Oscar Reyes and Tamra Gilbertson: Carbon Trading -- How It Works and Why It Fails

Carbon Trading: How it Works and Why it Fails
by Oscar Reyes and Tamra Gilbertson
New Left Project

Emissions trading is the EU’s flagship measure for tackling climate change, and it is failing badly. While in theory it provides a cheap and efficient means to limit greenhouse gas reductions within an ever-tightening cap, in practice it has rewarded major polluters with windfall profits, whilst undermining efforts to reduce pollution and achieve a more equitable and sustainable economy. This article briefly examines the theory of carbon trading, then looks at the empirical record of the EU Emissions Trading System and the UN Clean Development Mechanism - the world’s largest carbon trading schemes. It then briefly surveys the many alternative and equitable ways to tackle climate change.

Proponents of carbon trading argue that it offers a way for companies to `internalise’ the economic costs of climate change. It enables them to put a price on climate change impacts, which traditional economists would describe as an `externality’ - something that remains off the balance sheet and is therefore not taken into account when decisions are made. Putting a price on carbon is seen as allowing this `externality’ to be included in a company’s balance sheet. This is achieved either through taxation or trading (though the latter is claimed to be more flexible and corporate-friendly). The hidden hand of the market then guides finance towards the cheapest options for tackling climate change.

But there are some fundamental problems with this conception. Firstly, the claim that markets offer the cheapest solutions for tackling climate change begs the question: cheapest for whom and over what timescale? In fact carbon markets have tended to pursue short-term `fixes’, whilst displacing the responsibility for tackling climate change onto the global South. In this respect, such markets are promoting climate injustice.

Secondly, the adoption of carbon pricing through carbon trading entails a reframing of the climate change debate. It presumes that global warming can be addressed by the relatively simple translation of `unpriced’ pollution into a tradable, ownable commodity. This reduces the politics of climate change to a simple economic calculation about how to incentivise shifts in private sector investment. In so doing, it closes down the space for asking the very questions that are crucial if we are to make the structural changes that might tackle climate change: what changes do we need for escaping from our dependence on fossil fuels? What `development paradigms’ are being pursued? What environmental regulations are appropriate and just? What public investment programmes are needed, and how can community control of these finances be ensured? Is constant economic growth compatible with greenhouse gas emissions reductions?

More generally - and partly because of this reframing - the idea that the trading of `carbon’ as a commodity will address climate change implies that there is no need to ask key questions about where and when changes should be made. Even if the theory worked out as planned - which is far from the case - it would end up chasing the cheapest short-term cuts, incentivising quick fixes to patch up outmoded power stations and factories, rather than pursuing more fundamental changes. Moreover, what is cheap in the short term does not translate to an environmentally effective or socially just solution over the long term.

Cap and trade

There are two main forms that carbon trading takes: `cap and trade’ and offsetting. Under cap and trade schemes, governments or intergovernmental bodies set an overall legal limit on emissions in a certain time period (`a cap’) and then grant industries a certain number of licenses to pollute (`carbon permits’ or `emissions allowances’). Companies that do not meet their cap can buy permits from others that have a surplus (`a trade’). The idea is that a scarcity of permits to pollute should encourage their price to rise; and the resulting additional cost to industry and power producers should then encourage them to pollute less. The empirical evidence, however, suggests that the incentives created by the scheme work very differently - awarding profits to polluters and encouraging continued investment in fossil fuel-based technologies, while disadvantaging industry that is focused on transition away from fossil fuels. This is not an arbitrary product of misapplied rules; it is a product of the way these markets reinforce existing power relations, thereby contributing to unjust economic decision-making.

The world’s largest cap and trade scheme is the European Union Emissions Trading Scheme (EU ETS). It has created a trade in European Union Allowances (EUAs), which are allocated according to National Allocation Plans, which are in turn subject to European Commission approval. The EU ETS covers approximately 11,500 power stations, factories and refineries in 30 countries - the 27 EU member states, plus Norway, Iceland and Lichtenstein. These account for almost half of the EU’s CO2 emissions, and include most of the largest single, static emissions sources, including power and heat generation, oil refineries, iron and steel, pulp and paper, cement, lime and glass production.

In the first phase of the scheme, from 2005 to 2008, however, far too many emissions permits were handed out to these industries - largely as a result of intensive corporate lobbying. When the first emissions data was released in April 2006, it showed that 4 per cent more permits were handed out than the actual level of emissions within the EU. In other words, the `cap’ did not cap anything. Nor was it just the first year of the scheme that was over-allocated. By the end of phase 1, emitters had been given permits to emit 130 million tonnes more CO2 than they actually did, a surplus of 2.1 per cent. As a result the price of carbon permits collapsed and never recovered. From a peak of around 30, the price slid below 10 in April 2006, and below 1 in the spring of 2007.

A further major criticism levelled at the first phase of the EU ETS is that it generated huge `windfall profits’ for power producers, helping them to make large unearned financial gains as a result of flaws in the rules rather than any proactive measures taken to reduce emissions through structural changes. An inquiry by the UK Parliament’s Environmental Audit Committee found that `it is widely accepted that UK power generators are likely to make substantial windfall profits from the EU ETS amounting to £500 million a year or more’. At first glance, this seems contradictory. How can polluters profit when the value of the credits in the scheme fell to almost nothing? The answer lies in the way energy companies account for the costs of the EU ETS. The costs that are indirectly passed on to consumers through an increase in wholesale energy prices do not reflect what carbon credits actually cost, but rather what the companies assume they may cost. This leaves considerable scope for over-estimates. First, by assuming a larger than necessary need to buy permits or credits; second, by assuming that there will be a high carbon price; and third, by assuming the costs of replacing EU Allowances, irrespective of their actual use of offset credits, which in any case have consistently commanded lower prices. When these assumptions have turned out to be over-generous, the surplus is more often pocketed as profit than returned.

The same problems of over-allocated permits and windfall profits for polluters are occurring in the second phase of the EU scheme, which runs from 2008 to 2012. Research by market analysts Point Carbon, for example, has calculated that the likely windfall profits made by power companies in phase 2 could be between 23 billion and 71 billion (and between 6 and 15 billion for UK power producers alone). Given that the majority of permits are still allocated for free, the EU ETS is effectively providing a subsidy stream for highly polluting industry. The example of ArcelorMittal, the world’s largest steelmaker and the holder of the greatest surplus of EU ETS permits, is instructive. It has routinely been awarded a surplus of permits of around 25 to 35 per cent above its actual level of emissions, and this has allowed the company to gain a subsidy of up to 2 billion since 2005. A recent Carbon Rich List survey, meanwhile, concluded that the 10 industries (mostly steel and cement companies) with the largest surplus of permits stand to gain over 3.5 billion in subsidies between 2008 and 2012.

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