a low price. Economists will recognise a classic problem from game theory. Every member state has an interest in everyone else behaving while emitting as much as it wants itself. But free-riders ultimately destroy the discipline they want others to observe.

The second phase is looking much better. It happens to cover the key 2008-2012 period in which Kyoto protocol signatories are meant to hit their own international targets, and the EU Commission has been tougher with member states. As a result, the carbon price per tonne this week for 2008 permits was €23.

How do we know roughly what the price ought to be if it is to deliver change? One recent estimate by Vattenfall, the energy company, looked at the costs of each of the competing abatement technologies up to the marginal one that could deliver a near half cut in carbon emissions compared with business as usual by 2050.

A surprising amount of what is necessary has a positive rate of return in financial terms (such as insulation and energy efficiency). To bring on the more expensive solutions - at the margin, the avoidance of deforestation in Asia - is estimated to cost about €40 per tonne.

This provides a useful guide to the sort of price that should emerge from an effective cap and trade scheme like the ETS, and fortunately it is well below most of the estimates of the damage that unmitigated carbon emissions would do. For example, Sir Nick Stern's work suggested a social cost of carbon of some $85 per tonne and a UK government working paper suggested a range of £35 to £140 per tonne). Ministers should be worried if the ETS price is not somewhere in the Vattenfall range.

But will it get there? The World Wildlife Fund report raises the possibility that the Kyoto Clean Development Mechanism (CDM) could inadvertently undermine the EU emissions trading scheme. Investors in carbon-reducing projects in the developing world can earn Certificates of Emission Reduction which are accepted as a credit towards obligations to limit emissions under the ETS. In theory, therefore, big EU emitters could buy lots of CERs without cutting their own emissions.

WWF has assessed nine of the EU national plans - including the big ones like Germany, France and the UK- and calculates that between 88 per cent and all of the emissions reductions that they are planning for the second phase of the EU ETS could be met not by buying in credits for reductions undertaken in the developing world.

In practice there are many other industries also investing in CDM from Japan and other non-EU Kyoto signatories. So it is hard to imagine that the flow would be adequate to meet EU carbon cuts. Certainly, CDM and similar JI credits are cheaper to deliver than EU ETS permits at the current price, but there is also a much greater risk that the project will fail and will not be certified. Some of the pioneers in the market - such as Climate Change Capital - argue that the CDM and JI credits allow the EU to be tougher than it would otherwise be.

Another line of criticism was exemplified by a Guardian report on 2nd June that many of the CDM projects failed to deliver genuinely additional cuts in carbon. The CDM had, it said, been "contaminated by gross incompetence, rule-breaking and possible fraud by companies in the developing world". It cited UN paperwork, an unpublished expert report, and one senior assessment that as much as a fifth of projects might be problematic.

Essentially, the CDM is a giant offset scheme: you pay for someone else to be virtuous so you can emit more yourself. As the satirical website www.cheatneutral.com highlights, the idea of paying someone else to be faithful so you can cheat on your partner is never likely to catch on. Such offsets are essentially a transition mechanism to a world where we are all going to have to be much tougher about emissions.

But it would be a great mistake to throw the baby out with the bathwater. Cap and trade schemes like the EU ETS were modelled on the US sulphur scheme for power stations, and they are likely to be the basis for a US bill through Congress at some point in the next two years. They have the advantage (providing there are not too many leaks) of targeting what needs to be reduced and allowing the price to fluctuate, whereas carbon taxes have to be set in advance and the outcome is uncertain. Moreover, business has an incentive to find the cheapest ways of cutting carbon from whatever source.

EU environment ministers should take more interest in the credibility of the scheme if it is to survive. Companies that try harder to act environmentally are not going to be best pleased if cheats merely bypass the rules. Public opinion increasingly wants action on climate change, but that mood will not be sustained if there are real doubts about the integrity of the policy instruments.