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The Cap and Trade Pollution Solution

7 January 2008




Carbon trading is touted as an environmental revolution, but what will it take to make it profitable and save the earth? Drew Turney finds out more.


If you don't know what the term 'carbon market' means, you've not only been living under a rock for the last three years, you're about to be swept up in the most transformative movement to hit energy provision and financial markets since the steam turbine.

A lot of us understand the vague idea of letting the power of market forces bring the levels of air pollution down, as long as the financial incentive flows in the right direction, but what does it all mean for power consumers, producers and the industry as a whole? Is it really going to save the world or is it just the new gold rush now the dotcom boom is a distant, painful memory?

To understand carbon trading, it's just as important to understand what it isn't. In the days before economic rationalism, an environmental crisis would have resulted in governments simply restricting companies and industries from polluting as much, but two downsides make such totalitarianism unpopular today.

The first is that limiting the by-products of any service or product supply (greenhouse gases, in this case) means restricting production, which will mean the end of economic growth in the industry. Secondly, in this era of stripped-back government, there are few regulatory resources to police or enforce it.

Such a command-and-control move is known simply as a cap, and many power producers would have little choice but to pass harsh fines resulting from their activities onto customers, adversely affecting the consumer economy. Nobody would be better off.

"The reason carbon tax isn't as popular as carbon trading may simply be a question of language."

The other system favoured by many is a simple carbon tax as a flat percentage of emissions, meaning entrepreneurs would have an incentive to innovate cleaner fuels, and the dirtiest industries (who would pay much more in tax) would have an incentive to invest in them. Governments could then use the increased tax revenue to offset taxes to consumers, who would pay higher prices for power but lower taxes, a net change of zero to the household budget with therefore little effect on the economy.

The reason carbon tax isn't as popular as carbon trading may simply be a question of language. Taxes are a hard sell to voters, and no government gets ahead promising to raise them. To an equal degree, everyone – particularly big business – loves the sound of a new market.

HOW DOES CARBON TRADING WORK?

Carbon trading is a cap and trade system. Participating governments or treaty signatories to carbon reduction agreements agree on a total amount of carbon emissions that represents a reduction from current levels (the 'cap').

They then produce enough certificates of carbon emissions – often called 'carbon credits' – to ensure the total carbon emitted stays under the cap, and issue them to industries and bodies according to how much they pollute.

"If companies have to pollute more, they have to buy more certificates on an open carbon market, much like a stock exchange."

Those companies or individuals are then free to trade their certificates in a variety of ways. If they have to pollute more, they have to buy more certificates on an open carbon market, much like a stock exchange.

If they pollute less than they expected to, they are left with excess certificates that are worth money on that exchange. Or they can surrender them to reduce the overall amount of pollution in exchange for revenue. The number and demand of credits will then set the price according to the same market forces that drive the price of any other financial commodity.

THE SCHEMES

So far there is little real global leadership in carbon trading, with state, national and cooperating nation-based systems springing up everywhere. How do we know which one will become standard, or does it even matter, with markets intermingling the way stock markets do today?

It's been a few years since the word 'Kyoto' became the lexicon not just for a Japanese city, but for a set of emission control standards few people really understand but most agree is a good idea. Simply put, it's an agreement by all signatory countries to reduce greenhouse gas emissions to 1990 levels by 2012 – measures the scientific community have warned are the bare minimum necessary before damage to the environment is irreversible.

"The US and Australia were regarded as international embarrassments for refusing to sign the Kyoto Protocols."

The US and Australia (until the recent election of a pro-Kyoto government) were regarded as international embarrassments for refusing to sign the Kyoto Protocols. In fact, the cynical would suggest it is the US rejection that has left the rest of the world floundering with no agreed direction about carbon market mechanisms.

However, this has left Europe to claim the nascent movement as its own and London has become the de facto capital of carbon trading; the EU-based scheme the biggest carbon market in the world.

The disinterest from the US and Australian governments has not, on the other hand, stopped smaller state governments from getting in on the action; both California and New South Wales are launching their own cap and trading schemes which are actively trading and ready to join regional or global schemes.

HISTORY AND CONTROVERSY

So will the trading of emissions work? There is a lot at stake, from environmental collapse to the threat of an economic downturn that certainly does not need state-sanctioned limits on industrial activity. In fact, it has already worked.

"There is a flood of new capital, with world carbon markets set to reach $70bn (£34.6bn) this year."

In 1990 the US adopted a trading scheme for sulphur dioxide emissions, one that has caused an estimated 80% reduction in acid rain and almost halved emissions since 1980.

But carbon trading isn't without its criticisms. There's the creeping public and NGO distaste for leaving the environment to forces they feel are open to abuse and corruption. There's also the carbon offsets movement where we 'buy' our way out of environmental guilt but aren't encouraged to change our behaviour.

Plus, there is what many have called carbon trading's first major failure. The first phase of the EU scheme began in January 2005. Certificates were issued and trading began. Then everyone realised the initial cap was set so high, polluters collectively fell under it without making any reduction at all. The market was in fact so flooded that the value of EU carbon credits fell by 65%.

Then there is the potentially corrupting influence in a trading scheme, where everything from skilled lobbyists to generous campaign donations could ensure more than your fair share of credits issued, or – as has already been reported – considerable amounts of them given away for free.

"London has become the de facto capital of carbon trading; the EU-based scheme the biggest carbon market."

But most importantly, who is going to police industries, groups, companies or even entire countries to make sure they are only polluting for credits they hold?

Inside national borders there are government mechanisms such as the UK Environment Agency to ensure compliance with such a scheme, but everyone has seen the outcome when an international agency like the UN or EU tries to impose its will on a fiercely proud, independent nation like the UK or US.

THE FUTURE OF CARBON MARKETS

Regardless of its track record, the carbon market seems here to stay whatever its effect on global warming, looking like a win-win situation for the environment and the market. For starters, there is a flood of new capital, with world carbon markets set to reach $70bn (£34.6bn) this year, according to Barclays Capital.

Combine the money with the upsurge of public interest in the environment and the commitments made around the world by leading banks, resources prospectors, auto makers, power providers and other traditionally dirty industries and everyone has the incentive needed to start trading.

The biggest national economy in the world is still not part of the equation, but public sentiment has gradually turned against the Bush Administration in everything from foreign to environmental policy. Will it only be a matter of time before every government, company and individual in the world is prepared to agree on and embrace the carbon market?

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