Wednesday, July 9, 2008

Global Carbon Trading: Proposals from Down Under

There is good debate going on down under about creating a workable incentive/cost structure to reduce global carbon emissions. Australian economist John Quiggin started off a fertile thread of debate in his blog about the latest proposals for a global trading mechanism for carbon permits/tax.

Now that nearly everyone is agreed on the need for a market-based policy instrument to reduce CO2 emissions, the biggest unresolved question is whether to implement carbon taxes, tradeable emissions permits or some hybrid of the two.

I support tradeable permits...I have three main reasons for preferring permits, which I will list in order of significance
First, while the natural starting point for both systems is one in which the government collects the entire implied value of emissions, either as tax revenue or as the proceeds from auctioning permits, the emissions trading system allows for (but doesn’t require) free allocation of some permits. Particularly in transitional stages when not all sources are covered, this can be used to offset unanticipated distributional consequences of the scheme, and thereby increase its political feasibility.

Second, since we are uncertain about the elasticity of demand for emissions we are faced with a choice between allowing this uncertainty to be reflected in uncertainty about reaching the targeted level of reductions in emissions, uncertainty about the price, or some mixture of the two. Given the risk that we will fail altogether if individual countries fall short of their targets, I’d prefer some uncertainty about the price.

Third, and most importantly, the ultimate solution has to be an international agreement to reduce emissions in the most cost-effective way possible. The obvious way to do this is through the creation of international markets for emissions permits. Although a full-scale global market might be some way off, regional or multiregional markets linked through something like the existing Clean Development Mechanism could be set up reasonably easily. By contrast, I can’t see how, in a world of sharply varying exchange rates, it would be possible to set up a co-ordinated global system of carbon taxes.

Warwick McKibbin, another economist, has a more fleshed out proposition.

I agree that we need a world price for carbon. This can be achieved by picking arbitrary targets for each country and then having each country trade until a world price is reached. Problem with this is that if one major country pulls out the global market will be undermined – or in the European ETS analogy if one country over-allocates the system price will collapse (not hypothetical). The reason that attempts through history to have a single world currency has never worked is because money is the promise of a government and difference governments have different degrees of credibility.

The alternative is for all countries to have a domestic carbon price either from a domestic carbon tax, some other price mechanism or a hybrid carbon market along the lines that Wilcoxen and I have proposed.

Create a long term permit like a long term bond with diminishing annual permits for each year reflecting this long term target. Give these long term permits to all citizens and industry within a country. Trade these in a flexible domestic market like a long term bond market. A central bank of carbon issues annual permit announcing a price for each of the next 5 years. Anyone who can’t hit their annual commitment from owning or buying long term permits or buying annual coupons from long term permits can buy an emission permits from the central bank of carbon. The price of annual permits is therefore capped and constant for 5 years. This is adjusted domestically based on a mix of science, the global policy situation or by international agreement if there is a global system. The long term permits are flexibly priced within a domestic market. No one can manipulate the short term market price. Each country runs their own market so the existing domestic institutions can run the market. Different countries will do better and worse jobs but the cross border damage is limited within countries. The world coordinates on the same annual permit price in each country if a global regime can be negotiated. Think of this as a global cap and trade market with clear rules on compliance based on no country having to bear an unfair burden of cost relative to other countries where this is measured as the carbon price reached in any year. Two targets (long term emission reduction, equalizing short term economic costs across countries) and two instruments, the short term and long term carbon price.

I find taxes very opaque. How long would a tax reform take in the real political situation we face. The lobbying would be non stop over time whereas my system only faces a one off allocation fight. In a carbon tax world there is no constituency to prevent future politicians from cutting taxes but if people own the long term carbon rights then they will not like politicians changing the policy and debasing the carbon market.

See the entire article and debate thread in the link.

I agree with Warwick that having a global trading platform might be too cumbersome, and breakdown in compliance in one country undermines the entire system. Domestic trading platforms might work better. But I also have an issue with issuing long-term permits.

The possibility of local politicians altering carbon tax based on political convenience gives rise to fluctuations in value of the permits already issued. If a newly elected government will increase carbon taxes, then that increases the value of a permit issued during a lower tax environment. Vice-versa, if taxes are slated to go lower, an already issued permit will be priced lower, as companies that need to buy permits will be able to buy them at a lower price.

The existence of these arbitrage opportunities ensures that before long, financial speculators will come to dominate the markets, as opposed to the real carbon-based entities. Who knows, if implemented, we could one day see a bubble in carbon credits.

A trading platform creates a scenario whereby Warwick’s concept of “ownership of long term carbon rights” becomes fluid and arbitrary. Ideally, a strategy of developing a trading platform should be coupled with a fixed carbon tax program that should be upheld regardless of change of government. But if this is not possible, I guess we will have a new playground for the financial markets.

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