Cracking Copenhagen’s curse

Emissions trading schemes (ETS) have two major flaws preventing a global deal on climate policy. Government-determined design features, not “market failure”, are the cause.

The government’s recent release of the Mid-Year Economic and Fiscal Outlook (MYEFO) hinted at the first design flaw.

It noted an increase in the value of the $A, and consequent greater Australian purchases of cheaper overseas permits, would lower the price of permits issued in Australia. Revenue from sales of Australian permits would fall. So would government capacity to finance “compensation” to various interest groups. This is simply the “market-based” ETS/CPRS at work.

This revelation is but the tip of the iceberg in terms of its global ETS implications.

International trading of emissions permits is a design feature of ETS (and the CPRS). Those buying permits will try to source them from countries with the lowest price, while sellers will try to sell in the highest priced countries.

Let’s call this international trade “permit arbitrage”.

Sources of “permit arbitrage” include: (i) initial permit allocations between countries that result in different initial permit prices across countries; and (ii) currency fluctuations that have the same effect (as noted in the recent MYEFO).

“Permit arbitrage” shifts any initial permit allocation under a global ETS deal away from low price countries to high price countries until any price difference disappears.

Isn’t this just sensible trade in permits?

Yes - for trade in permits. However, under a binding global ETS, international sales of permits reduce the selling country’s capacity for ETS-compliant economic growth.

“Permit arbitrage” shifts the initial global allocation of permits away from countries with low initial permit prices, and further constrains their capacity for growth. That growth capacity is added to the initial growth capacity of the countries buying the permits.

There’s the rub.

Any conceivable global deal involving current ETS models will require tough emissions caps for developed countries, and softer caps for developing countries. Initial permit prices will probably be much higher in richer countries than in poorer countries.

Subsequent “permit arbitrage” increases constraints on growth in poorer countries, beyond what they agreed, and reduces them in richer countries, as permits flow from the former to the latter.

Poorer countries might use permit sale proceeds to buy more goods and services from rich countries to make up for their own more limited growth capacity under a binding ETS.

Is a policy that increases rich countries’ sales of products to poor countries, financed by sales of permits that further limit poor countries’ capacity to improve their own living standards via indigenous economic development, an intended outcome?

Whatever its global merits, this ETS model shifts economic control to rich countries, with less growth and trade for poor countries, financed by selling growth capacity to the rich.

This won’t appeal to developing economies. They are unlikely to “sign on” to any global deal based on this model.

The current ETS model also targets national production, within a policy context requiring non-harmonised national action on climate policy - the second design flaw. This causes “carbon leakage”.

“Carbon leakage” occurs when different national emissions permit prices (including zero in countries not acting) shift economic activity and jobs to countries with lower (or zero) permit prices. This is especially relevant where countries decide to adopt an ETS targeting their national emissions production, in a non-harmonised international policy action context.

“First movers” suffer losses in competitiveness compared with “late movers” or “no movers”. By putting a price on carbon first, “first movers” make their exports, and import-competing products, more expensive compared with substitutes produced in “late mover” or “no mover” countries.

This “negative protection” feature of ETS models (including the CPRS) is a powerful incentive not to be a “first mover”. It’s a strong incentive for developed countries not to act first (or only to pretend to act). It’s also a strong incentive for all countries to act last, or not at all.

The first flaw noted above is a big “turn-off” to developing countries. The second is a “turn-off” to developed countries first, if they are expected to take the lead on emissions reductions, and then to all others. Together, these “own-goal” design flaws constitute an anthropogenic barrier to global emissions reduction action.

It’s not surprising that the host country has now defined “success” in Copenhagen as: securing a “binding political agreement”. This oxymoronic benchmark is in the best traditions of modern “spin”.

There’s a way to eliminate these disincentives to a global deal:

• ban international trade in emissions permits, and require countries to meet their agreed targets internally, rather than offload part of the task to other countries;
• start with a carbon tax rather than an ETS, which allows differentiated action across countries without the adverse trade consequences noted above;
• target national consumption of emissions rather than production, eliminating “negative protection” effects inherent in the CPRS and other ETS models, and eliminate all special deals for “trade exposed” sectors as well; and
• start with a modest carbon tax, with a predictable longer-term path for increasing its rate, to provide investment certainty.

Some might argue this alternative won’t work. If so, it’s no worse than the Kyoto Protocol. But it’s got one clear advantage over that model. It hasn’t been tried yet.