Cap-and... oops-nothing-to-trade

Cap-and-trade mechanisms scored early successes when deployed within national boundaries against pollutants like SO2 and NOx. That success led politicians and economists to think that the approach could be extended to all emissions, and to international arrangements. In particular, they hoped it would provide a relatively pain-free way of tackling carbon emissions. They should have consulted sports scientists: no pain, no gain.

We have seen recently the failure of the most high-profile of the carbon cap-and-trade mechanisms - Phase 1 of the EU Emissions Trading Scheme (EU-ETS). This was, apparently, unpredictable, and anyway Phase 1 was just a trial period. Phase 2 will be much better, we are told.

Except EU-ETS wasn't the first, and it isn't the last. In July 2006, two economists (David A. Evans and Joseph A. Kruger) published a paper titled "Taking up the Slack Cap: Lessons from a Cap-and-Trade Program in Chicago", looking at Chicago's Emissions Reduction Market System (ERMS), and its lessons for larger mechanisms like the EU-ETS. They summarize its performance thus:

"ERMS is particularly relevant to the questions outlined above because the first years of its operation reveal a curious outcome. Despite expectations to the contrary, emissions have been significantly below the annual allocation of emission allowances, and allowance prices have been much lower than predicted. Trading has been limited and many allowances have expired unused. Essentially, it appears that a fundamental prerequisite for a tradable allowance program is missing - there is no scarcity of allowances."

Sound familiar? Now we hear that the Regional Greenhouse Gas Initiative (RGGI), "the United States' first foray into cap-and-trade programs for greenhouse gases", is "over-allocated by 24 million short tons or 13 per cent of the cap in 2009".

Three cap-and-trade mechanisms that were all over-allocated, leading to a collapse of prices in the market. And all of these were a surprise? Or did we need three trials, because no one could work out beforehand that if the cap was set higher than the level of emissions that industry could easily achieve, the market would collapse?

There is a difference between greenhouse gases and most other pollutants. It is not difficult to imagine a world with substantially reduced SO2 emissions. Most of the emissions come from a limited number of large sources, and the technology required to reduce emissions at those sources is well-established and practical to deploy (i.e. lime filters). The emitters could carry on operating their facilities much as before but with somewhat increased costs.

Now imagine a world with substantially reduced greenhouse-gas emissions. You can't practically take the carbon out of the chimneys of our existing coal-, gas-, and oil-fired generators. You are unlikely ever to be able to capture the carbon-emissions from our vehicle exhausts and gas-, oil-, and coal-fired boilers and furnaces, whether at home or in our factories. The low-carbon alternatives are immature, expensive, and in all likelihood can never be scaled to replace more than a fraction of our existing infrastructure. And it's not just (or even mainly) about the existing infrastructure, but keeping up with strongly increasing demand from rising standards of living in the rich and (more strongly) developing worlds. You'd have to run hard just to stand still in these circumstances. But our economists and policy-makers thought we could do it at a gentle jog. No pain, no gain.

The point of cap-and-trade is to protect customers from the "deadweight costs" of the more rational approach of carbon-taxation. Except those deadweight costs aren't deadweight at all. They are price signals that send the most important message of all - if carbon has a cost to producers, it has a cost to consumers as well. Consumers need price signals just as strong as those delivered to producers, to justify changes to behaviour and in the billions of small installations that cannot possibly be managed by the bureaucratic approach of cap-and-trade ("Mrs Smith, we've assessed the amount of carbon your household should be emitting and set a cap of 7 tonnes a year. We'll be monitoring your performance, and if you exceed your cap, we'll be expecting you to buy an extra tonne or two at the carbon exchange. Yes, I know the Joneses next door got ten tonnes, but they haven't got double-glazing, their boiler is a bit older than yours, and they've got a cat. We have to grandfather their rights, you know.")

The other argument for cap-and-trade is that it is more practical to obtain international agreement to a trading mechanism than to a tax. Yet, what we can see is that it is practical to gain international agreement only on the basis of caps that assure each of the international participants that they will not feel significant pain relative to their rivals. And the only way that can be achieved is to set loose caps. You can choose whether you want to deploy game-theory or public-choice theory at this one, but either way, the rational strategy is for government to do exactly what they have done - push for as high an allocation as they can get away with. So yes, you can get international agreement, but only on the basis that what is agreed is thoroughly ineffective. An ineffective mechanism is the worst of all worlds - all the bureaucratic costs and distortionary impact with little of the environmental benefit. Or in other words, exactly what we have seen so far.

I have argued before that cap-and-trade is a broken way to deal with carbon emissions. I am not alone in this view, which is gaining currency. OpenEurope recently brought out a detailed analysis of the EU-ETS, which came to much the same conclusion. Professor Michael Grubb - by-and-large a supporter of environmental market mechanisms - acknowledges that this is becoming a common view (though he does not entirely agree with it) in the opening passage of a paper on this subject that he submitted to the Stern Review:

"Economic models of the Kyoto system generally assume that the international mechanisms will function as a competitive market. Projections of international carbon prices under the Kyoto system, generated by such models, have fluctuated wildly over time and between models. Now, however, most models project very low prices due to the US pullout, the carbon sink agreements at Marrakech, and revised (much lower) projections of emissions especially in Russia and Ukraine. These factors together imply a large surplus of available allowances, leading to price collapse if all allowances potentially available are freely and competitively traded."

Even the Government, though outwardly supportive of the EU-ETS, warned in the DTI paper leaked to the Guardian that:

"If the EU has a 20% GHG target for 2020, the GHG emissions savings achieved through the renewables target and energy efficiency measures risk making the EU-ETS redundant, and prices to collapse. Given that the EU-ETS is the EU's main existing vehicle for delivering least-cost reductions in GHG, and the basis on which the EU seeks to build a global carbon market to incentivise international action, this is a major risk. Remedies to overcome this risk will be difficult to agree or ineffective."

Environmental groups are sufficiently pessimistic about the prospect for carbon-prices in the RGGI that they are campaigning for state governments to set a reserve price, in the expectation that carbon will be nearly worthless, and in recognition that a very low price for carbon is severely damaging to genuine efforts to reduce our carbon emissions. But once you set a reserve price on this sort of mechanism, what is the justification for it over the more rational approach of a carbon-tax?

Negotiations are in their early stages for what to do when the Kyoto Treaty runs out in 2012. It seems clear that a fresh approach is needed. Trying to prop up the corpse of cap-and-trade and send it again into battle, El-Cid-style, would be a huge mistake for our economy and our environment. We can and must do better than this.