Dear Mr Mortished

I read your article in the Times today with great interest.

Much of what you say rings true, although I would argue that  if we are able to curb the carbon leakage problem then the investment leakage problem will solve itself.

It is this very issue that we are hoping will be resolved at the Conference of the Parties to the Kyoto Protocol in Copenhagen this coming December.

However, in relation to your article, there are two issues that I would like to raise:

Leakage and the emerging economies

A great irony is that while the big emerging economies have resisted the imposition of carbon caps on their economies, it is their populations and economies that are likely to fair worse due to the effect of climate change. I believe that these countries are all well aware of this fact and that as a result their ostensible hard line on this issue is purely designed to position them well for international negotiations.

The expectation is that the emerging economies will accept carbon caps if the funding required to achieve those carbon caps is at least partially subsidised by the industrialised nations that created the global warming problem.  This subject was the focus of recent discussions in Bangkok and this is where a deal is likely to be struck in Copenhagen in December.

If this fails then the imposition of carbon tariffs on imports from countries that have not accepted a carbon cap may be the only solution. This is something that has been mooted in relation to the Waxman Markey Bill in the US.

Either way, the carbon leakage problem should be solved.

EU Emission Trading Scheme

While the media and various green groups take pleasure in bashing the Emission Trading Scheme, it is noteworthy that no viable alternative has ever been offered in its place.  No man made system is perfect. The legal system, which has been responsible for many miscarriages of justice, could also be attacked as being imperfect, but it is the best alternative that we have and so we stick with it and through its evolution we seek to improve it.  The same is true of the emission trading scheme.

Some will argue that we should adopt a carbon tax over emission trading and to those people I offer the following counter argument.

First, let us accept the generally accepted supposition that the environmental objective of reducing greenhouse gas emissions must be balanced with the pervasive political objective of protecting the economy. After all, shutting down emission intensive industry would solve the environmental problem but would be wholly undesirable for the economy.

Against this presupposition, let us examine how inequitable a carbon tax would be. A company without an economically viable emission abatement opportunity would simply be burdened with a penalty tax for emitting too much with no prima facie benefit to the environment. At the same time, a company with access to low cost emission abatement opportunities would receive absolutely no incentive to exploit those opportunities to the full: after all, why would it do any more than that legally required of it? The net result is lower total emission reductions at a higher unit cost to the economy.

By contrast, a cap-and-trade scheme encourages a company with a low cost emission abatement opportunity to exploit that opportunity to the full, in the knowledge that it is able to sell its over-achievement to companies with no economically viable means of reducing emissions. The net result is optimal emission abatement at the lowest unit cost to industry.

Moreover, many emission abatement opportunities involve large scale long term investments which may not be economically achievable for the owner of those opportunities if acting alone. However, under a cap-and-trade system, the cost of these investments may be shared by others through the trading of the emission reductions that are produced. Furthermore, the viability of the investment over the life of the carbon abatement project may be locked-in through the sale of carbon allowances in the futures market. The ability to properly hedge investments in emission abatement projects would be completely lost if carbon taxation were adopted as the means of curbing greenhouse gas emissions.

Cap-and-trade encourages money to flow to those that have the opportunity to make a difference to the environment.

Cap-and-trade provides a company with the flexibility of making direct or indirect investments in emission abatement in order to comply with its carbon constraints.

The carbon market is the conduit through which money being invested will find its way to the best (lowest cost) emission abatement technologies and therefore provide the most efficient mechanism for tackling the climate change problem. Cap-and-trade is a zero sum game in economic terms as the money that flows through the system remains within industry.

A carbon tax, by contrast, would completely undermine this mechanism. Taxation would see the money flow away from the people with the ability to reduce greenhouse gas emissions, i.e. industry, to the people with no direct ability to reduce emissions, i.e. governments. Carbon taxation creates a leakage of money from the system. Once appropriated by governments these funds will be used for defence, healthcare, infrastructure, welfare and perhaps a very small proportion will find its way back to the environmental cause (probably to be wasted on the likes of Carbon Capture and Storage research which is not currently a cost effective solution and, while it may or may not provide a solution in the future, does nothing to curb greenhouse gas emissions today).

To date the British Government have categorically refused to hypothecate funds raised through the auctioning of Emission Allowances (a quasi carbon tax).  Angela Eagle, Exchequer Secretary to the Treasury, defended the Government’s position by suggesting that other money has been earmarked for environmental causes (so in effect the British Government is providing funds for the climate change cause with one hand and taking funds away with the other hand).

Additionally, if carbon taxes were ever introduced, at what level would a carbon tax be set? The open market mechanism of a cap-and-trade scheme creates a floating price for the emission of one metric tonne of carbon dioxide equivalent. The market price will naturally tend towards the marginal cost of emission abatement across all industry. Over the course of the past twelve months, this free floating pricing mechanism has seen the price of EU Carbon Allowances fluctuate between €30 and €8 per unit. At each moment in time this price represents the marginal cost of the requisite level of emission abatement necessary to achieve the emission targets prescribed by the emissions cap set by governments. With such wild fluctuations in the marginal cost of emission abatement (caused by many fundamental market drivers including the health of the economy, fuel prices and the weather), the task of setting a “one price fits all” carbon tax is quite impossible.

Finally, in respect to your comments that suggest that Europe has made a mess of emission trading, I would strongly disagree. The EU ETS is designed for one purpose only and that purpose is to achieve a carbon cap on industries caught within the EU ETS legislation. The price of carbon credits in the scheme represents the market’s estimate of the marginal unit cost of achieving the requisite reductions, a priori a high market price indicates that the EU is far from achieving its carbon target while a low price indicates that less needs to be achieved and so the target is closer to being achieved. Once the target is achieved carbon compliance units will have no value.

While it is rather unfortunate that it has taken a severe economic downturn to take us closer to our target than we were a year ago (carbon prices in Oct 2008 were €23.00 while in Oct 2009 they stand at €13.70), the fact is that we are moving closer to achieving the targets set by the EU for industry.

It follows that the market is achieving its objective exceptionally well and so Europe cannot be said to have made a mess of emission trading. The only logical position that one may take is that the caps that were set by the EU were too low and that a more ambitious cap could possibly have been achieved. However, when one considers that despite the Kyoto Protocol being agreed in 1997 it has only been the EU that has made any real concerted effort to abide by its carbon cap obligation under the legislation then relatively speaking the EU has done remarkably well to have achieved as much as it has. In reality it would have been impossible to have set carbon caps that were any more onerous on EU industry when their non-EU counterparts have been subject to absolutely no carbon constraints at all.

In conclusion, not only has the EU has achieved additional emission abatement through the introduction of an emission trading scheme, but more importantly the EU has put in place the trading infrastructure that may be used as the most efficient means of achieving the more challenging emission reduction targets that we will need to achieve in the future.

Yours sincerely

James Emanuel

  The original letter can be found here:

http://business.timesonline.co.uk/tol/business/columnists/article6863776.ece