Emissions trading - notes on a scandal

Another day, another broadside against carbon emissions trading. The FT's Martin Wolf offers advice to the new Chancellor, including:

While simplifying tax, he should also take a close look at green taxation. Simple taxes that apply across-the-board are what is needed. The grant of valuable rights to big polluters through systems known as “cap-and-trade” is a scandal. [here]

This is an increasing theme, with even American giants like Alan Greenspan and Paul Volker coming out against cap 'n' trade and in favour of a carbon tax [see article]. I have to say I'm ever more swayed by this view, see my posting To Cap or to Tax.

But is the EU system 'a scandal', as Martin Wolf says? You can certainly make the case - the permits are given away to businesses, but they are valuable because they are scarce 'property rights' - the right to use the atmospheric sink for carbon. It's hard to put an exact value on these permits - see charts of the market price for EU allowances from Point Carbon showing the collapse of price in 2007 but a steady price of about €20 so far for the future price of 2008 EUAs... but in total they are worth a great deal.

€billions for what purpose?
So if, say, €20/tCO2 is used to give an illustrative value of the ETS price, the value of the rights to emit over 200MtCO2 to UK industry comes to over €4.3 billion. To the power sector alone, it comes to €2.7 billion (see numbers in this Google spreadsheet based on 2005-06 ETS results [XLS]. The power sector is especially annoying because it actually passes these costs on to the consumer, even though it doesn't actually pay for the permits, which are mostly given away in the EU system. They have adopted this as an accounting convention, reflecting the opportunity cost of holding the allowance for each unit of electricity sold. They can pull this trick off because they are an oligopoly and don't face competition from producers outside the system. So even allowing for the permits that they have to buy because they are given fewer allowances than they need, the power companies profit from this by €1.8 billion... and the bigger and dirtier they are, the more they make, because allowances are given to them in proportion to their historic emissions! What exactly is the public purpose served by transferring billions from energy consumers to energy company shareholders in approximate proportion to how polluting they are? Is that a scandal? Well you could defend it by saying that it was necessary to get the system off the ground - an argument that works if and only if the system is changed as soon as possible. Alternatively, you could see it as gullible fearful governments and bureaucrats being outsmarted at every turn with the poor public bearing the cost for nothing.

What to do?
This does in fact partially implement the polluter pays principle, in that the consumer is effectively 'taxed' for their pollution through this system because the permit costs are passed on. It's just that the 'tax' revenue goes to the companies not the government - and therefore the scope to do something useful with €4+ billion in the UK is lost. The answer is to auction the permits so that the government gets the revenue. The international competition arguments against making them buy their right to pollute are mostly hogwash and really apply only with force where the industry is energy intensive and highly traded internationally. Excellent analysis by Grubb & Neuhoff summarised by the Carbon Trust, [here] suggest that competitiveness is a minor concern and only aluminium should be a worry. There should be no question of violating the polluter pays principle, options include ideally reaching international sectoral agreements through the Kyoto Protocol or tax adjustments at borders to correct for ETS costs for trade across EU borders.

A novel approach for aviation in the ETS...
My suggestion is to bring as much EU aviation as possible into the system but give the sector no initial allowances at all. This would mean it would have to buy CDM credits or allowances from other emitters in the EU system. This has the equivalent effect of making 'carbon offsetting' mandatory for all flights. It's economically equivalent to taxing aviation and spending the proceeds on reducing emissions in developing countries.

This lot needs to be agreed in time for the third phase of the EU ETS - which starts after 2012, but is under discussion now.