Saturday, June 21, 2008

Why carbon trading may not be the way ahead?

The last couple of years have seen a proliferation of projects in India seeking to access the Carbon Emissions Reductions (CERs) provided under the Clean Development Mechanism (CDM) of the Kyoto Protocol. Millions of dollars worth projects have been approved by the Executive Board (EB) of the United Nations Framework for Climate Change (UNFCC), and many more are in the process of getting certified.

Into this climate of euphoria, with a large number of projects already approved and many awaiting sanction, the time may have come to instill a note of caution. The cap-and-trade system may not be the way ahead. In fact, there is a very strong possibility that it could be still-born, replaced by a universal carbon tax. The rising oil prices and its effects on the global economy, only strengthens this view.

The most prominent market-based emissions trading exchange in the world is the European Union Emissions Trading Scheme (EU ETS). The ETS was established in 2005 as part of the emissions reduction target in the Kyoto Protocol, to cap emissions from about 12,000 factories producing electricity, glass, steel, cement, pulp and paper. Under this scheme, companies buy or sell permits based on whether they overshoot or come in beneath their pollution goals.

But the ETS has been mired in problems and controversies since its inception. The NYT has this article by James Kanter that gives a dismal report card on the achievements of the ETS in the last three years.

The European Environment Agency recently reported that despite the EU ETS in operation for over two years, the emissions from factories and plants that trade pollution permits rose 0.4% in 2006 over the previous year, and 0.7% in 2007. During the three years in which they participated in the first phase of the market, carbon emissions in the iron and steel sector in Britain alone rose more than 10% while emissions in the cement industry rose more than 50%.

Some of the participating governments allocated too many trading permits to polluters when the market was created, leading to a near-market failure after the value of the permits fell by half, and called into question the validity of the system. Recent efforts by regulators to tighten the permits given to more polluting industries like electricity producers, oil companies, steel companies and airlines has been met with stiff opposition. Investors are threatening to limit their investments in these sectors and go elsewhere. Poorer countries in the union, led by Hungary, are clamoring to overturn emissions allowances that they say are too stingy and risk undermining their economic growth. If the EU ETS has to succeed, the price of carbon has to rise and the quantity of permits issued has to be reduced.

Cap-and-trade schemes face strong opposition on grounds of economic efficiency and incentive distortions, and an increasing number of influential economists have already thrown in their weight in favor of a universal carbon tax. I have already elaboarted on this ongoing debate here. On the balance, carbon tax appears to be a far superior method to reduce emissions. Unfortunately carbon taxes has not generated any debate or interest in India and other developing countries. We appear to be still caught up with cap-and-trade system and CERs.

There are important lessons to be drawn for the large numbers of projects in developing countries, which employ energy efficient/saving technologies and access CERs under the CDM, from the problems faced by the EU ETS and the debate between cap-and-trade and carbon tax. The CERs are a significant revenue stream in many of these long-life projects in solid waste, non-conventional energy power plants, and transport sectors. These projects will start looking seriously unviable if the CDM market collapses.

Since many of these projects are in the Government sector,undertaken by Urban Local Bodies (ULBs) and other government agencies, it is important that Governments exercise more stringent evaluation criteria before approving these projects. Otherwise, the same governments may end up having to bail out these failed projects.

The problems faced by the EU ETS also underlines the importance of harmonization of policies across countries for any carbon reduction scheme to succeed. Carbon reduction policies are typical examples of policies producing positive externalities. The marginal social benefits accruing to the world from individual nations following such policies is much more than the marginal private benefit accruing to the particular nation. There are strong incentives for individual nations to defect and free-ride, thereby imposing unacceptably high costs on those following these policies.

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