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Cap and Trade Doesn't Work

Obama can learn a thing or two from Europe's scheme

From: the Wall Street Journal, European edition The Obama administration has, as expected, re-engaged the U.S. in the negotiations for a global climate change mitigation regime after the Kyoto protocol expires at the end of 2012. A bill setting greenhouse gas reduction targets is currently progressing through Congress, with strong backing from the president. But apart from the warm feeling that comes with an improvement in America's international image, what is likely to be achieved in real terms, and at what cost? To get a good idea, U.S. policy makers need only look across the Atlantic. The European Union, keen to show global leadership, introduced the world's first Emissions Trading Scheme (ETS) in January 2005, just before the Kyoto protocol came into force. The principle of this and similar schemes -- including the proposed U.S. cap and trade regime -- is that certain sectors of industry are allocated permits to emit fixed amounts of carbon dioxide, held to be the primary driver of climate change. If they manage to reduce emissions more than planned, companies can sell their excess permits; if they need more, they have to buy them. Advocates of the system like it because "the polluter pays." Setting aside for the moment the question of whether it is justifiable to call carbon dioxide a pollutant, companies of course do not simply absorb these extra costs. Instead, they pass them on to their customers who are also, by and large, taxpayers. Not only does the taxpayer carry the cost of any cap and trade scheme, but their money also provides profit for a whole new industry: the new carbon trading sector, the middlemen who make the system work. Unlike normal tradable commodities, carbon dioxide emissions can only be estimated, rather than quantified exactly. And it is only international agreements and national law that give these permits a price at all. The result is a system open to misuse, since all parties -- seller, middleman and buyer -- have an incentive and opportunity to manipulate the estimates. Sellers want to show how much they are reducing their emissions, buyers benefit from lower prices as more units come to market, and traders do good business in a buoyant market. The biggest abuse began right at the start of the ETS when regulators handed out too many free permits. As a result, utilities companies made windfall profits by simply selling on large numbers of unneeded credits and not passing the savings on to their customers in the form of price cuts. Despite the EU's declared goal to dole out permits based on objective criteria, industry lobbying led to an overallocation. When push comes to shove, governments will always protect their national champions. The German government, for example, negotiated an easing of planned caps on emissions from cars to the advantage of manufacturers of higher-powered cars such as Mercedes-Benz and Porsche. And this is in a bloc where the environmentalists have far more influence than in America. Translated across the Atlantic, any climate change bill will become the subject of the worst kind of pork-barrel politics riddled with loopholes for key industries before it becomes law. This is already evident in the attitude of a significant number of Democratic Congressmen. Rather than back the bill, as many had assumed, they are looking for changes to protect powerful interests (and their own votes) in their constituencies. States with strong coal mining sectors are particularly vulnerable to cap and trade legislation, and, in the words of Democratic Representative Dennis Cardoza from California "the EPA under President Obama "doesn't get rural America." His Democratic colleague Tim Holden "I have grave concerns about where the administration is going on climate change." There is another major problem with cap and trade: its lack of predictability. Prices vary considerably. On June 15, the right to emit a tonne of carbon dioxide cost ¬12.50. Since the inception of the ETS, this price has varied from below ¬10 to peaks of more than ¬30. While these fluctuations may encourage businesses to increase energy efficiency -- for which they will in any case receive a direct financial benefit -- it is of no help for long-term investment decisions to permanently reduce carbon emissions. For this, a significantly higher minimum price is needed, perhaps about $140 per tonne, according to a U.K. government-sponsored report from Cambridge university, due to be published shortly. Given the system's inherent flaws, it comes as little surprise that the ETS didn't quite work as intended. According to European Commission figures, emissions from the 27 member states rose by 1.9% in the first three years of the regime. Following criticism, the caps for the period to 2012 were reduced for the majority of member states, but only to a little lower than actual emissions in 2005, and the evidence is that the recession is having a much more direct impact on emissions than the trading scheme (incidentally putting a lot of low-priced permits on the market). Despite the system's questionable results, the costs are considerable. In 2006, individual business and sectors had to pay ¬24.9 billion for over one billion tones' worth of permits. The WorldWatch Institute estimates that the costs of running a trading system designed to meet the EU's Kyoto obligations at about $5 billion. The estimated costs of a trading system to meet the EU's own and far more demanding commitments of a 20% reduction (against a 1990 baseline) by 2020 are around $80 billion annually. Substantial changes are planned for the European regime, with emissions caps to be set by a single EU body rather than national governments, more than half of permits to be auctioned, and the aviation sector and possibly shipping to be included. Household consumption and private transport cannot be included in the ETS as set up, although the idea of extending the concept to the allocation of personal carbon allowances is popular with some. But these are only cosmetic changes to an inherently flawed system. The auctioning of permits may avoid overallocation but instead saddle industry with huge upfront costs. The entire scheme will remain vulnerable to political interference and thus likely fail to reduce carbon emissions. The only certainty is that it will hurt the economy and drive up energy costs. If passed, the U.S. bill will probably commit to the headline figure of a 17% reduction (from a 2005 baseline) in carbon dioxide emissions by 2020. Before signing any bill which would reduce America's competitiveness for little real impact on emissions, President Obama may want to heed the warning of Europe's experience. The author is director of the Scientific Alliance Copyright WSJ

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