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 The clock is ticking. With all the odds against us, we've got to stay a step ahead of assured destruction.
This is the storyline of Tom Cruise's high-tech espionage blockbuster, “Mission Impossible.” Unfortunately, it is also the story of climate change, an even fiercer foe to defeat than government assassins. And in the absence of a hero suspended from roof cables, the world is looking for solutions.
Among the many tactics designed to help the world avoid catastrophe are climate-change financing strategies. By tapping into the efficient world of free-market distribution these financing strategies promise a skeptical world that significant greenhouse-gas (GHG) emission reductions are possible, without breaking the bank. One of the most promising is emissions trading, also known as cap and trade.
President Obama has all but promised Americans a cap-and-trade system. In response, one can almost hear the nation collectively asking, "Cap and who?" In order to understand how emissions trading works and whether it can be successful in the US, we can turn to the European Union, which started a cap-and-trade program over four years ago. While far from perfect, it is one of only a few time-tested programs of its kind from which to learn.
The EU System
The European Union Greenhouse Gas Emission Trading Scheme (EU ETS) began the world's first international trading system for CO2 emissions in January 2005. The aim of the EU ETS is to help EU Member States achieve compliance with their commitments under the Kyoto Protocol by meeting environmental targets at the lowest cost. It covers half of Europe's CO2 emissions, including 27 countries and 10,000 companies, ranging from combustion plants and oil refineries to factories making cement, glass, lime, brick, ceramics, pulp and paper.
Simply put, the EU ETS allows participating companies to buy and sell emission allowances. It's a hybrid program—half regulation, half market incentives. It first sets a cap on the level of greenhouse-gas (GHG) emissions deemed acceptable, then distributes that amount of emission permits to firms and allows them to trade among themselves for emission rights. Perhaps a real-world scenario will help. The following example is adapted and abbreviated from one the EU ETS provides on its website.
A company emits 100,000 tons of CO2 per year. The government gives all the companies within the cap-and-trade program 95,000 emission allowances. Each allowance represents the right to emit one ton of CO2, which means the company isn't fully covered for its emissions. At the end of each year, the company has to surrender the number of allowances corresponding to their emissions during the year, or face a fine of $70 per missing allowance.
The company does not want to pay the fine to cover 5,000 tons of CO2. It can either reduce emissions by 5,000 tons or purchase 5,000 allowances in the market. In order to decide which option to pursue, it will compare the costs of reducing emissions by 5,000 tons with the market price for allowances. If reducing its emissions is cheaper, the company can even choose to reduce its emissions below 95,000 tons and offset the cost of those reductions by selling their surplus allowances. If it's cheaper to buy allowances from another company that placed surplus allowances on the market, they can simply buy 5,000 allowances.
This flexibility allows emission reductions to come at a lower price as companies will seek out the cheapest reductions possible. The overall cost to industry and the economy would have been higher if either company had been forced to reduce emissions at its own plant at a higher cost.
Environmentalism 2.0
Clearly, this isn’t your grandmother’s environmentalism. In fact, it is important to understand that market-based programs like this signal a significant modern shift in ecological policymaking. Perhaps tired after decades of fighting with the private sector about the high cost of pure regulation, some environmentalists got savvy, learned about economics and introduced something of an “Environmentalism 2.0.”
The outcome was the realization that the consumption and destruction of natural resources (clean air, water, forests, etc.) has real costs that were not being adequately priced in the market. Without the inclusion of these resources in the modern economic model—beyond merely marginal or unquantifiable externalities, but as commodities of real value—companies would have little motivation to curtail their environmental impact.
Emissions trading attempts to place an appropriate price on the costs of excessive GHG emissions produced by human activities. Like any other resource in the free market, it lets the market decide.Today, the EU ETS remains the largest multi-country, multi-sector GHG emission-trading scheme worldwide. In the four years since inception, it has been closely monitored to understand how well it's working, and what lessons can be learned.
Initial Results
First the good news. In February 2009, prominent research firm New Carbon Finance showed that, despite serious criticisms, the European emissions dropped by roughly three percent in 2008. The drop was attributed to the trading system because it had encouraged greater use of natural gas in power generation rather than coal. New Carbon Finance said, “The existence of a carbon price in 2009 indicates that banking of allowances is taking place and the design of the scheme is working as originally intended by the European Union.”
However, common critiques include costliness, imperfect design and instability. In practice, many companies have complained of significant unintended economic costs and bureaucratic morass. In its own defense, the EU asserts that "if the Emissions Trading Scheme had not been adopted, other—more costly—measures would have had to be implemented."
Several key criticisms are based on the large surplus of emission credits that existed in 2006, accompanying a carbon price collapse. This signaled a possible miscalculation in the appropriate level of credits distributed. In 2009, the price of a ton of CO2 fell to record lows again. Although it is unlikely the price will collapse completely, the sharp ups and downs are a troubling reminder that market-based systems to reduce emissions are subject to significant volatility.
Though the system appears to be achieving some success, questions remain such as how emission permits should be distributed, and if the system should cover airlines and automobiles.
Cap and Trade in the US
The cap-and-trade system was actually modeled on the US's acid-rain program included in the 1990 Clean Air Act amendments. That program reduced sulfer-dioxide (SO2) emissions at a fraction of anticipated costs and produced health benefits exceeding program costs by more than 40 to 1. While the US government has yet to implement a national CO2 cap-and-trade system, several states have teamed up regionally to set forth limited emission-trading programs. The Regional Greenhouse Gas Initiative (RGGI) is the first mandatory, market-based CO2 emission-reduction program in the US. It represents a non-profit cooperative effort between ten northeastern and mid-atlantic states, which requires only electric power generators to hold allowances covering their emissions of CO2 and uses the proceeds of allowance auctions to support low-carbon-intensity projects like wind power. More recently, five western states developed a similar system called the Western Regional Climate Action Initiative.
In March 2009, the Europeans collectively began advising US officials on climate change amid talk of a cap-and-trade program by President Obama. Some legislators who attended the meetings noted that Europe had made some critical mistakes, such as miscalculating how many carbon allowances to distribute, as well as failing to meet its Kyoto targets. Rep. Steve Scalise (R-LA)—a member of the House Energy and Environment subcommittee—said, "We've got to be careful that we don't commit to anything that has unrealistic targets."
Despite concerns, President Obama appears willing to be quite aggressive. He is hoping the US can reach a benchmark of 83% below 2005 GHG emission levels by 2050, a goal announced in his proposed budget for fiscal year 2010 on February 26. The budget proposes to support clean energy development with a 10-year investment of $15 billion per year, generated from the sale of emission credits. In order to produce this funding, an economy-wide GHG emissions program must be passed by the federal government, which stipulates major emission-reduction milestones.
According to the Department of Energy, under the proposed cap-and-trade program, all GHG emission credits would be auctioned off, generating an estimated $78.7 billion in additional revenue in FY 2012, steadily increasing to $83 billion by FY 2019. According to the White House website, the revenue will fund vital investments in a clean energy future, and the balance of the auction revenues "will be returned to the people, especially vulnerable families, communities, and businesses to help the transition to a clean energy economy."
With this level of support, such a program appears capable of making major emission reductions possible. If implemented successfully, it would alleviate an enormous portion of the world's collective emissions due to the fact that the US is the world's largest GHG producer.
The EU ETS illustrates that such a system can be effective if done right. However, there are naysayers. One major worry is that a cap-and-trade program will cause a significant hike in electricity rates, particularly in coal-reliant states. The real test of market-based strategies like a cap-and-trade system will be whether they can be done without placing an undue burden on an already struggling economy. That remains to be seen.
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