04 December 2009

Story of Cap and Trade: answering the critics

There's quite a web buzz around the Story of Cap and Trade, including a host of misplaced criticisms.

Here are answers to some of them.

* The problem isn´t cap and trade itself. It is a good system ruined by corporate lobby interests - but they'd ruin whatever policy you try, so best stick with this one.

There's an element of truth in this: the power of corporate lobbying is a huge problem, both in the US (where such a system is currently being debated) and in the EU. But cap and trade as a policy escalates this problem. First, the free allowances are a subsidy for dirty industry. In the EU this happens in two ways (i) because companies bank the free permits as assets, and pass on the “opportunity cost” to consumers – in the case of the EU power sector, estimated to be between 23 and 71 billion euros between 2008 and 2012; (ii) because a number of companies have a surplus of permits which they sell – in the case of ArcelorMittal (the largest steel maker in EU scheme) this has netted an estimated 2 billion euros since start of the scheme for making no reductions (they've used the competitiveness argument to secure an overallocation of around 25 per cent). These kinds of subsidies are not awarded by other climate measures such as subsidy shifts from fossil fuels or taxes.

Second, carbon markets are far more complex and interlinked than regulations based on emissions limits. This means there are more loopholes for the lobbyists to exploit. The “trade” part of cap and trade encourages capital to go after the cheapeast abatements, and the cheapest tend to be those that have been achieved by over-allocation (and offset purchases) rather than any actual reductions.

Third, the ability to trade allowances amplifies the effects of lobby influence. If you have a regulation on factory emissions, and one factory (or even sector) is allowed to pollute too much, you have a problem with that factory (or industrial sector). Under cap and trade, the problem is amplified since this surplus can be sold on to allow other sectors to carry on business-as-usual as well. The same argument could be made as regards banking of permits – namely, that carbon trading is a system that locks in “hot air.”

*Trading doesn't affect the cap, and setting a cap is itself progress. So cap and trade is progress, right?

Actually, trading does affect the cap. Trading is supposed to be about finding the cheapest places to make "reductions." Here in Europe, where we've had cap and trade since 2005, the reductions that are cheapest are the result of over-allocation and offset purchases. Look at the EU's own data on transfers of pollution permits and you'll see that played out.

Lobbying made these holes; cap and trade amplifies their effects. Allocations are routinely applied according to "competitiveness" criteria, which result in massive over-allocations in most industrial sectors (especially cement and steel) which then provide a cheap source of purchasable permits for others (mostly the power sector). But what is purchased are reductions in name only. The interactions of this actual trading system (as opposed to the fiction of a market without distortion) work to spread loopholes in the regulation of certain sectors across all sectors covered by the scheme. This undermines the "cap."

Trading also pushes capital after the cheapest cuts first. But what is cheapest in the short term is not environmentally effective or socially just in the long term. In the real world, stopping coal power is not the same as planting trees or destroying refrigerant gases - yet creating a commodity called "carbon" requires that they be treated in this way. It requires that you create single commensurable emissions reduction units out of incommensurable things.

A further argument is sometimes made that, even after all this, that "the cap is the cap" and so remains fundamentally unaltered. This argument only works if emissions reductions are assumed to be all the same, wherever they take place. That's true in a scientific sense - greenhouse gases mix uniformly in the atmosphere - but is not much help in assessing how industry or power production develops and changes. Cap and trade theoretically encourages all the cheap reductions to be made up front, assuming a gently declining emissions pathway.

But what are these cheap changes actually? They often involve simple retrofits that prolong the life of dirty factories, or workarounds like co-firing coal power stations with biomass. (In practice, the cheap changes are also often a result of the holes from over-high caps and offsets). Such extensions, in turn, delay the kind of infrastructure investments that are needed to really shift to a cleaner economy. So the gently declining emission path way turns out to be a poor reflection of a complex world in which technical changes often require rapid breaks or changes of tack. If you arrange things "cheapest" first, even assuming no holes or cheating, you can end up stuck with patched up technology or marginally-more-but-still-very-inefficient factories that you still need to replace. So what is short-term cheap (according to cost benefit modelling) can end up costing you more. In social science terminology, this is a problem of "lock in" or "path dependency."

* Not all carbon offsets are the same - the film just picks the worst cases and extrapolates from those

The Clean Development Mechanism (CDM) is by far the largest offset scheme globally, and some of the “worst” projects featured in the many critical case studies of it are the most numerous types. As of September 2009, three-quarters of the offset credits issued were manufactured by large firms making minor technical adjustments at a few industrial installations to eliminate HFCs (refrigerant gases) and N2O (a by-product of synthetic fibre production). This picture is unlikely to change dramatically by the time the Kyoto Protocol’s first commitment period expires. By the end of 2012, HFC and N2O credits are still expected to account for the largest share of the CDM (28.5 per cent and 14.4 per cent respectively), followed by hydro-electricity projects (10.8 per cent). By comparison, solar power is expected to account for just 0.03 per cent of CDM credits by 2012.

As Michael Wara of Stanford University puts it, “the CDM market is not a subsidy implemented by means of a market mechanism by which CO2 reductions that would have taken place in the developed world take place in the developing world. Rather, most CDM funds are paying for the substitution of CO2 reductions in the developed world for emissions reductions in the developing world of industrial gases and methane.”

More fundamentally, though, offsets are not in and of themselves reductions. An offset is a compensation mechanism – a way to move the obligation to reduce from one location to another, usually from the global North to the South. This raises serious global equity issues. Any kind of crediting from deforestation (REDD in the UN jargon) would massively exacerbate this.

There's far more to say about offsetting than this – see chapter 4 of our recent book.

Moreover, proposals aimed at linking cap and trade markets – a generally stated intention - would help to circumvent even “fairly stringent measures for policing offsets.” Proposals for a global carbon market mean what is called, in part of the Copenhagen negotiating text, “full fungibility” - the ability to exchange different emisisons reduction units without limit.

If schemes with different rules are allowed to share permits without constraint, carbon traders will tend to reach for the lowest common denominator. So, for example, if the US were to set a limit on certain types of agriculture permit because of measurement difficulties but Australia allowed them, US companies could look to purchase Australian carbon. The net effect would be to displace domestic reductions in the EU.

This is also a problem that the US scheme poses for the rest of the world. It is pretty universally acknowledged, I think, that the US scheme would – like virtually all cap and trade schemes before it – be over-allocated at the outset.

Overallocation means far more permits in circulation than the actual level of pollution (ie. the caps are not “capping” anything). Full fungibility exacerbates this problem, since it allows the surplus of permits in one location to be sold on and undermine the “cap” in another location. In other words, it is a recipe for the circulation of “hot air.”

* The film indulges in populist scaremongering about markets - and, as a whole, it is too simplistic.

Carbon markets now are miniscule compared to Wall Street projections of $2 trillion or more by 2020, so it is true that some of the evidence isn't yet in. But we need to look at what financial products are being created, learn from analagous experiences, and make plausible future projections. On the first of these points, it is clear that a whole line up of new carbon derivatives are being created – on the risks of these, see Larry Lohmann´s writing.

Steve Suppan of IATP also makes an important point about the potential impact on food commodities: “index funds controlled about a third of all corn futures contracts from 2006–2008", but now, carbon derivatives are expected to be "bundled into commodity index funds. Depending on how traders formulate the mix of commodities in the fund formula, it is likely that carbon emissions could become the dominant 'commodity' in some fund formulas, displacing oil. ... Wall Street forecasts at least a $2 trillion market in carbon derivatives within five years. The current estimated value of all agricultural and non-agricultural commodity derivatives traded under Commodity Futures Trading Commission authority is $4–5 trillion. ... Agricultural commodity prices, and to a lesser extent global food security, could be vulnerable to a swing in carbon derivatives prices, as carbon dominant index funds roll over to take profits."

These are complex and technical arguments, and to accuse an introductory film of being simplistic seems rather mean-spirited.

* The argument that cap and trade is a "distraction" has no proof to back it up

Again, it may be possible to take issue with how this complex point is simplified – but there certainly is evidence.

First, emissions trading is a distraction because it can undermine other regulations.

When the EU was discussing a renewable energy target, the UK argued that this should be weaker because a strong target would undermine carbon prices, as this leaked document shows.

The intersection between the Integrated Pollution Prevention and Control (IPPC) Directive, the main EU legislation to control air pollution, and the EU ETS is another case of this. The IPPC sets energy efficiency requirements and gas concentration limits on a range of installations, some of which were also covered by the EU ETS. To make the two systems compatible, the terms of the IPPC were relaxed - as the European Environment Agency reported: “[O]perators of large sources might be obliged to reduce their emissions (in order to comply with the IPPC Directive) when it could be more economically efficient to increase emissions further and buy additional allowances instead.” The result of this conflict was that the IPPC Directive was amended to exclude “CO2 emission limits for installations which are covered by the EU ETS.”

An analagous problem exists with offsets: to generate offsets, there's a need to show “additionality” (that a project wouldn't have happened anyway). If a country tightens environmental regulations, it cuts off this additionality. Governments tend not to see this as in the economic interests of companies based in their territory (and in the case of China, where there's a hefty tax on HFC project credits, such regulations would also put a dent in the state coffers).

In the debate on the expansion of Heathrow airport in the UK, meanwhile, one of the most common defences from the government was that it didn't matter if emissions increased from the airport because “ETS would cover it.”

The second form of distraction has to do with “locking in” pollution (related to what social scientists call path dependency). In chasing after the cheapest short-term cuts, cap and trade tends to encourage quick fixes to patch up outmoded power stations and factories – delaying more fundamental changes. Our book, cited above, goes into more detail on this – as does a recent Friends of the Earth UK report.

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