The atmosphere is everybody’s property

In an article that appeared yesterday on Dollars & Sense as well as, Jim Boyce of UMass Amherst first breaks down all the climate policy we talk about into demand-side (encouraging energy efficiency, subsidizing renewables, investing in mass transit) and supply-side (putting a price on carbon emissions) approaches to reducing emissions. Then he does a really good job describing the latter: a carbon tax and a cap-based system, what they might look like, and how they differ. If you have trouble grasping these so-called ‘market-based’ climate solutions, this article is for your understanding of that debate. And if you already know all that stuff, the way Boyce explains it will probably be interesting and may even give you a new perspective on some aspects (it did for me).

A tax sets the price and allows the quantity of emissions to fluctuate. A cap sets the quantity and allows the price of emissions to fluctuate.

Then the piece goes on to advocate for a market-based policy that treats the atmosphere in a manner consistent with popular opinion: it’s a global commons — we all own it, so nobody should accumulate private wealth by profiting from using it as a waste dump. Even as we reduce emissions, there are huge profits to be made from burning fossil fuels. Let’s share them equally.

Notably, Boyce argues for applying the pricing system when fossil fuels “enter the economy” — when oil gets on a tanker or changes hands to slip into a pipeline; when coal leaves the mountaintop-removal operation or the strip mine; when natural gas leaves the fracking well. This method of pricing takes the costs straight to dirty energy companies and spreads them around the economy from there, such that goods whose production, distribution, or use involves a lot of carbon emissions will get much more expensive. So high-consumption wealthy regions can’t escape the economic costs by simply sending polluting industries to poorer areas. Instead, they might be forced to grapple with the big C: Consumption, the economic boogeyman we’ve been so reluctant to address.

In a world where emissions are ‘capped’, reducing consumption in rich nations would leave more atmospheric space for poor ones to consume and emit while they work to meet material needs and provide basic human rights. And if we split the revenues from auctions of limited carbon permits on an equal per-person basis, the least well-off members of society will benefit the most, since they contribute so little to climate change. Furthermore, over half the population would gain income greater than their increased expenditure from paying for the carbon in their lives, because shares of the global carbon footprint skew so heavily toward the wealthiest few.

Don’t take it from me. Read the damn article!


EU Emission Trading Scheme: Radical Proposal to Meet Ambitious Goals

To reach 2030 targets set by the new EU framework on climate and energy, I propose eliminating energy subsidies and instead using those funds to tighten the carbon market and reduce emissions cost-effectively

This is the fourth post in a series about the EU ETS

On January 22, the European Commission presented the new EU framework on climate and energy for 2030. The new document sets two binding targets: (1) 40 percent emission reductions from 1990 levels by 2030; and (2) 27 percent of energy produced from renewable sources.1

The path to meet these goals, however, is not so clear.

Environmental groups gathered in Brussels to urge the EU to support stronger climate targets for 2030. Yet even the goals set by the "weak" climate and energy package will be difficult to achieve without major policy reform. Source: WWF EU

Environmental groups gathered in Brussels to urge the EU to support stronger climate targets for 2030. Yet even the goals set by the “weak” climate and energy package will be difficult to achieve without major policy reform. Photograph: WWF EU

What is clear is that the EU Emission Trading Scheme (ETS) and various national climate programs and policies, as they exist now, will not produce the emissions reductions necessary to reach the 2030 targets, much less achieve levels of success that might persuade other high-emitting states to imitate the early adopters. Something must change.

I argue that European states should eliminate subsidies for renewable energy, instead deploying these funds to effectively lower the ETS cap. These subsidies for wind and solar power are popular among environmentalists, but simply providing financial incentives to carbon-free energy producers is an inefficient way to reduce greenhouse gas output.

What’s more, subsidizing certain emerging energy technologies undermines the cost-effectiveness of cap-and-trade. These two policies interact in a way that sabotages the economic benefits of a market-based climate solutions.

Even more absurdly, renewable energy subsidies in the EU don’t actually decrease total emissions. 

In terms of social equity, subsidies spread the costs of reducing emissions across all taxpayers, whereas a strong, well-designed carbon-trading system can force polluters to pay the brunt of the costs of transitioning to a low-carbon energy economy.

Policy failure

A recent article from The Economist on European climate policy calls the current emission-reduction efforts “a mess.” The piece, entitled “Worse than useless,” laments that Europe’s carbon market and incentives for renewable energy have proven to be immensely expensive approaches that have achieved only modest results:

“The cost of subsidies has been far greater than anyone had expected: €16 billion ($20 billion) in Germany in 2013, which works out at a massive €150-200 per tonne of carbon dioxide. (Home insulation, in contrast, saves money while reducing emissions.)”

New German 'superminister' Sigmar Gabriel plans to cut renewable energy subsidies to reign in rising electricity prices. Environmental organizations accuse him of favoring coal-fired electricity, which is still used to back up intermittent sources like wind and solar power. *Source*: Sean Gallup, Getty Images (Europe)

New German ‘superminister’ Sigmar Gabriel plans to cut renewable energy subsidies to reign in rising electricity prices. Environmental organizations accuse him of favoring coal-fired electricity, which is still used to back up intermittent sources like wind and solar power. Photograph: Sean Gallup, Getty Images (Europe)

Sigmar Gabriel, Germany’s minister for economy and energy, estimates even higher costs  — he calculates that private consumers pay an extra €24 billion per year on electricity to finance the country’s ‘feed-in tariff‘ program, which accelerates investment in new technologies by providing long-term contracts that pay renewable energy producers a fee above the retail electricity rate.

Meanwhile, the price of an emission allowance in the ETS hovers around 5 Euros per metric ton, which points to two clear corollaries: (1) the most expensive emission reductions necessary to meet the ‘cap’ of the cap-and-trade system cost just €5 per metric ton carbon dioxide-equivalent; and (2) this carbon cap — the overall limit on emissions within the system — can and should be lowered, a lot. I will elaborate both points.

Inexpensive mitigation

First, how do we know that it costs industrial emitters in the ETS less than €5 to mitigate one ton of carbon? Well, if it were to cost more than €5 to avoid a ton of carbon emissions, then that company could simply buy another emission allowance for €5 and proceed with emitting that ton.

Firms will do whichever is cheaper: decrease their emissions or buy allowances from other firms to permit their emissions.

This is the way that cap-and-trade advocates claim that a hard limit and a system of freely tradable ‘pollution permits’ will automatically produce the most cost-effective set of emission reductions across the economy. Germany has huge subsidies for renewable energy, but it takes €150-200 of ratepayer money, collected through an electricity surcharge, to avoid the same quantity of greenhouse gas emissions that the ETS prevents with €5 of corporate money.2

Lenient limit

To my second contention: the fact that carbon permits trade at €5 per ton shows that the cap is too high. As firms in a cap-and-trade system reduce emissions, they start with the least costly reductions and then work their way to more expensive strategies for decreasing greenhouse gases.

It’s clear that ETS companies are still working through cheap carbon fixes in their facilities, since market participants choose to perform the emission reductions necessary to meet the overall carbon limit rather than pay just €5 for an emission allowance.

If the cap is tightened, it will speed up the implementation of these low-cost emission reductions. And as it becomes more costly to make that last reduction — because the low-hanging fruit will have been picked — the price of an allowance will slowly increase.3

Policy interaction

The Economist makes another good critique of clean-energy subsidies: because German emissions are constrained by the EU ETS cap, subsidizing solar and wind power does not decrease emissions at all. Instead, these incentives for renewable energy only shift emission reductions away from other potential carbon-abatement strategies, like improving energy efficiency or fuel-switching from coal to natural gas.

Ultimately, the cap determines the total emissions from a carbon-trading system. Other climate policies like energy subsidies only alter the set of greenhouse gas reductions selected to meet the cap. Economists call this ‘distorting’ the market.

An example: let’s say I could renovate my German factory to use energy more efficiently — and thus reduce carbon emissions — for just €4 per ton of emission reductions. Alternatively, I could put solar panels on the roof for €5 per ton of emission reductions.4 But the German government will pay me extra for the electricity produced by my solar array — beyond what the power is actually worth — such that it effectively costs €3 per metric ton reduction. Well, I’ll choose the solar route, foregoing the less costly energy-efficiency project thanks to ratepayer-subsidized inefficiency!

Protracted bureaucracy

The EU 2030 framework bridges near-term climate and energy targets toward the 2050 goal of reducing greenhouse gas emissions 80 to 95 percent below 1990 levels. The policy framework proposes reform of the EU Emission Trading System (ETS) to address the oversupply of emission allowances that has built up in recent years, but these changes — the creation of a ‘market stability reserve’ and the rise of the annual emission ‘cap’ decrease from 1.74% to 2.2% each year — will not take effect until 2021.

To meet the new objective of 40 percent carbon reductions by 2030, the ETS will have to be either overhauled or scrapped in favor of simpler, more direct climate policy. At the very least, the EU must revamp its approach this decade, instead of waiting for the next one.5

But the EU is a big, bureaucratic monster with an entire continent of stakeholders. Progress comes slowly for the multinational, multi-body institution, even without dissent. The “Next steps” listed on the 2030 document’s official press release say that the European Council “is expected to consider the framework at its spring meeting” in March.

And when competing interests do fight over EU decisions, the work-rate of change implementation decelerates nearly to the standstill we see in US Congress. Poland, which produces 90 percent of its electricity by burning coal, will fight tooth-and-nail against strengthening the ETS.

Effective cap lowering

How can the carbon limit be effectively lowered in the short run while the European Union slowly transforms its climate strategy to meet the ambitious 2030 goal?

Germany plans to decommission its entire fleet of nuclear power plants by 2022, which will create pressure to build new fossil fuel-powered electricity generation. Source: DPA

Germany plans to decommission its entire fleet of nuclear power plants by 2022, which will create pressure to build new fossil fuel-powered electricity generation capacity, since wind and solar alone do not supply steady, 24/7 power. Photograph: DPA

Here’s one idea: Germany can cancel its €16 billion-per-year (or more) renewable energy subsidy program and use some of that money to retire emission allowances instead.

Consumers currently pay a surcharge on their electricity bill to finance the subsidies for wind power, biomass, hydropower, geothermal energy, and solar photovoltaics. I propose the German government redirect these funds toward paying itself to throw allowances in the shredder, essentially lowering the ETS limit by however many tons worth of allowances they are able to do away with.

This strategy of retiring carbon permits would actually reduce overall emissions, unlike the climate policies on which European states currently spend. Moreover, the effective cap lowering will drive up the price of allowances, as well as put energy efficiency on a level playing field with renewable energy, ensuring cost-effectiveness.

Yet redirecting government spending from encouraging climate-friendly energy to making emission allowances scarcer has two potential drawbacks, each of which I will address.

Developing industry

First, advocates of subsidizing renewable power argue that it drives the development of a young industry — one that must grow quickly if we are to transform our energy systems to run fossil fuel-free. By encouraging investment in low- and no-carbon energy production, these technologies advance more quickly and achieve higher penetration.

But the same argument can be made for energy efficiency. Emerging clean technologies allow us to attain the same energy services using fewer resources by simply reducing wasted energy.

Since these efficiency solutions decrease the need for burning fossil fuels, they are as effective as solar and wind power at reducing emissions — often at less cost. Thus the development of energy-efficient technology and expertise deserves to compete on even terms with renewable energy.

It could even be argued that reducing energy demand is more effective and better for the environment than replacing fossil fuel burning with renewable power, because solar and wind plants (1) provide electricity only intermittently; (2) use lots of land per unit of energy produced; and (3) require more resource inputs in their construction than the implementation of most energy-efficiency technology. From this perspective, fair market treatment of all emission-reduction strategies seems like the bare minimum for achieving optimal outcomes through cap-and-trade.

Social justice

Secondly, the regressive nature of market-based climate policies like cap-and-trade fuels a strong argument against cutting subsidies for specific emission-decreasing technology and using the savings to tighten the overall carbon limit.

As the price of a permit to emit greenhouse gases rises, the price of goods and services whose production is emission-intensive rises too. Buying emission allowances costs producers; like any cost of production, firms pass this expense on to consumers.

The lowest earners in an economy spend the greatest share of their income on necessities that entail emissions to produce, like electricity. So those with the least income are affected disproportionately as a rising carbon price drives up electric power bills.

The solution to this dilemma is simple. I will use Germany as an example once again: after getting rid of the €16 billion subsidy program, electricity prices will actually go down. Most of this money can be returned directly to the people through greatly reducing the surcharge on electric power.

EU member states like Germany get allocated allowances to auction to emitters, while some other allowances are freely distributed to firms, who can then trade them with one another. Therefore the German government need not purchase permits on the open market to drive up the price of carbon; instead, the number of allowances available for auction can simply be reduced.

In 2012, the German government assumed the above ETS revenues to finance their Special Energy Climate Fund. *Source*: Federal budget draft 2012, Federal Ministry of Finance, 12/20110706-Bundeshaushalt2012-Anlage2,templateId=raw,property=publicationFile.pdf

In 2012, the German government assumed the above ETS revenues to finance their Special Energy Climate Fund. Source: Federal budget draft 2012, Federal Ministry of Finance.

Of course, some of the €16 billion saved by eliminating the feed-in tariff subsidies for renewable energy will need to be used to offset the decrease in government revenue caused by auctioning off fewer allowances. But not nearly all of it.

Auction sales in 2014 are expected to feed about €3 billion into Germany’s Special Energy and Climate Fund for ETS revenue. Even if Germany withholds a third of the allowances set to be auctioned, it will still cost them less than €1 billion because the prices fetched at auction will rise thanks to scarcity.

Thus if revenue from the surcharge on electricity is used to tighten the carbon cap instead of subsidize renewable energy, this extra fee on the power bill can be reduced to about one-sixteenth its current size. So in Germany, reallocating funds to strengthen the emission trading system will in fact lower the price of electricity in addition to benefiting the climate. That is a progressive change, not a regressive one.

Moreover, even when emission-reducing programs like cap-and-trade are regressive within states or the EU, these policies are progressive from a worldwide perspective, because the costs of climate change are far more regressive than the burdens of cap-and-trade. The poorest and most vulnerable people on Earth will be affected most as sea level rises, droughts lengthen, storms intensify, and food production slows.

Reducing emissions through market-based climate policies in wealthy, high-emitting states helps protect the world’s least-well-off populations, since global warming is just that: global. The lowest-income people whom the policy may disproportionately impact within the EU — though not as lopsidedly as with energy subsidies — have much more wealth than the impoverished millions who stand to benefit the most if we avoid catastrophic climate change.

Widespread reform

Wind turbines in front of a brown coal-fired power plant near Bergheim, Germany. Massive investments in renewable energy have not eradicated the use of fossil fuels to produce electricity in Germany. Photograph: dpa picture alliance archive/A/Alamy

Wind turbines in front of a brown coal-fired power plant near Bergheim, Germany. Massive investments in renewable energy have not eradicated the use of fossil fuels to produce electricity in Germany. Photograph: dpa picture alliance archive/A/Alamy

Similar changes to my cap-tightening proposal can be implemented in many EU states that subsidize renewable energy. Saving money on subsidies can help countries like Spain achieve their budget goals without fudging the numbers.

If each state acts to remove energy subsidies and auction fewer allowances, then overall emissions within the ETS will drop like the Times Square ball on New Year’s. The price of carbon will increase, and businesses will undertake tons of new emission-reducing projects, starting with the least costly climate solutions.

To protect ourselves from worldwide ecological and economic devastation, we must drastically reduce the amount of climate pollution we emit. It matters much more that we save the climate than how we do it, but as long as economics exists, we may as well implement the lowest-cost emission reductions first.

Note: The policy proposal advocated in this blog post was developed from a lecture given by Western Washington University Professor of Economics Dan Hagen.


  1. A recent Ecofys study concludes that in order for Europe to contribute their ‘fair share’ to international emission-reduction efforts, the EU must set a 2030 target between 39% and 79%, with a median value of 49%. Sandbag’s effort sharing approach indicates that a goal of 65% below 1990 levels would be appropriate. 
  2. The cost of emission allowances is ultimately passed on to consumers through a tiny increase in the price of goods whose production is carbon-intensive. Economically, carbon trading works like any rise in the cost of production. 
  3. The cost to society of one CO2-equivalent ton of greenhouse gas emissions is more than 5 Euros. That much we can agree on, though climate economics nerds fiercely debate what the actual societal cost of carbon is. Many others think that putting a monetary value on climate pollution is silly, for a variety of reasons, including that catastrophic global climate change could destroy our entire economic system. In this piece I ignore the real value of reducing emissions and focus on how reductions can be achieved most cost-effectively. Read more about estimating the complete cost of carbon emissions in my blog post The Price Ain’t Right
  4. Obviously, energy projects are not priced by the amount of emission reductions they achieve, but skipping the calculations necessary to determine price-per-ton of carbon mitigation makes the example easier to follow. 
  5. In the meantime, the EU has approved a ‘backloading’ of allowances to reduce the cap the next few years, but this plan only shifts emissions to later in the decade (it’s a political compromise — take notes, US Congress). Read more about this weak attempt to resurrect the ETS in my blog post Band-Aid for a Broken Market

The EU Emission Trading Scheme: The Price Ain’t Right

Emission allowances in Europe are too cheap to prompt greenhouse gas reductions, but don’t ask the US government what the price of climate pollution should be, lest they mention the Social Cost of Carbon

This is the third post in a series about the EU ETS

Last week’s piece about the European Union Emission Trading Scheme (ETS) makes clear that persistently low prices on climate pollution prevent the carbon market from working effectively. That is to say, an emission allowance price that won’t budge above 5 Euros per metric ton of carbon dioxide will not drive investment in carbon-free innovation. Without a hurried global transition to low-emitting energy systems, the future looks bleak  —  our climate will become increasingly unstable and extreme.1

Market price

In a cap-and-trade system like the ETS, no central authority sets the price of greenhouse gas emissions. Instead the total number of allowances on the market sets a restrictive “carbon limit.”

Ideally, a scarcity of emission allowances would produce trades among emitting entities, with firms implementing the least costly emission-reduction strategies first. The price at which emitters trade allowances equals the cost of the last emission reduction necessary to meet the cap, according to economic theory.

So to drive up prices, the number of allowances must be reduced. In a closed system this lower cap would bring fewer emissions. The EU’s ‘backloading’ rescue plan employs this strategy by withholding carbon allowances until later in the decade.

Social Cost of Carbon

Nobody believes that €5 — or $6.80 U.S. — is the actual cost to society of one metric ton of carbon dioxide. But estimates of the true cost of greenhouse gas emissions vary widely.

If only figuring out the 'true' social cost of carbon were as easy as understanding a marginal benefit-marginal cost graph. *Source*: UK Eco Study

If only figuring out the ‘true’ social cost of carbon were as easy as understanding a marginal benefit-marginal cost graph. *Source*: UK Eco Study

Compare $6.80 to the latest revised estimates of the Obama Administration’s Interagency Working Group on the Social Cost of Carbon (SCC) — $37 per incremental metric ton of carbon emissions.

Note that $37 is simply the ‘cost of carbon’ that the group has chosen to publicize from the numerous results of an update to the SCC calculations. The SCC makes use of the averages of estimates from three integrated assessment models (IAMs) of climate projections, each run through five socio-economic reference scenarios.

The outcomes from the three IAMs are evaluated using three different discount rates, which are used to combine costs over time. The $37 estimate represents the average of all scenarios, discounted at 3 percent.2

I argue that the U.S. government’s calculation, though more than five times the price of carbon in Europe’s market, is still a very conservative estimate for four reasons.3

First, the chosen social discount rate is too high for assessing the costs of global climate change. For those familiar with discounting in a business setting, 3 percent may seem like a low rate — one that values the future highly at the expense of the present.4 But carbon dioxide emitted now will be causing atmospheric warming in fifty years; social costs and benefits that will affect the world far into the future are subject to a special social discount rate.

If you’re new to discount rates, you can think about them like an economist: costs that will be incurred further into the future carry less weight than immediate costs in today’s decisions (the same is true for future and present benefits). ‘Discounting’ future costs allows the SCC working group to unite today’s and tomorrow’s climate impacts into one Social Cost of Carbon.

But discounting can’t be applied equally to any analysis —  the rate at which future costs and benefits are discounted matters. A high discount rate gives the future less influence over today’s evaluations, because future values are ‘discounted’ a lot. On the other end of the spectrum, discounting at zero percent makes present and future costs equally important in economic analyses.

Researchers analyzing expected future values get to simply choose a discount rate they deem appropriate and defend as such. The following example demonstrates why we must acknowledge the importance of choosing carefully.

A few years back, Sir Nicolas Stern, a top adviser to the British government, and Yale professor William Nordhaus engaged in a polite-yet-heated intellectual dispute on this subject. Simply by applying different discount rates, Stern and Nordhaus used largely the same scientific data to prove that a ton of carbon should be priced at $85 and less than $10, respectively.5

The trillion-dollar question remains unanswered: At what rate should we discount the anticipated costs of global weirding when we play this name-a-carbon-price game? Only economics nerds like Stern and Nordhaus debate such matters. And they can’t seem to agree.

One group’s opinion is certain, though: if future generations had a seat at the carbon-pricing table, they would advocate a rate much lower than 3 percent. Yet-to-be-born people certainly would not favor employing a discount rate so high that it treats people 24 years from now as if their lives are worth half as much as ours today.6

So 3 percent is too high — discounting the values of the future that quickly might lead us to destroy the planet in pursuit of riches that can’t buy back a stable climate. But we must discount at least a little to account for the fact that present gains can be invested in making the future better. Today’s profits from a fossil fuel-based economy could hypothetically fund the development of tomorrow’s clean-energy technology.

I am not qualified to have an opinion on the optimal social discount rate for evaluating the economic impacts of the climate crisis on our children and grandchildren, but we all know what’s at stake. The future of the planet can’t be assessed in the same way as a typical investment, even a typical investment in public goods or social welfare.

For intergenerational issues, even guidelines from the Obama Administration’s Office of Management and Budget promote using a discount rate less than 3 percent. I guess that department of the executive branch never spoke with the group developing the SCC.

To reiterate my first point, social discount rates, in order to treat future people equitably, must be low enough that they allow consequences that won’t show up until decades — even centuries — from now to shape our present evaluations and actions.

Second, the $37 Social Cost of Carbon completely ignores catastrophic climate risk. The range of climate change risk scenarios is not distributed in such a way that lends itself to looking at the average when establishing a Social Cost of Carbon.

The chance that global warming may produce cataclysmic effects — outcomes in which the standard of living to which we’ve become accustomed in the modern world is no longer achievable — make it hard to justify simply taxing greenhouse gas emissions based on the average climate change-socioeconomic scenario and then continuing our business-as-usual pursuit of profit maximization.

Check out the 'long tail' costs of extreme climate change in the far-right column. *Source*: Interagency Working Group on Social Cost of Carbon, United States Government. May 2013 Technical Update of the Social Cost of Carbon for Regulatory Impact Analysis.

Check out the ‘long tail’ costs of extreme climate change in the far-right column. Also, notice how much the ‘average’ Social Cost of Carbon increases just by discounting at 2.5 rather than 3 percent. *Source*: Interagency Working Group on Social Cost of Carbon, United States Government. May 2013 Technical Update of the Social Cost of Carbon for Regulatory Impact Analysis.

In technical terms, the worst-case effects of climate change would cause a great deal more damage than the economic models’ 50th percentile predictions. Statisticians call this phenomenon a long tail. In practice, the abnormal distribution of impact scenarios suggests that we should proceed with caution.

Even the Obama Administration’s report acknowledges the risks of the most extreme climate scenarios by including an extra SCC value, in addition to the average result at each of three chosen discount rates. This fourth calculation illustrates “higher-than-expected economic impacts from climate change further out in the tails of the … distribution.”7

The fourth SCC figure is the models’ 95th percentile value, at 3 percent discounting. In May 2013, this estimate was $109 per metric ton — nearly three times the publicized “average” Social Cost of Carbon.8

This discrepancy illustrates the massive risk to which we expose our world and ourselves if we simply take the average of all projections when planning for the warmer future.9

The third reason that the Social Cost of Carbon estimate is too low has to do with the trend of all climate change estimates and projections — and the fact that reality has far outpaced most models. With each new Assessment Report, the Intergovernmental Panel on Climate Change (IPCC) has become more certain about the anthropogenic causes of our warming planet, and the group’s projections for the future are increasingly ominous and confident.

This pattern of worse and worse forecasts from the leading international body for climate change study should not be ignored. Why shouldn’t we expect the prognoses to continue their descent into the realm of doomsday prophecies?

One reason that the future predictions keep getting more dismal is that models must be repeatedly updated to take into account climate change impacts arriving earlier than even the worst-case scenarios of earlier studies. Sea-level rise and the diminishing of Arctic sea ice extent are just two items in the list of climate consequences coming on more quickly than had been previously projected by the IPCC.

Studies that underestimate the degree of future change are often called “conservative,” but I argue that with respect to climate change, the conservative way to predict the future would be to plan for the most catastrophic scenario. The Obama Administration should raise their SCC to avoid making the same mistakes as the IPCC.10

Lastly, even the “conservative” IPCC, in their Fourth Assessment Report, remarks that the Social Cost of Carbon “very likely…underestimates” the damages of climate change. And the US EPA itself admits, “The models used to develop SCC estimates…do not currently include all of the important physical, ecological, and economic impacts of climate change recognized in the climate change literature.”

Limitations of data availability and model construction render impossible the task of aggregating all of the costs of climate pollution, even if emissions could be accurately measured and the future could be accurately predicted. Moreover, some of the costs of climate change are difficult to quantify. What is the present-value total cost of future ocean acidification?

In fact, the economics literature that informs the SCC often omits severe expected climate-change impacts simply because they do not lend themselves to monetization. Species extinction, for example, is not easy to economically value, and thus is left out of many climate economics models.

Because data is imperfect and models ignore many non-market anticipated costs, we should heed the Precautionary Principle. We should acknowledge that it is in our collective best interest to accept and apply a greater social cost of carbon than our complex models calculate.

The European Corollary

If the US estimate of carbon emissions’ external cost is not comprehensive enough, forward-looking enough, ‘trendy’ enough, or vigilant enough — all of which skew the SCC figure toward inexpensiveness — then the almost-negligible price of an allowance in the European carbon trade must be far too low. Yet the ETS is a cap-and-trade system rather than an emission tax; nobody directly sets the price of carbon.

Do low prices mean that the cap-and-trade system failed? Or that it is working so well that emission allowances have become nearly worthless simply because total emissions stay under the ‘cap’ more cheaply than expected? Most economists would respond in the same way they answer most tough questions: “It depends.”

It depends how the  goals of the ETS are defined. It depends whom you ask. It depends on whether or not you believe in putting a price on pollution. It always depends on the discount rate.

President Truman once requested a “one-handed economist” because he was sick of hearing, “On the one hand, … On other hand, …” Well, this series of blog posts about the EU ETS may end up looking as if it were written by the Indian deity Durga — there will be a piece about every viewpoint.

The following addendum provides a glimpse into a once-prevalent perspective that has been regaining momentum recently: that the cost of ecological destruction cannot be expressed in dollars and cents. Certainly this argument deserves its own long-winded post; the next section is only a preview.

Non-monetizable harm

Evidently, using money as a metric assumes that anything can be traded for anything else. The idea that every cost and benefit in the world can be ‘dollarized’ provokes doubts from many non-economists (and from some scholars within the economics community).

Hard-to-quantify losses, like the aforementioned extinction, lead to an important dilemma. Assigning a dollar value to the survival of polar bears as a species suggests that for this amount of money society could be compensated for the end of that animal’s existence. Such a human-centric view offends people who think of the world from an ecological perspective.

On the other hand, if we exclude unmonetized damages from the societal cost of carbon — or exile them to the oft-ignored ‘caveat’ and verbal qualification appendices — then these costs are treated as effectively insignificant. In a capitalist world-economy, ‘priceless’ sounds a heck-of-a-lot like ‘worthless.’

  1. For a basic explanation of the ETS and its current predicament, check out my blog post “Band-Aid for a Broken Market.” 
  2. The Interagency Working Group ran each climate and socio-economic scenario combination with 2, 3, and 5 percent discounting. 
  3. “Conservative estimate,” in this case, means “way too low.” But remember that America is still the Land of the Free (right to pollute the climate) — the Social Cost of Carbon is, at this point, an intellectual exercise. 
  4. In the world of business, discount rates typically mirror the cost of capital or expected return on an investment of similar risk profile. For example, if I can invest my money somewhere guaranteed grow 5 percent yearly, then the future income generated by any other potential investment should be discounted at 5 percent per year, since I could just put all my money into the guaranteed-5-percent fund. 
  5. What’s more, they each had very convincing arguments defending their choice of discount rate. One sentence simplified summaries follow: Nordhaus, rather than deciding upon a rate at which we “should” discount future costs and benefits, used market interest rates to determine peoples’ actual time preferences. Stern, on the other hand, considers discounting with respect to climate change a moral issue, making a case that we should take intergenerational equity and sustainable development into account when examining alternate trajectories that diverge vastly and are highly uncertain. 
  6. According to the superscientific Rule of 72
  7. Interagency Working Group on Social Cost of Carbon. (2013). Technical Update of the Social Cost of Carbon for Regulatory Impact Analysis. United States Government. 
  8. Before the November 2013 revision, the official SCC was $38. Again, this number was based on the average of every ‘run’ of the models. The results were discounted at 3 percent. 
  9. For reference, a few sources (one more) calculate that every dollar-per-metric ton increase in the price of carbon dioxide emissions will result in a one cent-per-gallon hike in gasoline prices. According to that hypothesis, a carbon tax of $109 would add just over a dollar to the price of a gallon of gas, while pricing emissions at the level suggested by the Obama Administration’s SCC would raise gas prices by a third as much. That the U.S. Social Cost of Carbon estimate would have such a small effect on consumer prices plainly illustrates how absurdly cheap carbon is in the EU’s cap-and-trade system. 
  10. And of course the Social Cost of Carbon should be implemented as something more than a theoretical exercise. 

The EU Emission Trading Scheme: Band-Aid for a Broken Market

The EU passed a spongy amendment to soak up some surplus carbon permits in their flooded cap-and-trade scheme, but the ‘backloading’ plan only delays emissions until later in the decade

This is the second post in a series about the EU ETS

Economists generally believe that if money incentives for individuals and businesses match benefits and costs for all of society, then goals like protecting the environment will be achieved automatically. For example, a fee representing our electricity’s contribution to the costs of global climate change should make us decrease our power usage, reducing carbon emissions by simply acting in our own interest.1

This theory provides the basic reasoning behind the European Union Emission Trading Scheme (ETS). Europe’s massive cap-and-trade system puts a price on carbon pollution through a complicated permit market rather than a simple fee, but the concept is the same: producers have to pay for their emissions, and this climate-impact charge is then passed on to consumers.

Transaction prices do not normally take climate pollution into account because it is a global environmental cost   it’s spread upon everyone instead of affecting just the buyer and seller of some good whose production or use causes emissions. In general, market mechanisms like emissions trading can safeguard natural resources from overuse and degradation by adding societal costs to prices.

Economists call this ‘internalizing‘ an external cost. And it only works if the price is right.

Market resuscitation

On Monday, December 16 the European Union finalized approval for a measure intended to revive the market for emissions allowances. These freely tradeable allowances act as permits for large industrial facilities like coal-fired power plants or steel mills to spew greenhouse gases into the atmosphere. Companies in the ETS must surrender one allowance for each metric ton of carbon dioxide (CO2) they emit.

The total number of allowances issued sets a ‘cap’ on emissions within the system. According to neoclassical economic theory, ETS members will trade allowances among the group to meet the predetermined cap with the lowest-possible-cost set of emissions reductions.

The carbon trading system needs saving because the right to contribute to global climate change can be purchased quite cheaply allowance prices are far too low to incentivize emissions reductions.

Backloading proposal

The European Union’s rescue plan involves delaying the distribution of 900 million allowances that were set to be available in the next three years. The proposal, called ‘backloading’, transfers those withheld permits to years later in the decade. The aim is to drive up prices in the ETS by increasing scarcity.

Yet news of the withholding measure hardly affected market prices. On Saturday, December 14, Thomson Reuters’ Point Carbon website reported that the price of a permit closed at just €4.80, or $6.60 the exact amount at which they were traded before the plan passed in EU Parliament the week before. For comparison, EU policy makers envisioned permit prices around €25 or €30 when they designed the ETS.

Oversupply of allowances causes low prices in the ETS. A flood of extra permits has inundated the market a few times in the system’s eight-year history, preventing carbon prices from reaching levels that might induce utilities to commit to low-carbon energy generation.

Price collapse I

In the carbon market’s first phase (2005-2007), EU member states allocated too many allowances in response to intense lobbying from ETS emitters and uncertainty about baseline emissions. During this period overall emissions from the trading system increased by nearly 2 percent, yet still fell short of the too-loose cap set by allowance distribution.

Carbon prices fell near zero for all of 2007 because of the over-allocation. Some firms had reduced emissions in anticipation of allowance prices up to €30 the April 2006 peak level but in the end a non-restricting cap hardly disturbed business-as-usual emissions growth.

Supporters of the ETS dismiss the 2007 price crash, calling Phase I a pilot period intended to establish baselines and set up a greenhouse gas market rather than produce significant emission reductions. Unreliable data on past emissions, very small reduction goals, and the intricacy of predicting future emissions made an allowance surplus likely from the beginning, according to a report by MIT economists.

Price collapse II

Oxford economist Dieter Helm uses this graph to show how the ETS' price crashes could be avoided with a set carbon tax. *Data*: Bloomberg. *Graph*:

Oxford economist Dieter Helm uses this graph to show how the ETS’ price crashes could be avoided with a set carbon tax. Data: Bloomberg. Graph:

The second phase of the ETS (2008-2012) provided a chance to restore a functioning market and to begin decreasing emissions toward the scheme’s 2020 goal of 21 percent reduction below 2005 levels. These goals complement one another: all else equal, tightening the carbon cap drives up allowance prices.

In 2008, the price rose over €20 per ton CO2, but the schedule for annually decreasing emissions did not anticipate the Great Recession. The global financial crisis led to a decrease in output from energy-intensive sectors, causing emissions from ETS members to fall. Greenhouse gas emissions decreased simply because economic activity slowed; thus firms needed very little abatement to meet the cap.

Carbon prices dropped as diminished demand for allowances made them abundant once again. As Phase II ended in December 2012, permits had been consistently traded at less than €10 for over a year.

Phase III

The beginning of the third phase brought a few small changes to the ETS, including tighter limits on the use of carbon ‘offsets’ and the addition of Croatia to the trading scheme. Yet Phase III brought no immediate market adjustments that might lift the price of emission allowances.

Prior to the recent adoption of the backloading amendment, industrial emitters, the EU Parliament, and national governments had clashed for 16 months over proposals to intervene in the carbon market.

On one side of the debate, environmental activists and economists alike emphasize that the ETS cannot stimulate the climate-saving investment necessary to reduce emissions unless the allowance price includes more of the full cost of atmospheric warming. On the other side, politicians from high-emitting countries like Poland  which burns coal for about 90 percent of its electricity production  side with industry interests, opposing any meddling in the market for fear that a steeper carbon price might hurt fossil fuel-burning sectors of the economy.

Rescue, then reform

The Climate Change Committee will update European Union regulations over carbon-permit auctions in January 2014. The committee, which includes representatives from national governments, will determine details of the backloading measure such as exact dates and amounts of allowances to be withheld.

It may seem that the passage of a rescue plan to alleviate the glut of allowances marks the culmination of this lengthy debate over how   and if   to tweak the EU carbon market. But it is really only a first step; major structural reform will be necessary to salvage the scheme’s status as the centerpiece of Europe’s climate policy.

The long haul

Saving the carbon trading system may require leaving behind the ideal of a ‘free-market’ solution, according to a report from the London School of Economics. Regulating the price or supply of allowances goes against key principles of cap-and-trade, but letting capitalist market incentives drive emission reductions has not worked so far in the ETS.

The European Commission published its first report on the carbon market in November 2012, presenting six possible longer-term structural changes.2 Proposed reform options include strengthening the EU’s greenhouse gas-reduction goal for 2020 from 20 percent to 30 percent below 1990 levels, permanently withdrawing allowances, or expanding the ETS to cover more sectors.

The choices for further altering the ETS will elicit passionate responses from all stakeholders  the drawn-out disagreements over a short-term fix for the carbon market were likely just a prologue to the looming quarrel. The European Commission’s suggestions are a good starting point for discussion; they are strong proposals that can give the scheme the big makeover it needs.

With or without successful revitalization, the system will hobble onward. Dismantling the EU Emission Trading Scheme would prove just as difficult as amending it.

  1. Maybe saying the environment will be protected ‘automatically’ is an oversimplification of economic theory, but assume that (1) we are rational and (2) we know exactly how changing electricity consumption affects our utility bill. We will consume exactly the amount of electric power that equates the marginal costs and benefits of electricity use. If we are charged for the power plant greenhouse gas emissions associated with our electricity use, then buying an energy-efficient furnace or turning off our computers at night might make more sense than without a carbon pricing mechanism. 
  2. Find a link to the state-of-the-ETS report as well as the initial proposal and impact assessment for the backloading amendment  here

The EU Emission Trading Scheme: An American Perspective

Europe’s too-intricate-for-just-one-blog-post carbon market

The European Union Emission Trading Scheme (ETS) is a multinational carbon market. Policymakers created the ETS to economically incentivize cost-effective reductions in climate-warming emissions among over 11,000 of Europe’s biggest climate polluters.

This cap-and-trade system serves as an exemplary model for climate policy, right? Shouldn’t climate activists in the United States demand Congress adopt something similar? Even better, the U.S. could enact parallel legislation and then integrate the top American greenhouse gas emitters into the European trading system, setting the foundation for a global carbon market!

As Lee Corso would put it: Not so fast, my friend. Europe’s ETS can hardly be considered the prototype for a functioning market-based climate change solution.

Cheap to pollute

European companies must have permits for their emissions, but the price is not steep. *Source*: European Commission.

European companies must have permits for their emissions, but the price is not steep. Source: European Commission.

For one, the current price to purchase a permit sits just under €5. Each permit, or allowance, is good for the release of one metric ton of carbon into our atmosphere.

For the corporations that own the large industrial facilities and power plants of the European emissions trading market, that’s pocket change. Five Euros per metric ton will not drive investment in the technologies necessary to create a low-carbon energy system.

Outsourcing emissions

Moreover, the smokestacks covered by the ETS account for less than half of total greenhouse gas emissions from the 28 European Union countries. And even if a cap-and-trade system could hypothetically include every emitter in the EU, carbon leakages would remain an intractable issue without an all-inclusive international market.

Put simply, if the climate pollution emanating from one region is subject to a predetermined limit, and in this way a price is placed on emissions, then high-emitting activities like steelmaking will simply relocate to areas outside of the system — places where emissions remain uncapped and thus free.

Side effects

The EU Emissions Trading Scheme has even more shortcomings: The system has brought about massive fraud as well as windfall profits for huge emitters. More importantly, it has indirectly caused human rights abuses to some of the world’s most vulnerable people thanks to the fundamentally flawed concept of carbon offsets.

Total ETS emissions have fallen sharply since the system was put in place in 2005, but how much of that decrease is related to the 2008 dip in economic output? Chart: Environmental Defense Fund. GDP data: World Bank. EU emissions: A. Denny Ellerman, “The EU ETS: Path to the Future or Dead-end?” European Environment Agency. 

Total ETS emissions have fallen sharply since the system was put in place in 2005, but how much of that decrease was caused by the economic recession? Chart: Environmental Defense Fund. GDP data: World Bank. ETS emissions: A. Denny Ellerman, “The EU ETS: Path to the Future or Dead-end?” European Environment Agency. 

Yet the system seems to be working from a perspective focusing narrowly on industrial climate pollution. Total emissions from the installations regulated under the ETS have fallen since the system was first implemented in 2005. In fact, greenhouse gas emissions among participants in the system have decreased even faster than the cap has tightened.

This drop in emissions within the system has led to an oversupply of allowances. Consequently, the ETS price to emit greenhouse gases has plunged far below the level that might reflect such emissions’ cost to society. In technical terms, the externality is nowhere near ‘internalized’ into the market price of goods whose production entails significant climate pollution.

Even with an emissions trading system in place, Europeans don’t pay for the global warming costs of the things they buy.

An American perspective

For an American like me, it’s worth taking a look at Europe’s complicated carbon market.

The day will arrive at last when climate legislation becomes politically feasible in Washington, DC. Before we rush to the conclusion that complex cap-and-trade systems will successfully reduce greenhouse gas emissions in the most cost-effective way possible, as prevailing economic theory promises, we should evaluate every aspect of the European scheme in place, from efficacy to unintended consequences.

Assessing the world’s largest illustration of the most popular policy solution to global climate change warrants thorough examination. Which means more blog posts — a series on the economics, narratives, and divergent views of the EU ETS.