The Case for an Emissions-Trading System to Help Resolve the Climate Change Crisis

Abstract

To deal adequately with the climate change crisis, an emissions-regulating system is required to help resolve the following policy goals: (i) ecological sustainability—which requires, among other things, stabilising the atmospheric concentration of greenhouse gases at no more than 450 ppm of CO₂-e; (ii) distributional equity—which involves efforts to narrow the income gap between rich and poor and to ensure the needy have access to basic necessities; and (iii) allocative efficiency—which requires a price to be assigned to greenhouse gas emissions to induce a shift away from fossil fuels; maximise the use value generated from the emission of greenhouse gases; and encourage the development and use of greenhouse gas-abatement technologies. The system must also be designed to resolve these policy goals in the above order. It is argued in this chapter that these requirements can only be satisfied by implementing an emissions-trading system. There are, however, many observers who believe that an emissions-trading system is inferior to an emissions tax. The preference for an emissions tax is based on a number of assertions. Following a brief outline of the key features of an effective emissions-trading system, this chapter repudiates these assertions and explains the many advantages that emissions-trading systems have over emissions taxes. Because of market imperfections and non-market barriers, assigning a price to greenhouse gas emissions via an emissions-trading system does not guarantee the realisation of all economically viable abatement potential. In response, this chapter concludes with complementary forms of government intervention to help a nation cost-effectively achieve its emissions targets.

Notes

• 1. Since an emissions-trading system is effectively a specifically designed cap-auction-trade system, many of its basic features are similar to those outlined in relation to cap-auction-trade systems in Chap. 3.

• 2. Eligibility would be restricted to individuals and organisations that have not been barred from participating in public auctions or in possession of the maximum allowable number of permits.

• 3. There are many observers who believe there should be no time restriction on the use of emissions permits (e.g., Garnaut 2008). The basis for this is twofold: (i) the hoarding of permits does not breach emissions budgets; and (ii) it reduces the cost of achieving emissions targets (i.e., increases the efficiency of an emissions-trading system) by allowing permit holders to hoard or bank permits and use them when they have their greatest value. It is certainly true that having longer life permits increases the flexibility and efficiency of an emissions-trading system. However, as stipulated at the beginning of the chapter and earlier in the book, an emissions-trading system needs to be based on the principles of ecological sustainability, distributional equity, and allocative efficiency. As we shall see, allowing permit holders to hoard their permits promotes speculative behaviour, which, in turn, allows windfall profits or economic rents to be earned. This is not only inequitable, but price-distorting—the latter of which can dramatically reduce economic efficiency. Even allowing for a small net improvement in efficiency by issuing long-life permits, such a small efficiency gain is worth sacrificing in order to ensure distributional equity.

• 4. The free issuance of permits can act as a market-entry barrier for new firms.

• 5. The point of obligation defines the party liable for surrendering emissions permits under an emissions-trading scheme (Garnaut 2008). The point of obligation may exist anywhere in the supply chain of a final good or service—from the extraction of the resources used to produce the goods that eventually lead to the release of greenhouse gases; to production processes that directly generate greenhouse gas emissions; and to the consumption of emissions-related final goods. The point of obligation is best imposed at the stage in the supply chain where monitoring and reporting of emissions is easiest and most accurately and cost-effectively achieved.

• 6. Other examples would include: (i) the owners of coal-powered electricity-generators having to purchase emissions permits rather than electricity-users; (ii) farmers clearing land to grow crops having to purchase permits rather than the consumers of agricultural products; and (iii) fertiliser-producing companies having to purchase permits rather than farmers. Of course, the buyers of emissions permits would be free to pass on some of the cost of having to purchase permits to the consumers of the relevant products. However, this should encourage end-users to purchase products made from renewable-energy sources and low emissions-intensive production methods.

• 7. Supply-side forces are constrained by the emissions cap set by the central-government authority.

• 8. It may well be that a nation’s anti-trust legislation could already deal successfully with this requirement. For example, in Australia, the Competition and Consumer Act enables the Australian Competition and Consumer Commission (ACCC) to prohibit any action it construes would ‘significantly reduce competition’. There are various sections of the Act that would allow the ACCC to limit the ownership of greenhouse gas-emissions permits.

• 9. Although some people would claim that the failure to grant additional permits would deter individuals and entities from taking action to prevent the release of greenhouse gases, it should be remembered that appropriate sustainable development policies would already be preventing a decline in natural capital that, in turn, would be reducing the release of greenhouse gases.

• 10. Presumably, most if not all the greenhouse gas-emitting activities would be undertaken by the entity that has invested to preserve the forest.

• 11. Further emissions reductions would be required if the ecosphere’s diminished sequestration capacity exceeded the reduction in allowable greenhouse gas emissions arising from the confiscation of the transgressor’s permits.

• 12. This would depend, again, on the ease with which the source of greenhouse gas emissions can be monitored.

• 13. This assumes that the three firms operate in a perfectly competitive market.

• 14. High quality goods generally command higher market prices than similar goods of lesser quality.

• 15. Similar to Chap. 6, the Marginal Damage curve in Fig. 7.1 includes both direct damage costs plus adaptation costs.

• 16. The reason for this is that if the marginal profit of a particular emissions level is positive, an increase in emissions boosts profits. A profit-maximising firm would therefore increase its emissions. Assuming a downward sloping marginal benefit (mb) curve, the increase in profits is exhausted once marginal profit equals zero. At this point, profit is maximised. Any further increase in emissions reduces a firm’s profit.

• 17. This is just a different perspective of the welfare-maximising outcome illustrated in Fig. 5.1. I should also add that the welfare-maximising outcome depicted in Fig. 7.1 assumes that the social benefits from emitting greenhouse gases are confined to the private consumption benefits generated from consuming the goods and services produced from greenhouse gas-emitting activities. In other words, it is assumed that there are no spillover benefits from the greenhouse gas-emitting activities.

• 18. By non-tradeable, I mean that a firm is prohibited from trading part or all of its emissions quota with another firm, organisation, or individual.

• 19. To reflect this, the Marginal Damage curve is a dotted instead of being an unbroken line.

• 20. It is because of this that ABC Ltd’s marginal profit exceeds the emissions tax rate over a much larger output level than JKL Ltd and XYZ Ltd. Thus, ABC Ltd can afford to emit more greenhouse gases than the other greenhouse gas-emitting firms.

• 21. This assumes that one emissions permit equates to one tonne of greenhouse gas emissions.

• 22. In this analysis, it has been assumed that the marginal benefits (marginal profits) of each firm are different and that the marginal abatement costs of each firm are the same. In some analyses, it is assumed that the marginal benefits of each firm are identical and that it is the marginal abatement costs of each firm that differ. In this alternative situation, the firms with the lowest abatement costs purchase fewer permits and undertake considerably high levels of emissions abatement. Conversely, the firms with high abatement costs find it cheaper to undertake minimal abatement and purchase a large quantity of emissions permits. A good textbook example of this latter type of analysis can be found in Pearce and Turner (1990).

• 23. This assumes that the number of permits initially auctioned by the government is limited to the welfare-maximising level.

• 24. This also important given that permit prices can automatically adjust to take account of price inflation. The impact of an emissions-tax is eroded by inflation.

• 25. The rises in total CO₂ emissions for the other three countries were: (i) Denmark (2.6 per cent, 1990–2002); (ii) The Netherlands (13.1 per cent, 1990–2002); and (iii) Finland (9.6 per cent, 1990–2002) (Lawn 2006a).

• 26. Referring back to Fig. 7.5 does not imply recourse to the mainstream economic framework. Regardless of what a firm’s economic motives are, if market conditions change but the emissions tax rate does not, the firm will almost certainly vary its emissions levels.

• 27. If permits have a short lifespan, it will also be necessary for the government to reduce the number of permits it sells in subsequent auctions.

• 28. This, for example, could take the form of evidence showing that the ecosphere’s greenhouse gas-absorbing capacity has been overestimated; that greater-than-expected deforestation has reduced the rate of carbon sequestration; or that positive feedback processes (e.g., the ‘ice-albedo feedback’) are accelerating.

• 29. As we shall see in Chap. 10, the extent and the speed of emissions cuts in the world’s high-GDP countries are likely to be greater than what is applied to the rest of the world.

• 30. The real greenhouse gas price takes account of the general rate of price inflation (i.e., the real GHG price = nominal GHG price ÷ general price level).

• 31. This also means that permit prices will be above the conventional ‘efficient’ level (i.e., where MB = MD).

• 32. Although these are hypothetical short-term price fluctuations, they would not be dissimilar to the short-term price variations being generated by the emissions-trading systems currently operating around the world.

• 33. It is worth noting that economic modelling exercises consistently lead to the conclusion that the social cost of greenhouse gas emissions—of which the price of emissions permits should reflect—is likely to increase for many decades (Watkiss et al. 2005). See also OECD (2008, Fig. 6).

• 34. The eventual decline in the price of permits (social cost of carbon) goes very much against popular opinion. Garnaut (2008), for example, believes the price of permits should continue to increase at the market rate of interest, much like the Hotelling (1931) model predicts in relation to the price of a non-renewable resource. Garnaut considers there to be a parallel between the two markets because, although greenhouse gas emissions do not resemble a non-renewable or exhaustible resource, the remaining allowable emissions budget does. Assuming that the Hotelling model is an applicable one, it should be remembered that an upward-trending price for a non-renewable resource is based on a number of parameters remaining constant, such as the demand for the resource, the marginal cost of extraction, and the choke price for the resource (i.e., the price at which would-be users of the resource switch to a cheaper substitute).

  In the case of greenhouse gas-emissions permits, the equivalent parameters would be the demand for permits, the cost of low-carbon technologies, and the permit price that would choke off demand for high-carbon technologies. It is not unreasonable to expect the demand for permits to decline as firms shift to low-carbon technologies and for the cost of employing low-carbon technologies to eventually fall because of technological progress and economies-of-scale effects (i.e., as the deployment of low-carbon technologies increases). In addition, we would expect the falling cost of low-carbon technologies to lower the choke price of emissions permits. Should these changes occur, the Hotelling model suggests that these forces would exert downward pressure on the price of emissions permits. Since these forces would eventually be significant in magnitude and on-going, it is highly likely that they would over-ride any price-increasing influence of market interest rates, thus resulting in a declining permit price.

• 35. In almost all instances, firms will not be able to pass the entire cost of purchasing emissions permits onto the next stage of the supply chain. The reason for this is that the market demand and supply curves for a particular product will invariably be downward-sloping and upward-sloping respectively. Because of this, firms will be forced to bear some of the cost of purchasing emissions permits and therefore some of the increased cost of supplying goods and services. Consumers will be required to bear the remainder. In all, the price of final goods and services will almost certainly rise by something less than the increase in the cost of producing goods and services caused by greenhouse gas-emitting firms having to purchase emissions permits.

• 36. The Clean Development Mechanism is an offset arrangement under the Kyoto Protocol that allows greenhouse-gas emitters in the world’s high-GDP (Annex I) countries to invest of projects that reduce greenhouse gas emissions in low-GDP nations. The Clean Development Mechanism exists as a means by which greenhouse-gas emitters in high-GDP nations can avoid more expensive emissions reductions in their own countries. Although the Clean Development Mechanism operates under the auspices of the United Nations Framework Convention on Climate Change (UNFCCC), there are concerns that spurious emissions credits have been granted due to inaccurate estimates of reduced greenhouse gas reductions (overstated baselines); inadequate monitoring of offset projects; and an incentive for firms located in low-GDP countries to initiate high-emissions operations in order to be paid to stop polluting (Rosenthal and Lehren 2012). I’ll have more to say about the Clean Development Mechanism in Chaps. 8 and 9.

• 37. In the case of the Clean Development Mechanism, which currently exists as an international offset arrangement, it is critical that the Mechanism be better designed and resourced to minimise abuse of the system.

• 38. The carbon tax in Australia was repealed in 2014.

• 39. It is an emissions trajectory that stabilises the atmospheric concentration of greenhouse gases at or below 450 ppm of CO₂-e.

• 40. As anyone who has studied first-year undergraduate economics will know, the current position of the Marginal Benefit (demand) curve for a particular good is influenced by future expectations of the price of the good. Should people believe that the price of the good will rise in the future (or is temporarily low), they will demand more of the good now and less in the future. Consequently, there will be a rightward shift of the demand curve for the good.

• 41. It is worth considering what happened to the price of emissions permits at the end of Phase I of the European Union’s Emissions Trading System (EU-ETS), where holders of unused permits could not bank the permits and use them in Phase II of the EU-ETS. The price of these permits almost fell to zero. I would not expect a similar price plunge if there was a more effective emissions-trading system in place.

• 42. For more information on each of these emissions-trading systems, see: (i) EU-ETS (Ellerman and Buchner 2007; http://ec.europa.eu/clima/policies/ets/index_en.htm); (ii) UK-ETS (Smith and Swierzbinski 2007); (iii) JVETS (Sudo 2006); and (iv) NZ-ETS (Bertram and Simon 2010).

• 43. This condition was the basis for the four sustainability precepts outlined in Chap. 2.

• 44. Given that a greenhouse-gas offset arrangement can be incorporated into an emissions-trading system and an emissions-tax system, we shall ignore the ability of offsets to allow for a higher ‘safe’ rate of greenhouse gas emissions.

• 45. This again assumes that one permit equates to one tonne of greenhouse gas emissions.

• 46. Because permit prices would be determined by the intersection of the MD_ETS and MB_True curves, the lack of knowledge about the exact whereabouts of the upward-sloping Marginal Damage (MD) curve is irrelevant. It is only relevant if the aim is to achieve an efficient outcome, which is itself irrelevant if, firstly, the efficient rate of greenhouse gas emissions is greater than the safe rate, and secondly, achieving a safe rate is the primary objective of the central-government authority.

• 47. This assumes that the penalties for emitting greenhouse gases without an emissions permit are severe enough to deter illegal emissions-related activities.

• 48. In Fig. 7.11, the higher demand for emissions permits would be represented by a further rotation of the mb _True and MB_True curves.

• 49. As explained in endnote 8 in Chap. 3, taxes do not technically generate the spending power that currency-issuing central governments require to spend. See Mitchell and Muysken (2008).

• 50. No market operates perfectly. Hence, permit prices would closely approximate rather than precisely reflect the demand and constrained supply-side forces in the permit market.

• 51. In essence, carbon leakage occurs when reductions in greenhouse gas emissions are negated by increases in emissions caused by the relocation of emissions-intensive forms of production to other parts of the world.

• 52. As Stern (2009) stresses, as much as markets are the most effective efficiency-promoting mechanisms, they rarely function to their full potential without some form of government assistance.

• 53. The importance of this is exemplified by the fact that public and private spending on research and development into new and more efficient forms of energy has been declining globally (IEA 2007; Stern 2007, 2009).

• 54. Of course, the inflow of natural resources should never be greater than the maximum sustainable rate.