The foundations for emissions trading on a global scale were laid at Kyoto in 1997. With strong support from industry, this could become the main mechanism of combating climate change. However, there remain strong objections to trading, and there are many obstacles to overcome.
Following the United Nations Framework Convention on Climate Change at the Earth Summit in Rio de Janeiro, environmental aims are increasingly becoming part of economic and political policies. At the Kyoto Conference in December 1997, negotiators from over 160 countries agreed on a Protocol to reduce greenhouse gas emissions. For the first time, governments had agreed to quantifiable reductions in emissions, which they are legally obliged to see through.
The world’s industrialized countries, the so-called Annex 1 countries, have agreed to reduce, by 2010, their overall emissions of carbon dioxide and five other greenhouse gases to levels 5.2 per cent below 1990 levels. As electricity generation is one of the main causes of greenhouse gas emissions, this Protocol has placed a serious burden on the electricity industry to adapt the ways in which it does business.
A basis for trade
One of the Protocol’s main weaknesses was that it was not initially signed by the USA, and several other countries have been skeptical about its benefits. Their main objection was that any measure to reduce emissions will involve cost for energy companies which could severely hamper competitiveness.
Should a move to reduce emissions result in higher domestic electricity costs, there would also be political difficulties in explaining higher energy bills to the voting public. This is quite apart from the possibility that if the Protocol limited itself to the reduction of emissions in Annex 1 countries, there would be nothing to encourage companies from these countries to develop sustainable electricity generation techniques in developing countries.
The Protocol therefore contains three main “flexibility mechanisms” aimed at helping Annex 1 countries achieve their emission reductions. The first of these is Joint Implementation (JI), which enables an Annex 1 party to invest in projects that reduce emissions of another Annex 1 party over and above reductions that would otherwise occur. For every unit of emissions that are reduced, the investing Annex 1 country receives a credit – an emission reduction unit (ERU) – against its own required reductions. The emissions savings become equivalent to an international emissions trade, being deducted from the allowed emissions of the host country and added to the allowed emissions of the investing country.
The second mechanism is the Clean Development Mechanism (CDM). This is designed to harness the resources of the private sector and extend investments under the Protocol to developing countries. It will also enable certified emissions reductions from sustainable development projects in a developing country (non Annex 1) to be transferred to an industrialized country.
The third mechanism is Emissions Trading (ET). This has been a hotly contested issue, strongly favoured by the USA, but opposed by China and members of the G77 group of developing nations. It allows Annex 1 parties to participate in emissions trading to fulfil their reduction commitments. Thus one party may emit more than its allocation if it can buy an emissions allowance from another party, who might have a surplus of such allowances.
An emissions trading scheme could operate in one of two ways. One of these is for the polluter to emit up to a certain amount of the pollutant and trade any of that allowance with other polluters. This is known as the “cap and trade” scheme. The other system is through emission reduction units, where pollution allowances up to the allowed amount cannot be sold. Trading is only allowed if the emissions reduction target is exceeded by the polluter, who thus generates an emissions trading “unit”, which can then be sold.
A major concern about emissions reductions is that they could adversely affect industry and quality of life in industrialized countries. The Global Climate Coalition, which represents chemical, oil, automotive and coal firms, alleges that a seven per cent reduction in emission levels in the USA would lead to a loss of over three million jobs and lower industrial production.
Environmental groups have expressed concerns that a tax on energy is not guaranteed to reduce emissions levels, as companies could just lower costs in other areas and maintain the same emission levels.
A “cap and trade” method of emissions trading is therefore felt by many to be the most sensible way to comply with Kyoto. A system of emissions trading is thought to be economically efficient because it enables companies to make an assessment of which is the least cost option: to reduce emissions and sell permits, or buy permits and continue polluting. This means that pollution reduction is achieved at least cost across the whole economy.
The success of the US sulphur dioxide allowance-trading programme, which resulted in sulphur dioxide emissions among 263 Phase 1 units being halved between 1980 and 1998, is seen as an important argument in favour of emissions trading. It has achieved 100 per cent compliance and sulphur emissions in 1998 were 30 per cent below the allowable level, having dropped from 9.4 million tonnes in 1980 to 4.7 million tonnes by 1998. There has also been a steady growth in the inter-utility trading of allowances, from 700 000 tonnes in 1995 to 2.8 million tonnes in 1997.
The market has reached approximately $2 billion/year in registered trades, while Environmental Financial Products estimates that there is an additional $2 billion/year in derivatives such as options, forwards, and other unregistered trades. The market is still adjusting to this innovation, however, with estimates that this system will save $784 million annually beginning in the year 2000 and cost 43 per cent of the estimated costs of a command and control regime.
Overall the benefits of this system appear to far outweigh the costs, with current compliance costs estimated in the $1-2 billion range. The Environmental Protection Agency estimates that by 2010, this system will have saved $40 billion/year in health costs, $3.5 billion in visibility costs, and incalculable benefits in terms of fewer acidic lakes and streams and reduced damage to buildings and monuments.
Although evidence from the sulphur dioxide trade in the USA would appear to make this the most sensible method to reduce emissions, it is not easy to apply the US model to the rest of the world. A key factor in the success of a trading system is verification and compliance, which is obviously difficult in a global emissions market.
There have also been extreme difficulties in deciding the best way to allocate permits on an international basis – the two most popular methods under discussion are grandfathering and benchmarking. Grandfathering uses information from a base year to influence allocations of emissions, while benchmarking allocates permits on a target rate of emissions per unit of production. The advantage of the first system is that it is simple, transparent and flexible, while the second system incorporates new entrants more easily. Until industry and governments can decide on a system, there is no way that emissions trade can take place.
Internationally recognized ways to monitor emissions levels and track them will also be essential to the implementation of a trade system. In order to be able to carry out a truly transparent trading system, both domestic and international trading systems will need to be open. Trading through regulated trading houses is a possible solution to this. It has also been suggested that tradable permits could be placed with the Stock Exchange, the Bourse or local Board of Trade.
But there have been strong political and moral objections to emissions trading, such as the worry about “hot air trading”. This is an allocation of emissions to a country which exceeds the amount of emissions that the country will actually produce. This is the case for countries such as Russia and the Ukraine, where the deteriorating economic situation means that the emissions levels have reduced greatly since 1990. Such countries could flood the market with their surplus allocations, frustrating the environmental objectives of the Protocol and depressing the value of ERUs.
The imposition of ceilings on purchases or sales of emissions could solve this problem. The EU council confirmed in its meeting on 3-4 June 1999 that no more than 50 per cent of reductions targets should be allowed to be obtained from the use of flexible mechanisms.
Tax vs trade
Such difficulties have prompted economists such as Harvard’s Richard Cooper to propose internationally agreed carbon taxes as superior to Kyoto’s cap and trade system. These economists argue that the large amount of administrative work generated by emissions trading could be a burden on market players, particularly the smaller ones, as there would be a fixed cost element to trading activities.
Recognizing that it might not be possible to achieve Kyoto commitments through any one single policy, the UK has favoured a combination of taxation, regulatory controls and market mechanisms. In its 1999 budget, the UK government announced a Climate Change Levy to be taxed on the business use of energy from 2001. The government claimes that this could raise $3.3 billion.
Most industry bodies have been extremely critical of this system, with the UK Chemical Industries Association stating that the levy would result in a loss of 5500 jobs, a 2.9 per cent decrease in output and a 0.2 per cent decline in productivity in the chemical sector. In September 1999, the Government decided to extend the consultation period on the proposed tax, fuelling speculation that it is preparing to scrap or overhaul the plan.
In a 1999 Datamonitor survey, which surveyed over 60 per cent of the UK generating market, emissions trading was the preferred method of combating pollution, with an average respondent score of 4.13 out of a maximum of 5. Generators clearly liked the flexibility built in to this scheme of pollution control.
Taxation was thought to be a bad policy, with an average score of 2.63. Although all methods of combating pollution would involve extra costs, the fact that a taxation system would both be politically determined and inflexible makes it unpopular.
Industry backing of an emissions trading system has led the Emissions Trading Group, a consortium of 25 companies led by the Confederation of British Industry and including BP Amoco, Air Products, BOC and Du Pont, to develop an emissions trading scheme. The Group presented its scheme to the UK government in October 1999 and the scheme could be operating in the UK by April 2001.
A report released by Mobil in October 1999 stated that reducing worldwide CO2 emissions could not succeed unless all countries and all industries joined in the effort. According to this report, even if developed countries widely implemented advanced technology, their reductions in emissions would be small compared to the massive global increase in emissions levels as the economies of developing countries grow and prosper.
The report notes that “by the end of the 21st century, developing countries are projected to contribute up to 80 per cent of the world “by the end of the 21st century, developing countries are projected to contribute up to 80 per cent of the world’s CO2 emissions”. This suggests that, although the reductions suggested by Kyoto are a step in the right direction, far sterner measures might be needed.
The report concludes by stating that “the path to stabilizing emission levels will likely involve substantial cost, affect living standards, trigger global regulation of energy resources and require the participation of every nation”.
But a concerted global move to reduce emissions levels remains a distant possibility. While most Annex 1 countries agree in principle to reducing emissions, scientists are still undecided as to whether man-made global warming is a reality.
Richard Courtney, Senior Materials Scientist of the UK’s Coal Research Establishment, has stated that “the path to stabilizing emission levels will likely involve substantial cost, affect living standards, trigger global regulation of energy resources and require the participation of every nation”.
Nevertheless, should countries agree to reduce their greenhouse emissions levels, the strong level of support from industry for trading could be enough to convince governments to help set up the necessary infrastructure.
Of all the systems being discussed to reduce emissions, trading appears to be the most economically viable. But such a system depends on firm evidence of man-made global warming, a clear legal framework, and a framework which will allow international trading.
Datamonitor is an independent market analysis firm specialising in the global power equipment and energy industries. Datamonitor publishes a wide variety of market information reports on utilities and power generation equipment, based upon primary research and significant expertise in the area. Datamonitor can offer a tailored research & analysis programme. To discuss your requirement please contact:
108-110 Finchley Road
Tel: (+44) 0207 675 7000
Fax: (+44) 0207 316 0002