2.5

EMISSIONS MARKETS

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Purpose

Government initiatives to reduce the risk of global climate change have had a profound impact on the energy market. This chapter introduces the emissions trading markets that governments are using to achieve their environmental goals.


Summary

Motivated by signs of global climate change, countries have begun taking steps to reduce global levels of carbon dioxide, sulfur dioxide, and nitrogen dioxide emissions. The two most popular ways to limit pollution are through taxes and cap and trade systems. Of the two, only the cap and trade system is a trading market.

A cap and trade system sets a limit on the amount of a substance that can be produced. Everyone producing that substance is required to have a license for their production. This has the advantage of ensuring a cap on pollution levels. When licenses are freely tradable, anyone with an ability to shift to a less polluting technology can do so and make a profit by selling their licenses. By reducing the amount of licenses over time, a free market encourages the most economical changes be made first. The two main problems facing cap and trade systems are how to distribute licenses and how to enforce compliance.

The emissions markets are closely linked to the use of coal to generate electricity. Although it produces more pollution, coal historically was able to produce electricity for a fraction of the cost of any alternative fuel. However, the increased popularity of natural gas fracking has substantially lowered the cost of natural gas. This has allowed natural gas generation to displace many coal generators and has largely achieved the goals of carbon legislation without legislation being passed.


Key Topics

•   Attempts to reduce pollution, particularly nontoxic greenhouse gases, are controversial because they increase the energy prices.

•   Market-based approaches to reducing emissions are popular since they allow the free market to minimize the cost of reducing emissions. It is believed these systems will have a greater chance of getting fully adopted because they keep costs to a minimum.

•   The most common type of emissions market is a cap and trade system. In this type of system, a limited number of pollution credits are issued. Anyone who pollutes is required to turn in a pollution credit.

The possibility of global climatic change, sometimes called global warming, has forced most countries to adopt policies that limit the creation of greenhouse gases and other pollutants. This is complicated by the fact that reducing these emissions makes electricity more expensive. Coal is the lowest cost and most polluting fuel. Completely eliminating coal from the generation stack will cause a large increase in the price of electricity. The goal of the emissions markets is to keep that cost to a manageable level. It is crucial that consumer prices be prevented from jumping to 5 or 10 times today’s prices. A price jump of that magnitude would almost certainly send the economy spiraling into a depression and eliminate the possibility of future reforms.

Having someone else pay the cost of more expensive electricity is not a feasible solution. It is the primary reason that international discussions on reducing greenhouse emissions have deadlocked. Ignoring the flowery political speech, the ultimate issue is that reducing carbon emissions will be very expensive. Neither consumers in industrialized countries nor consumers in developing ones can afford to pay electrical and heating costs that are 10 times higher than their current bills.

Emissions markets offer the promise of finding the lowest cost way to lower greenhouse gas emissions. They provide a reasonable approach to what would otherwise be an intractable problem. In a practical sense, affordable power is synonymous with coal power. Coal is easy to mine and there are plentiful reserves of coal in the United States, the former Soviet Union, China, and India. Coal has such a price advantage over alternative fuels that it is hard to develop a scenario where coal power isn’t being used to keep power prices affordable.

The increased popularity of natural gas fracking has largely derailed carbon legislation in the United States. It has done this by making highly efficient natural gas generation cheap enough to displace many less efficient coal generation units. Since the primary goal of emissions markets was to remove coal as a major electrical generation fuel, many of the objectives of this legislation have been achieved at little or no cost to consumers.

Why Is Global Warming Dangerous?

The primary concern about greenhouse gases is that climate change will destroy the arable land needed to provide food for a growing world popu-lation. Crops require a balance of sunlight and rain, and almost any disrup-tion in that balance is harmful. If a regional climate changes, the local plant and animal life in that region will probably die out. Even if the climate in some other region changes so that it could support those organisms, there is no easy way to move the inhabitants from one area to the other.

History

Global climate change became a hot topic around 1990. Scientists noticed that temperatures were slowly increasing over time in many areas (Figure 2.5.1). Concerns over global warming spawned a series of international discussions on greenhouse gas emissions hosted by the United Nations (UN). The goal of these international discussions was to create a set of binding international treaties that limited emissions of greenhouse gases to 1990 levels. The UN coordinated many of the discussions since it is ineffective for a single country to cut emissions if other countries don’t slow down their output at the same time. Ultimately, these discussions were derailed by disagreements over who had the responsibility for paying the cost for reducing greenhouse emissions.

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Figure 2.5.1 Average annual temperature: Paris

For example, Europe has a high proportion of relatively efficient power plants. The European Union (EU) advocated taxing countries with highly polluting power plants and paying the proceeds to countries with efficient power plants.

Another plan was put forward by Russia and the other states of the former Soviet Union. Russia advocated capping emissions rights at the historical level of 1990. Of course, by the time of these discussions in the mid-1990s, Russia had suffered an economic collapse following the dissolution of the Soviet Union. Its emissions during the mid-1990s were 30 percent below its emissions in 1990—leaving it plenty of spare capacity to resell to other countries.

The role of developing nations in reducing carbon emissions is also problematic. China and India are first and fourth largest emitters of carbon dioxide in the world, respectively. Moreover, both countries are rapidly building coal-based power plants, and increasing the amount of pollution they produce. However, with their vast populations, these countries advocate allocating emissions targets per capita. This would allow both countries to continue to build highly polluting coal power plants while still maintaining surplus emissions rights to sell to other countries.

On the other side of the argument were the industrialized countries. The United States, EU, Russia, and Japan agreed to cut emissions to 5 percent below 1990 levels. However, these cuts—which would involve a substantial expenditure of cash—would still be insufficient to halt global climate change if developing countries continued to build highly polluting coal-based power plants. Ultimately, the UN committee was unable to reach an international compromise. Even so, a lot of countries have voluntarily agreed to follow most of the UN’s suggestions. However, because of the lack of a global compromise solution, carbon emission schemes have been implemented unevenly around the world.

The Kyoto Protocol

In 1997 the Kyoto Protocol became the first global agreement to limit the production of greenhouse gases. The core of the Kyoto agreement is the creation of a cap and trade system that imposes both international and national limits for greenhouse gas emissions. It was approved, in prin-ciple, by almost every country in the world. However, the agreement in principle did not turn into a binding agreement.

Determining the right level for the national allocations for emis-sions rights became a highly political process. The core disagreement is whether the United States should be forced to replace its coal-based power plants to allow the rest of the world to construct their own coal-based generation. On one side is the argument that carbon limits should be set per person, on the other is the argument that the world shouldn’t be constructing highly polluting technologies regardless of the current carbon output per person of each region. Ultimately, the disagreement is over who pays for more expensive power.

The two countries that produce the most pollution are China and the United States. China is rapidly building coal-based power plants and will soon overtake the United States as the largest carbon producer in the world. China, with its large population, would benefit if carbon limits were set per person. Population-based caps would allow China to continue its rapid construction of highly polluting coal-based power plants. The United States did not feel that it should be responsible for removing less polluting power plants so that China could replace that carbon output with even more polluting plants.

The issue comes down to who pays a higher cost for power.

Reducing Carbon Emissions

There are two popular mechanisms for encouraging the development of environmentally friendly emissions technologies—taxes and trading. The first approach, a carbon tax, is a tax that needs to be paid whenever carbon dioxide, or other greenhouse gas, is produced. The second approach is a trading scheme that caps the amount of emissions and requires possession of a freely tradable permit that is consumed whenever pollution is created. In practice, the two policies often coexist and are not mutually exclusive.

Carbon taxes are a price-based approach that makes more polluting technologies less attractive. Taxes are a highly effective way of making highly polluting technology more expensive and cleaner technology less expensive. This is achieved by taking money received in taxes and using it to subsidize the cost of less polluting technology. Within a single country, taxes are relatively simple to implement. Most countries already have a mechanism in place to apply taxes to many activities.

In a cap and trade system, the total amount of emissions is fixed (capped), and the right to create pollution becomes a tradable commodity. This allows companies to make their own economic decisions about how to lower their individual costs. Because the only transactions are generally exchanges of goods (cash for permits) between private companies, trading can easily cross country borders and span multiple currencies. Trading provides the best way to minimize everyone’s cost of complying with environmental goals.

Cap and trade adds a variable surcharge to energy costs that fluctuates based on supply and demand. In comparison, a carbon tax adds a fixed cost. Another difference is that in a cap and trade system, the government is usually revenue neutral—it doesn’t make a profit from the emissions system. Taxation usually involves a direct cash payment to a government. Any taxation system involving multiple governments is substantially complicated by the need to determine which government receives revenue.

Public Goods and Common Land

Emissions are hardly the first time that humanity has had to deal with the problem of sharing a cost among a large group of people. Humanity has been dealing with this type of problem for hundreds of years and economists have developed their own terminology to discuss this issue.

The term public goods is used by political economists to describe something that benefits everyone regardless of who pays the cost. National defense is the classic example—it is impossible to defend the borders of a country without protecting everyone in the country. As long as the costs are paid by someone, everyone gets the same benefit. The term applied to people who take benefits without contributing any money is free riders.

One way to look at the reduction of greenhouse emissions is as a public good. There will be a cost associated with the change, but once it is made, everyone will benefit. Typically, these types of problems have been addressed by taxes—everyone is required to pay something to the public coffers. The major problem with this approach is that much of the world doesn’t make heavy use of electricity nor does it have money to pay the costs of lowering emissions.

Another way to look at the problem of emissions is to think of carbon emissions rights as a limited commodity. There are a limited number of emissions rights, and when used, an emissions right gives the owner the right to low-cost electricity. Political economists refer to this subset of public goods problems as common lands problems. The name comes from shared lands often found in England, Scotland, and Wales prior to the seventeenth century. When thought about this way, the emissions problem becomes more of a problem of distributing low-cost electricity permits.

Emissions Trading Markets

The emissions trading markets, of which there are a number worldwide, are all based on cap and trade systems. The rationale behind trading emissions rights is that it doesn’t matter where cuts are made—as long as emissions are reduced, everyone is better off. This allows the trading market to dynamically reallocate savings in response to changing interest rates, foreign exchange rates, and similar economic stimuli.

Cap and trade systems create property (emissions rights) where no property previously existed. These rights are a license to pollute, or alternately, the right to use affordable (coal) power. There is no way of allocating these rights that makes everyone happy. Ultimately, someone—perhaps lots of people—will have to pay a higher cost for their power.

In theory, cap and trade systems have a couple of advantages over taxes to reduce carbon emissions. By capping the maximum amount of carbon emissions, the total amount of pollution is well known. Cap and trade systems also give businesses maximum flexibility in determining how to meet government requirements. These producers can either install more environmentally friendly technology or they can buy emissions credits. Because it can be done globally, there is no danger of companies relocating factories from high-tax to low-tax regions.

Another advantage to cap and trade systems is that they are broadly applicable across countries and different types of greenhouse gases. Because no government needs to be involved as an intermediary, cross-border transactions are relatively straightforward. For example, a trading market would allow cuts to be paid for in one country using one currency, and the benefits received in another country with a separate currency. Additionally, unlike a taxation system that would need to be constantly adjusted by a legislature, a trading system can adjust itself to changing economic situations.

Distributing Rights

Because no one naturally owns emissions rights, there is the problem of determining who is allowed to produce carbon emissions. Often this problem boils down to which people have access to the low-cost electricity provided by coal-fired power plants. The tempting solution is to say that everyone pays the same amount for power is at odds with the concept of the trading market. The primary benefit of the trading market is to find the greenhouse gas emissions that can be eliminated most easily and to compensate those people for cutting their emissions.

Another complication is that consumers need to be protected during the whole process. The largest source of greenhouse emissions is power generation. Governments can’t allow power generators to go out of business. When a power plant goes bankrupt, the government can’t allow the municipality served by that power plant to go without power. The government would need to step in and assume the obligations of the power plant operator. In the end, it is the residential consumer who would be left paying the high cost of complying with environmental regulations.

Emissions Credits

There are two ways to get emissions rights in most cap and trade systems. The first is to receive the right from the administrator of the cap and trade system. Usually these rights are allocated or auctioned off. The other way is to create something that offsets carbon emissions in some manner. This might be through creating a carbon sink (like planting a forest), capturing carbon dioxide emissions and storing them underground (carbon sequestration), or by creating a nonpolluting source of electricity (building a hydroelectric plant or solar power installation).

The ability to creatively reduce carbon dioxide is a key advantage of a cap and trade system. Essentially, this allows countries to keep using coal power until alternative sources of power can be developed. In many cases, carbon capture doesn’t have to be done close to home either. Particularly under cap and trade systems conforming to the Kyoto Protocol, it is possible to offset carbon emissions anywhere around the world. This ensures that the lowest cost alternative can be found.

Carbon Sequestration

Carbon dioxide is a necessary byproduct of almost all combustion. The process of forming carbon dioxide is what creates heat when fuel is burned. Long chains of carbon are completely broken up, forming single carbon molecules that combine with oxygen. As a result, as long as we use hydrocarbon fuels, it is impossible to stop the creation of carbon dioxide.

It is possible to capture carbon dioxide exiting from fossil fuel power plants. This carbon dioxide then needs to be stored somewhere like a depleted natural gas well or water reservoir. This is called carbon seques-tration. Carbon storage facilities are very similar to natural gas storage facilities except that they store carbon dioxide instead of methane.

Another way of reducing carbon emissions is to use plants or bacte-ria. Plants use carbon dioxide to form wood, bark, and leaves. However, plants usually require the use of fossil fuels for fertilization and harvest-ing. Bacteria can also be used to absorb carbon dioxide. The advantage of using bacteria is that a very dense colony of bacteria can be located in a small area and it doesn’t require a lot of petroleum products to maintain.

Limitations to Cap and Trade Systems

In practice, while cap and trade markets sound good, they face several implementation problems. Tracking all carbon dioxide emissions is impossible, and even if it were possible, it would be far too complicated to trade. For example, animals naturally produce carbon dioxide when they breathe. They produce even more than normal when they exercise. It isn’t possible to have a cap and trade system that applies to something like jogging. As a result, emissions trading markets must pick and choose the carbon dioxide sources that they want to restrict. Most carbon trading is focused on reducing carbon dioxide resulting from the combustion of fossil fuels.

However, emissions credits can be created from almost any source. This means that cap and trade systems run the risk of funny accounting when emissions credits are granted for offsetting carbon emissions. For example, if a region is capping power plant emissions but not car emissions, it might seem to make sense to shut down a local commuter railroad that is powered from the local power plant to encourage more driving. After all, this would reduce the “emissions” at the power plant. However, in reality, since cars are also a major source of pollution, this would actually increase the amount of carbon emissions in the area.

A related limitation on carbon trading is that it can force companies into making investments in carbon mitigation systems that would normally be considered poor ideas. For example, if a power producer wants to protect its customers, it needs to minimize the risk that speculators corner the market on emissions rights. The primary way to eliminate this risk is to be able to create emissions credits on demand. Essentially, companies that utilize carbon credits need to ensure that they have a way to “manufacture” carbon credits in the event of a spike in prices.

The chance of speculators trying to corner the market is high—it is just about the only way for speculators to make a profit trading emissions credits. However, since emissions credits can be manufactured by carbon offsets, the easiest way to protect against speculators is to keep a couple of carbon offset ideas on the side. While the economic value of these ideas might be really bad, it just has to be better than being held hostage by speculators.

Carbon Taxes

Although they commonly coexist, carbon taxes are generally considered the primary alternative to cap and trade systems. Taxation adds a surcharge to energy costs and relies on high costs to incentivize adoption of new technologies. Most countries have implemented domestic energy taxes. However, an international tax remains unlikely due to concerns over who gets the money. As a general rule, countries favor tax schemes that levy taxes on other countries and benefit themselves.

Compared to a cap and trade system, there are some big advantages to taxes. They can be applied universally to a wide variety of things and require minimal administration. For example, adding a surcharge to the price of gasoline is much easier than checking if someone owns enough gas credits to be allowed to purchase gasoline. Taxes are simple. Taxes can also be used to promote domestic carbon reductions. This is accomplished through reinvesting tax money into local projects. With carbon trading, cash is commonly transferred away from local consumers to a carbon sink in some other jurisdiction. With taxes, the money can stay in the local economy.

On a domestic level, the biggest problem with taxation is that energy consumers are a captive audience. Energy companies pass along taxes directly to consumers. As a result, the only group that is being financially affected by the taxes is consumers. The power companies, who have the ability to adopt less polluting technology, don’t have a lot of motivation to improve their technology under a taxation system.

Trading Carbon Emissions

It is possible for carbon emission trading to achieve its goal of reducing global climate change without ever becoming a major financial market. Speculators don’t have a clear role in the emissions markets. In most markets, having a large number of people willing to transact limits volatility and keeps transaction costs low. However, in the emissions markets, it seems unlikely that speculation will limit volatility or keep costs low.

Over time, the general economic thought is that a rising population and demand for power will force the price of emissions rights upward. However, no one—particularly the government—benefits from higher carbon emissions prices. The only downside to low prices is that companies might not have any incentive to invest in environmentally conscious technology. As long as environmental targets are met, governments prefer low prices. Governments also have some excellent tools to stabilize prices—they can both issue new rights and determine how easy it is to create carbon credits through offsetting.

If carbon prices are too high, the cost gets paid by consumers (voters) and the economy. Governments have a civic obligation to keep their local power grids operating and their economies moving forward. As a result, along with a great ability to manipulate emissions market prices, governments have an incentive to keep emissions prices at the right level. Governments want prices high enough to spur changes, but low enough that the economy and their citizens are not negatively affected. Governments don’t want speculators cornering the emissions markets and making a windfall profit at the expense of consumers.

Carbon Equivalents and Other Pollutants

Although this chapter concentrates on the carbon dioxide trading, there are other emissions markets. These markets are substantially similar to the carbon market, and share much of the terminology and trading limi-tations. The biggest difference is that most types of pollution only affect a limited area. As a result, most emissions markets are regional (cover-ing a couple of countries) rather than global in nature.

•   Carbon Equivalents. There are a number of greenhouse gases other than carbon dioxide. Methane, nitrous oxide, and ozone are examples of other greenhouse gases. These are usually converted into “carbon dioxide equivalents” and traded as part of the carbon market.

•   SOX. Sulfur oxide (SOX) is a source of acid rain. Acid rain is a re-gional problem that is commonly addressed through emissions markets. These markets are separate from the carbon emissions markets and typically organized by region.

•   NOX. Nitrogen oxide (NOX) markets are closely associated with the sulfur markets. Like SOXs, NOX emissions are associated with acid rain.

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