Greenhouse markets
The Kyoto Protocol of 1997 set targets for greenhouse gas emissions. Like other countries, Britain has had to devise a scheme to meet its target. Will a government levy on use of energy or a market in emission permits (or both) work best?
Buying the right to pollute sounds perverse. Surely, people say, business (especially "big" business) should be prevented from polluting at all. But this is not what markets in pollution-or, more specifically, emissions of greenhouse gases-are about. They aim to find a more efficient means of meeting environmental targets. This article examines how the rules are being set for such a market in Britain. The story might turn out to be a happy one: an example of innovative public policy helping to achieve goals, with the grain of the market, which might otherwise cause much more pain and disruption. But it also shows how difficult it is to make policy in such a complex area-and as Prospect went to press, the Treasury was about to announce measures which would either kill or save the scheme.
The Kyoto Protocol
Not so long ago, the production of greenhouse gases was cost-free. Although environmentalists had worried for years about their effect on the atmosphere, reactions to the warnings were halfhearted. There was no way of putting a value (or a disvalue) on the production of the gases. The Kyoto Protocol, agreed in December 1997, changed all that. The protocol was devised to control global warming by setting targets for greenhouse gas emissions-although it has not yet been ratified by the US. Setting such targets has allowed us to put a cost on the production of these gases for the first time.
Under Kyoto, the EU is committed to reducing emissions of greenhouse gases (six gases, including carbon dioxide) to 8 per cent below 1990 levels by the period 2008 to 2012. As its share of this commitment, Britain has accepted a legally-binding target of a 12.5 per cent reduction on a 1990 base to 189m tonnes. This means finding an additional reduction of 5m tonnes of carbon.
This is not the place to discuss the effect this may or may not have on global warming, nor whether the US will ratify the agreement. Of course, both these issues are important, but they are independent of the mechanisms by which Britain will reach the targets to which it is now committed.
Some mechanisms have been suggested as part of the Kyoto protocol itself. These include the establishment of an international emissions trading scheme and two mechanisms whereby countries can use carbon-reducing investments in other countries to compensate for their own emissions. The international trading scheme is still in its infancy; it will not be sorted out until the end of next year. Even then it may not be fully resolved.
The interested parties
Three groups in Britain are making a contribution to the development of policy in this area. The first is the government, which has legal responsibility for delivering the agreed target. A number of government departments are involved in this process: the Department of Environment, Transport and the Regions; the Department of Trade and Industry; and the Treasury. (We might also include in this group public agencies with responsibility for environmental matters, although these have somewhat different agendas).
Then there are non-governmental organisations (NGOs) such as Greenpeace, Friends of the Earth and Forum for the Future, which lobby on environmental issues. The third group is business, which will certainly be affected by policies to reduce emissions-especially given the failure of the last government's attempt to impose higher taxes on consumers' use of fuel.
The views of these three groups are usually easy enough to predict. NGOs believe that business should be more heavily regulated to prevent it from doing bad things, while business always resists any attempt to reduce its autonomy. Meanwhile, government usually likes regulation, and in any case wants to be sure that its (legally binding) targets can be met. But on emissions trading they are all taking more sophisticated positions. NGOs are at pains to argue that regulation can enhance competitiveness. Individual businesses are paying serious attention to environmental issues, and several, such as Shell and BP Amoco, have published environmental audits. BP has even imposed experimental greenhouse gas targets on its business units and set up an internal trading scheme to deliver them. A larger group of businesses came together last year to think about how to deliver Britain's Kyoto targets and the kinds of market mechanisms which might help. Government wants to deliver targets with minimum burden on business and it asked Colin Marshall, the British Airways chairman, to produce a report on how to do this. The report was published last autumn.
The Proposals
In mid-1998, discussions began about a trading scheme for emissions, sponsored by the Advisory Committee on Business and the Environment (ACBE) and the CBI. But progress on this was diverted by the government plan-announced in the March 1999 Budget-to introduce a climate change levy (CCL) on business use of energy. The levy aims to increase energy efficiency and reduce emissions. It is also expected to raise ?1.75 billion for the Treasury, although for most companies the levy will be partly covered by a compensating reduction in national insurance contributions. The government has also offered an opportunity to reduce the burden of the levy, if energy-intensive sectors are willing to accept sector-based targets for their own emissions.
The energy-intensive businesses most affected by the CCL are worried that the levy will be an additional threat to their competitiveness at a time when the strong pound is already a problem. Most are much more enthusiastic about the plans for a domestic trading scheme for emissions which would allow them to meet their targets more flexibly. Such schemes have already been shown to work, for example, in sulphur dioxide trading in the US. Denmark, Norway and Australia are already working on their own versions.
The CCL and the emissions trading scheme are alternative-and potentially conflicting- policy routes to the same objective. It soon became clear that the government was not about to abandon the levy, but the businesses interested in emissions trading also saw no reason to abandon their plans. Thus, at a meeting in June 1999, CEOs of interested companies-including Blue Circle, British Gas and Du Pont-agreed to set up an emissions trading group (ETG), chaired by Rodney Chase, deputy chief executive of BP Amoco, to come up with a workable scheme before the next pre-Budget statement. To the astonishment of everybody involved, an agreed scheme, supported by more than 25 big companies, was presented to ministers on 27th October.
Trading Emissions: the Scheme
So what has been agreed? A market has been created to trade in permits issued by the government to companies which have voluntarily accepted limits on their emissions-this is known as "cap and trade." Consider it this way: the government issues a company with permits allowing emission of 5m tonnes of CO2 for one year. If the company reduces its emissions below 5m tonnes it can sell permits to a company which wants to pollute over its "cap." The emissions permits cover all greenhouse gases, and are defined and measured in terms of CO2 equivalent. In time, such permits should have international validity-an important matter to some of the businesses involved.
How is the permitted emission cap arrived at? Caps are usually calculated on the basis of the average of emissions over a period of preceding years. This creates an absolute pollution limit which can then be expressed in permits. In Britain, however, the capping calculation has been hugely (perhaps fatally) complicated by the CCL. When the government first proposed to reduce the burden of the levy on energy-intensive sectors willing to accept targets for energy use and emissions, it insisted on negotiating with sector associations rather than with individual companies. But these associations were unwilling to negotiate binding limits on emissions for the group as a whole because, they said, this would involve problems of confidentiality and enforcement. Unlike, say, Germany, Britain has no tradition of strong business associations acting on behalf of companies.
The associations were also concerned about the effect of growth on absolute emission limits. They therefore lobbied successfully for the targets to be set in relation to energy efficiency, as an alternative to absolute limits. This means that if output goes up but emissions rise more slowly, a company will not be penalised. (If a company has 5m units of output and 5m tonnes of emission, its energy efficiency ratio is 1. If it increases output to 8m but emissions are only 7m, its energy efficiency ratio will improve despite higher absolute emissions.) CCL agreements are due to be completed by the end of the year and almost all sectors are currently expected to reject absolute limits.
The ETG aimed to create a relatively large and straightforward market in permits. But tradeable permits are much more problematic without absolute limits. If permits were to be issued to both groups (those with energy efficiency targets and those with absolute limits) on the same basis, there would be no upper limit to the number of permits-faster growth would simply mean more permits. These would not be valid in an international market. They would also be unacceptable to the government. So a two-part market has been created. Companies with energy efficiency targets may trade with each other, although they will need to translate their sector target into a company-based equivalent. But they cannot trade freely with the companies with absolute limits. They can freely buy-this does not dilute the number of permits in circulation-but they can only sell outside their own group if it can be shown that permit numbers overall do not increase.
Will it work?
In principle, a trading scheme will help deliver emissions targets. It allows businesses which find it difficult to reduce emissions to buy from those which find it easier. It avoids the need to produce a set of regulations which will be appropriate for all companies. In theory, we could find a tax rate which would produce just the right incentive, but this would require huge amounts of information. Markets are good at providing simple substitutes for such information-in the form of a price.
It could be argued-and many businesses do argue-that a levy on energy use/emissions is misguided; and that a market, combined with an auction of permits, would do the job just as well. But people tend to think that pollution is something which must be paid for-and payment should be made to government. (That ?1.75 billion is now included in the Treasury revenue forecasts- and hence immovable.) Others still maintain that "command and control" regulation is a better tool. One institution where the command and control approach is rooted is the European commission.
The commission already impinges on emissions trading in various ways. A European directive controls emissions on a site-by-site basis. The emissions of several greenhouse gases, such as NOx and SOx, are controlled on relevant sites on the basis of Bat-best available technique. These provisions are now enshrined in British law. In addition, consultation on control of carbon dioxide has just been completed. It differs from the above gases in that it is not a local pollutant. It does not affect people near the plant; rather, its effects are on global atmosphere. None the less, if a Bat approach is applied to carbon dioxide emissions, then industrial plants will be forced to conform to whatever standards are imposed, and the necessary margin for improvement-a precondition for trading permits-will disappear. (This is also a problem with CCL.) Not all industrial plants are covered by the directive, but large sites invariably are, and these are likely to be the basis for trading. In addition, the commission is examining the form which emissions trading may take, and there is a lobby in favour of controlling all trading-not just by registering trades, but by having the right to approve the price.
Markets and Mechanisms
The delivery of an emissions target with minimum economic disruption is a complex task. The methods we choose must acknowledge the depth of our ignorance. This is not so much ignorance about the way in which global warming occurs (although that ignorance, too, is huge), but ignorance about the ways in which enterprises will react to signals.
The story of how an emissions trading scheme has been designed is at once hopeful and depressing. It has involved unusual levels of cooperation between businesses, and with government. It has required individuals to rise above their parochial concerns in order to make something happen. There are important issues to resolve, but there is no doubt that the permit scheme is feasible.
But this is also a case study in institutional conflict. The CCL has complicated the picture by making trading more difficult and also by reducing the margin for improvement on which permit selling depends (the same problem created by EU directives). A further anomaly concerns the power companies. CCL has been designed as a tax on the consumers of energy, not on its producers. Yet it is these which have most experience in environmental matters and responsibility for much of the actual emissions by industry.
Unlike many other developed countries (including Germany), Britain will have little difficulty reaching its Kyoto targets because so many oil and coal-fired power stations have been phased out in the recent "dash for gas." Nevertheless, the progressive attitude of many of our business leaders combined with the skill of our best civil servants suggests that we can be in the vanguard of emissions trading. Such trading offers the best solution to emissions reduction with minimum impact. I can't be sure about the precise outcomes, but I don't have to be. To avoid unintended consequences, it is best to invite them.
Bridget Rosewell
The author is chairman of Volterra Consulting and has also represented Blue Circle Industries on the Emissions Trading Group
