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April 25, 2007


Some Inconvenient Truths

The Financial Times has uncovered some stumbling blocks on the road to carbon neutrality.  Its multi-part report starts with a useful tutorial:

Offsetting is a fundamental principle of the Kyoto protocol – an agreement among more than 160 countries that came into force in 2005. It allows developed nations to meet emissions reduction targets by funding projects such as wind farms or solar panels in poorer countries through the so-called “clean development mechanism”. This awards such projects “carbon credits”. The credits, which can be traded on the international carbon markets, sell for between $5 and $15 (€3.66-€11, £2.50-£7.50) per tonne of carbon dioxide. To aid comparison, other greenhouse gases – such as nitrous oxide and methane – are measured as equivalents of CO2.

Carbon markets have grown rapidly since they were brought into being by the Kyoto treaty and the start of the European Union’s emissions trading scheme in 2005, under which companies were issued with tradeable permits to emit carbon. The price of carbon in the EU scheme more than halved last year after it was revealed that more permits had been issued than were needed in the first phase, from 2005 to 2007.

In the first nine months of 2006, according to the United Nations and World Bank, up to $22bn of carbon was traded. About $18bn of this was through the EU’s emissions trading scheme, and $3bn through the Kyoto mechanism.

The third element, the voluntary market, is where most offsets are bought. Businesses participating in this are not bound to reduce emissions, unlike companies under the EU trading scheme or governments under Kyoto. In 2005, the World Bank estimates, the voluntary market formed under 1 per cent of global dealings, trading fewer than 10m tonnes of carbon a year. But by 2010, the consultancy ICF International forecasts it will grow 40-fold to be worth $4bn.

Most companies going carbon-neutral use intermediaries to buy offsets on their behalf.

According to the FT, however, all has not gone well:

The FT investigation found:

■ Widespread instances of people and organisations buying worthless credits that do not yield any reductions in carbon emissions.

■ Industrial companies profiting from doing very little – or from gaining carbon credits on the basis of efficiency gains from which they have already benefited substantially.

■ Brokers providing services of questionable or no value.

■ A shortage of verification, making it difficult for buyers to assess the true value of carbon credits.

■ Companies and individuals being charged over the odds for the private purchase of European Union carbon permits that have plummeted in value because they do not result in emissions cuts.

In the end, the FT editors conclude that it's time to join the Pigou club:

The Kyoto protocol to fight climate change expires in 2012. The shape of a successor treaty is still in doubt, but one aspect seems certain: carbon trading will play a major role. A Financial Times investigation today reveals that carbon markets leave much room for unverifiable manipulation. Taxes are better, partly because they are less vulnerable to such improprieties.

I'm waiting to hear a good case made to the contrary.

UPDATE:  More on the topic, from Greg Mankiw and from Felix Salmon.

UPDATE AGAIN: Yet more at Reviving Economics: Here, here, and here.

April 25, 2007 in Energy, This, That, and the Other | Permalink

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A carbon tax program is not going to eliminate the problems with compliance and monitoring. You still need to figure out who is polluting and by how much, and to verify any claims of output reduction. This has to occur within a multinational framework where many countries are going to be motivated to cheat and to assist their local industries. The system doesn't regulate itself.

Another big question with taxes is whether there would be tax credits for projects that sequester carbon. From the policy perspective, this is desirable: if someone can come up with a cost-effective technology to remove carbon from the air, we would want to reward them. If everyone else has to pay to put carbon into the air, they should get paid to remove carbon from the air.

But once we do this, I think we would see many of the same problems of abuse and misdirection that have bedeviled the carbon credit program. If someone is planting a forest and wants to claim a tax credit, how do we know that the trees are really going to be allowed to grow for the next 50 years? Particularly in the third world, the institutions necessary for accountability and monitoring just do not exist.

While a Pigouvian carbon tax does make economic sense and is probably simpler to implement than cap and trade, it is far from a simple fix. Advocates should be prepared to face the same kinds of messes and problems that the EU carbon trading system has run into in its first years.

Posted by: Hal | April 26, 2007 at 12:41 PM

I forgot to mention another problem with a carbon tax: setting the level. The paradox is that setting the carbon tax rate at a level corresponding to economic estimates of future harm will probably not produce significant reductions in greenhouse gases.

A commonly bandied about figure is $100 per ton of carbon. This is actually rather high compared to most analyses. (Tol[1] reviewed the literature in 2005 and found that $14/tC was the median among over 100 studies, with higher quality studies producing lower values.) The Stern report did come up with a higher number but that is something of an outlier and has been criticized for unreasonably low discount rates[2].

But even if we use $100/tC, that is only about 20 cents a gallon of gasoline. That's going to be a drop in the bucket compared to existing European gasoline taxes. And even in the U.S. it's largely going to be lost in the noise of our month to month gas price fluctuations. I can't believe that an extra 20 cent gas tax is going to force anyone to conserve significantly or change their habits to reduce CO2 emissions.

It may be easy to sign up for the Pigou tax program, but when it is time to bell the cat and put a number on the table for the cost to put a ton of carbon into the air, I think we're going to see a lot less agreement. It's pretty tough to come up with a number that is both scientifically defensible as a cost, and which will also lead to realistic CO2 reductions.

[1] http://www.uni-hamburg.de/Wiss/FB/15/Sustainability/enpolmargcost.pdf
[2] http://www.econ.yale.edu/~nordhaus/homepage/SternReviewD2.pdf

Posted by: Hal | April 26, 2007 at 12:56 PM

Hal,

the short-run elasticity e.g. of gasoline demand with respect to the gasoline price maybe very low, but the long-run effects are much more pronounced. Although it will not likely reduce the mileage, it will definitely make buyers shift toward more efficient cars. The difference between U.S. and Europe does not need to be mentioned. It's like with the recent hike with gasoline prices - it had a deniable effect for the moment, but I bet that people think much more about fuel consumption when they get their new car.

A similar development is likely to be seen in the energy efficiency of housing, an area where there are even higher reserves, I believe.

Having said that, I have to agree with you that 20 cents per gallon (I am relying here on your claim) is very small. In this respect, the increases in market prices will have a much stronger impact. (I was tempted to write "were much better", but did not, since I am not convinced at all what is "better" in this game).

Posted by: pinus | April 26, 2007 at 01:31 PM

Taxes at the point of production of coal, oil, and natural gas should be moderately simple. Other pollutants, even water vapor, should be considered but unless concentrated would probably not be workable. Subsidies for technologies that lower demand and increase efficiency should be more substantial, measurable, and concentrated. Sequestration is more difficult as all the energy inputs must considered and are often difficult to measure. Many actions may have impacts which are nearly incalcuable.

Posted by: Lord | April 26, 2007 at 03:19 PM

Hal -- Your points are well taken. Conceptually the cap-and-trade system will look like some sort of equivalent tax scheme, as Greg Mankiw points out. You note the issue with tax credits, and that does seem to be part of the problem. By way of analogy, think about a tax policy designed to increase saving. We can either tax consumption or subsidize saving. We can construct these policies so that they are in an abstract sense equivalent, but with the latter it might be harder to eliminate loopholes that merely involve shifting around behavior. (Think tax-preferred accounts vs other forms of saving.) I could be wrong, but I take it from the FT article that this is what is happening to some degree with the carbon-trading system. Perhaps there is a way to construct the trading system that avoids that particular problem, but it seems easy with a tax system -- just don't go down the road of crediting particular types of activity (inputs) and focus on outputs. Not easy to do, but it seems to me that applies to both approaches more or less equally once a trading system involves caps.

Posted by: Dave Altig | April 28, 2007 at 09:53 AM

Another issue with regard to a Pigou tax, which is touched on in some of the articles you link to, is what to do with the embarrassing windfall of tax revenues. Classic Pigovian theory would be to rebate them to the public more or less evenhandedly. In practice everyone seems to feel that they have better ideas, whether Mankiw's reduction of corporate income taxes or alternative proposals to boost renewable fuel research.

Actually we in the U.S. are lucky. Since carbon pollution is a global problem, it needs to be solved on a global level. A global Pigouvian tax of say $100/tC would collect $200 billion/year in the U.S. based on per capita U.S. emission of about 7 tC/year. Since worldwide average emission levels are only about 1.4 tC/yr, 80% of the U.S. tax receipts should be distributed to the 100-odd countries which emit less than the global average. This $160 billion will make a nice supplement to our existing foreign aid budget of $15 billion and will no doubt be welcomed by the third world.

The bottom line is that to really do Pigou right most Western countries will have to divert the great majority of these new tax revenues to the poor countries of the world which are getting harmed by global warming caused by the rich. It is plainly equitable, but given the relatively modest funding levels foreign aid has achieved in the past it is questionable how well this will go over as part of the Pigou package.

Carbon numbers from http://www.nationmaster.com/graph/env_co2_emi_percap-environment-co2-emissions-per-capita (dividing by 3 since that page shows CO2 rather than C emissions).

Posted by: Hal | April 29, 2007 at 02:47 AM

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