Global cooling
Australia’s carbon pollution reduction scheme – to be unveiled in all its legislative minutiae, if not its glory, next week – is not the only carbon trading regime facing a severe test of its credibility.
The European Trading Scheme, being the first of its kind, has acted like something of a crash test dummy for global carbon trading. The lesson of the first phase of the scheme was that proper auditing of emission levels is essential. The scheme almost blew itself up in 2007 when it was discovered that way too many permits had been issued to countries who did their calculations on the back of an envelope, and added a little more for pocket money and R’on (later on), and the carbon price slumped to next to nothing.
Now, in phase two, the ETS is facing a new crisis and another price collapse caused partly by the deep economic recession, but also due to two characteristics that it has in common with the proposed Australian scheme – the fixing of a rigid emissions cap far in advance, and the free allocation of permits.
Business Spectator has previously noted how the deep recession is causing a flood of carbon credits on the market as energy utilities – far from having to buy credits on the market, and having the incentive to make the transformation necessary to reduce the burden – are simply cashing in their excess credits and using the ETS as a cheap source of funding (A second carbon windfall, January 28).
The price of carbon credits in Europe plunged to near €8 last month, from a peak of more than €31. Though it is back up to just over €10, the €8 level is considered significant as it is the minimum price under which the United Nation’s clean development mechanism – the ambitious but highly complex and contested scheme to bring developed nations into the fold – is considered workable.
Deutsche Bank’s Mark Lewis, a Paris based analyst considered to one of the foremost carbon trading experts in the world, says this is not a good development, and that if European carbon prices remain stuck at such low levels, it could become a serious political embarrassment in the lead-up to the crucial climate negotiations at Copenhagen at the end of the year.
“Given its status as the global flagship, what is at issue with the EU-ETS is not just its own credibility, but the credibility of a market per se to deliver on climate policy targets.”
Lewis argues for greater flexibility in setting emissions caps, and also questions the issuing of so many free permits, suggesting that such actions completely distort the market.
That leads right back to the debate that we are nearly having in Australia and that is currently in train in the US about the merits of a carbon tax versus a carbon trading scheme. President Obama has signalled his preference for cap-and-trade, and analysts predict that such a scheme could raise $1 trillion to fund renewable energy and health care programs.
However, unless such a scheme is robust enough to send a price signal that drives transformation, it is waste of time, which is why green groups in Australia have withdrawn their support for the CPRS as it currently stands.
Intriguingly, both Lewis and Emmanuel Fages, another Paris-based carbon analyst at Societe Generale, have embraced the concept of a “central bank of carbon”, an idea first proposed by the ANU economist and RBA board member Warwick McKibbin (The McKibbin protocol, July 3, 2008) as part of his 'hybrid' carbon regime (The great carbon debate, November 16, 2007) which combines a tax, a “carbon copy” of the long term bond market to ensure long term reductions, and a central bank pulling the levers of short term supply to even out market variables.
Lewis and Fages say that such a central bank of carbon would regulate the supply of emissions permits in a similar way to a central bank regulating monetary supply, either by holding and storing when supply is over-abundant, as it is at the current time, or by selling if a sudden shortage sends prices spiralling beyond the parameters of the scheme.
“A central bank would have been able to intervene from time to time to ensure that the market remained within the parameters of the policy objectives, whatever the prevailing economic, weather or commodity price conditions,” Lewis says.
He also argues for the EU to consider a reserve price for the next phase of the ETS, which will run from 2013 to 2020, to ensure its credibility. In this way, he says, the authorities would be reminding the market what the underlying purpose of the ETS was, and forcing it to focus on the long-term policy objective.
The latest McKinsey quarterly hosts a debate on this issue, with Brookings Institution’s Gregg Easterbrook arguing for a carbon tax because it is simple, effective and less bureaucratic. He says carbon taxes will offer a clear, easy-to-understand profit incentive to those who devise carbon-reduction technology, while cap-and-trade programs will offer an incentive to game the system. He argues a tax provides a motive for inventors and energy developers, while a trading system simply provides a motive for pollsters and lobbyists.
Interestingly, the proponents of cap and trade in the McKinsey debate are leaning to the McKibbin model. Cater Bales, the head of private equity firm Wicks Group, and Richard Duke, a market specialist, argue that a cap and trade scheme offers more investor certainty because it establishes clear, long-term abatement requirements and allows the private sector to estimate the allowance prices needed to get the job done.
They believe – despite the experience of the ETS – that a carbon tax would likely start too low to provide much of an incentive, because of political pressures. But they also argue for specific tax-like provisions in the scheme and, more importantly, for the ability of a government (or its representative such as a central bank), to purchase and delete allowances if the price falls below a gradually rising floor.
In short, they argue, if a cap-and-trade scheme is to function and deliver on its purpose, it needs to be well designed.
And this is the principal criticism of Rudd’s CPRS. Given the current economic conditions, and the huge cuts in industrial production, and therefore emissions, it is almost certain to follow the path of the ETS and create excess credits and a carbon price so low it proves meaningless and ineffective. In short, it needs bite, and it needs flexibility.
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