Carbon credits: Enlisting market forces to combat climate change

One of the greatest environmental threats that our planet faces today is the potential for changes in the Earth’s climate and temperature patterns known as global climate change. Although fossil-fuel combustion has generated most of the buildup of climate-altering carbon dioxide (CO₂) in the atmosphere, effective solutions require more than just designing cleaner energy sources. Equally important is the establishment of institutions and strategies, particularly markets, business regulations and government policies, which provide economies with incentives to apply innovative technologies and practices that reduce emissions of CO₂ and other greenhouse gases. 
 
After years of opposition, hundreds of the world’s major companies and investments firms, including several oil giants, have agreed that carbon must have a higher price if the risk of catastrophic global warming is to be contained. This is crucial in discouraging the use of carbon based energy and stimulating investments in renewable energy. So far, seventy four countries, including the EU, China and Russia, but not the US and Canada, Japan or Australia, and about one thousand big businesses, including BP, Nestle and Coca Cola, have signed up to a UN Declaration in support of carbon pricing. An international carbon market may become soon a reality.

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The EU currently runs the world’s biggest carbon trading scheme, which means, there are limits on about forty five percent of total emissions from twenty eight member states, plus Iceland, Liechtenstein and Norway. More than eleven thousand power stations and manufacturing plants are covered. Under the system, companies that emit greenhouse gases can buy credits from “emission saving projects around the world”. They can be fined if they fail to buy enough allowances to cover their emissions.
 
A marketable asset
How does emission trading benefit companies and the environment? Companies A and B both emit 100,000 tonnes of CO2 per year. In their natural allocation plans, their governments give each of them emission allowances for 95,000 tonnes, having them to find ways to cover the shortfall of 5,000 allowances. This gives them a choice between reducing their emission by 5,000 tonnes, purchasing 5,000 allowances in the market or taking a position somewhere in between. Before deciding which option to pursue they compare the cost of each.
 
In the market, the price of an allowance at that moment is Euro 10 per tonne of CO2. Company A calculates that cutting its emission will cost it Euro 5 per tonne, so it decides to do this because it is cheaper than buying the necessary allowance. Company A even decides to take the opportunity to reduce its emissions not by 5,000 tons but by 10,000, to ensure that it will have no difficulty holding within its emissions limit for the next few years. Company B is in a different situation. Its reduction costs are Euro 15 per tonne, higher that the market price, so it decides to buy allowance instead of reducing emissions. Company A spends Euro 50,000 on cutting its emissions by 10,000 tonnes at a cost of Euro 5 per tonne, but then receives Euro 50,000 from selling the 5,000 allowances it no longer needs at the market price of Euro 10 each. This way, it offsets its emissions reduction costs by selling allowances, whereas without the emissions trading scheme, it would have had a net cost of Euro 25,000 to bear.
 
Company B spends Euro 50,000 on buying 5,000 allowances at a price of Euro 10 each. In the absence of this flexibility, it would have had to cut its emissions by 50,000 tons at a cost of Euro 75,000. Emissions trading thus brings a total cost saving of Euro 50,000 for the companies in this example. Since Company A chooses to cut its emissions (because this is the cheaper option in its case), the allowances that company B buys represents a real emissions reduction even if Company B did not reduce its own emissions.
 
Challenges

Several problems have emerged in the short history of the EU carbon market. Countries have struggled when handing out the property to be traded, the critical starting point for any market. Many of the allocation plans that each government devises have arrived late and have been incomplete. In some cases, they were laden with politically inspired manipulations designed to benefit favoured firms or business sectors. Some governments have pumped the market with cheap credits from the clean development mechanism, which lowers prices and therefore makes it easier for industry to comply with restrictions.

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The EU has also encountered trouble in ensuring that traders get access to accurate information on the supply and demand of carbon credits. During the 2005-2006 emissions trading scheme’s trial period, confusion in the market caused prices to gyrate from almost $40 per tonne of CO₂ to about a dollar today. The loss in value resulted when it became clear that governments massively oversupplied the market with permits, much as poorly managed central banks cause inflation by printing excess money. Brussels tightened the screws for the next trading period (2008 to 2012), which sent the price for those permits to about $25 each. 
 
Most controversial has been the distribution of permits to industry. The German government, for example, was keen to protect its coal industry. It awarded free credits to coal-fired electric power plants, whose owners then charged customers for carbon ‘costs’ they never had to pay. Most of Europe’s electricity markets are not competitive, which has allowed utilities to find such ways to keep those extra revenues for themselves. Similar malfeasance has occurred in other countries, including The Netherlands, Spain and the UK. In principle, the EU reviews each government’s allocation of credits so that favoured companies are not subsidised unfairly. In practice, however, member states hold most of the political cards and are not hesitant to deal them as they deem fit. It remains to be seen whether the Chinese scheme will be more rigorous.
 
The practical and political obstacles to widespread carbon pricing are daunting, in particular the challenge of linking regional systems together. Eighty two percent of the world’s energy is still produced by fossil fuels. Research funds allocated towards new forms of renewable energy remain minuscule compared to the $1 trillion invested annually in the extraction and transport of fossil fuels. There is still a long way to wean humanity off carbon, but carbon trading is a step forward.
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