An inconvenient economic truth

Observations on carbon trading

Britain’s faith in carbon trading as a way of reducing greenhouse gases could be dangerously misplaced, according to an independent academic working with the Department of Energy and Climate Change.

Dr Chris Hope of the University of Cambridge’s Judge Business School has been commissioned by the government to calculate how much environmental polluters would have to be

charged for emitting CO2 to make it worthwhile for them to cut back. However, his research, due to be delivered to the government later this year, has led him to a far wider conclusion: that the current European Emissions Trading Scheme (ETS) is deeply flawed and should be replaced – or at least augmented – with a green tax.

Under the ETS, companies or countries are given quotas for their annual carbon emissions. If they exceed the quota, they have to buy extra from others who have undershot their limit. However, if they become more efficient, and so generate less CO2 than their quota, they can sell the surplus and make a profit. This raises a vital question: how much should energy users be charged for each tonne of CO2 they emit? For the ETS to work, the price has to be set at a level that makes it worthwhile for consumers to cut their energy use.

According to Hope’s research, the minimum price needed is about £85 per tonne, rising at roughly 2 to 3 per cent a year. What’s more, this price needs to show long-term stability. After all, the whole point of putting a price on carbon emissions is to place

a financial burden on heavy environmental polluters. If carbon prices fell, then that burden would shrink and there would be little incentive to improve efficiency.

So far, so simple – but Hope has reached a second, personal

and, for the government, far more embarrassing conclusion. He believes a market-based trading system such as the ETS is very unlikely to generate consistent high prices, and this instability could undermine the whole point of the scheme. The heart of the issue is a problem we are all sadly familiar with: financial markets are highly variable, with prices liable to surge and collapse. Hope says that the first two phases of the ETS have illustrated the problem: the prices of CO2 emissions quotas fell so low as to be almost worthless. Prices now stand at roughly £9.50 per tonne of CO2 – less than 12 per cent of what Hope’s calculations show is needed.

The alternative, he says, is to put a price directly on carbon. Hope means that Britain and Europe must consider a system of carbon taxes, by which a surcharge would be placed on gas, oil and coal according to how much CO2 they generate. Such a carbon tax on fossil fuels would lead to sharp rises in prices for electricity and heating – perhaps by up to 50 per cent. This sounds politically unacceptable but not, Hope believes, if the money were used to cut other taxes such as VAT or income tax. He calculates that the UK government could gain about £50bn in annual revenues – equivalent to roughly 10 per cent

of the current total tax take. “With this new source of revenue, they could then reduce other taxes such as VAT and income tax,” he says.

Ed Miliband, Britain’s Energy and Climate Change Secretary, defends the carbon cap-and-trade system. “The current low carbon price is a market response to the global economic crisis and is not a good guide to the future carbon price,” he said recently. “Cap-and-trade is still the right way to go.”

Hope, who worked with Lord Stern on the 2006 Stern Review on the economics of climate change, is in good company, however. At this month’s climate science summit in Copenhagen, William Nordhaus, Sterling Professor of Economics at Yale University, attacked cap-and-trade as unworkable, arguing that today’s low carbon price is an “inconvenient economic truth” that politicians are unwilling to face. “The world is making a huge wager that the cap-and-trade system will eventually do the job of slowing global warming,” he said. “To bet the climate on a model with such clear structural flaws is a reckless gamble.”

Jonathan Leake is the science and environment editor of the Sunday Times