2. Existing approaches to regulating greenhouse gases

2.1 Main approaches

The main existing approaches to regulating greenhouse gas emissions are:

the Kyoto Protocol of the UN Framework Convention on Climate Change (UNFCCC) (http://www.unfccc.int). Referred to below as "Kyoto1".
the European Emissions Trading System (EU-ETS), which applies the Kyoto Protocol within the European Union.
Contraction and Convergence (C&C) as conceived and promoted by Aubrey Meyer and the Global Commons Insititute (http://www.gci.org.uk).
Domestic Tradeable Quotas (DTQs), a system under which individuals will be allocated a personal allowance of GHG emissions which they may use up or trade, as conceived by David Fleming and further developed by the Tyndall Centre (http://www.tyndall.ac.uk/research/theme2/summary_t3_22.shtml).
Carbon Taxes, taxation levied on emissions of carbon dioxide (or equivalent of other GHGs) by national government; the UK has a related approach in the Climate Change Levy raised on business use of energy.
Carbon cap, auction and trade (CCAT), as proposed by Peter Crampton (University of Maryland) & Suzi Kerr (Motu Economic and Public Policy Research) in their paper Tradeable Carbon Permit Auctions - How and why to auction not grandfather (Energy Policy 30, pp.333-345, 2002) for the USA.

2.2 Country-based approaches in general

One of the main faults of all existing approaches (including Kyoto1) is that they allocate carbon emission rights on a country basis. This is of limited benefit in the context of the global economy, in which "embodied carbon" is freely traded across national boundaries, and of the global climate which is indifferent as to where GHGs are emitted.

Note, for example, that the recent industrial expansion in China, India and Brazil, which has given rise to huge increases in GHG emissions, much of it aimed at production for export. Why then should the GHG emissions associated with this exported production be accounted for at the point of manufacture, rather than at the point of consumption?

One reason is there is no reliable mechanism for attaching the GHG impact of a product to the product itself so that it is transferred to the importing country. To even try to do so would involve an enormous carbon audit and acounting exercise which would be both error prone and costly.

Likewise certain countries have very high emissions of GHGs not because their inhabitants are profligate in their consumption of fossil fuels, but for geographical, geological and historical reasons. Countries with substantial oil resources tend to have high GHG emissions associated with the oil industry, even though the oil may almost all be exported and the people of those countries do not themselves benefit directly from emissions arising from the oil industry.

A further difficulty arises from the major GHG / carbon audit and accounting exercise associated with any country-based system. This is only added to if trading takes place, as under the flexibility mechanisms of the Kyoto Protocol. The huge audit and accounting system required creates three serious problems:

the sheer expense and difficulty involved in carrying out audit and accounting
the likelihood of accidental error
the incentive for deliberate error.

However the country-based approach has one important point to recommend it: it brings a sense of national pride and prestige to bear upon the problem. By making Governments responsible for reducing GHG emissions in their territories, they have an incentive to act in order to preserve national reputation. It is worth noting that compliance with Kyoto1 is actually voluntary, in the absence of any formal compliance mechanism. Nonetheless governments have made some effort to ensure compliance with their targets.

So while the country-based approach does not have the rigour and fairness necessary for truly effective GHG regulation, it can nonetheless harness additional resources towards GHG emissions reductions.

The original Kyoto2 proposal was to abandon the idea that GHG emissions from fossil fuels should primarily be controlled by country. However an essentially voluntary country-based process on the Kyoto1 model could in fact continue at the same time as, and in parallel with, a more rigorous, mandatory approach.

The main areas where GHGs should be regulated on a country basis are those where GHG emissions are the direct result of Government policy (or or policy failure), for example emissions of methane from defunct coal mines, and emissions of carbon dioxide and methane from the mass clearance of forest.

2.3 The European Emissions Trading System - EU-ETS

The EU-ETS inherits the problems generic to country-based controls, but adds extra difficulties of its own to make the system intrinsically unworkable. Under the Kyoto Protocol, GHG emissions reduction targets within the EU are allocated to member states to achieve as they see fit. At the same time the EU-ETS - which applies only to large GHG emitters such as steel works and power stations, some 6,000 companies in all across the EU accounting for approximately half of all emissions - allows emissions reductions to be traded between member states. This creates conflict between the different policy approaches of member states.

Thus the UK's approach to meeting its Kyoto targets is to cut back on industrial emissions by setting relatively tight targets under the EU-ETS, while doing little to reduce domestic sector emissions. Germany on the other hand is doing the opposite: pursuing reductions in the domestic sector through ambitious programmes of energy efficiency and renewable electricity generation, while granting generous Allowances (EUAs) to its industries. Because the EUAs are tradeable among member states, however, this makes it cheaper for UK industries to buy up cheap German Allowances than to invest in reducing their own emissions - frustrating the UK Government policy objective.

As a consequence the market in EUAs has been highly unstable, and in early 2007 the price dropped to around €1/tCO2e, from a high the previous year in excess of €30. This market instability calls into question its abulity to act as a long term price signal to guide large scale investment in low-carbon technologies for the future.

But maybe the biggest failing of the EU-ETS is its very limited scope. It applies only to the largest emitters of GHGs accounting for approximately half of emissions, and so leaves out small companies and the entire domestic sector. Moreover it does not yet - as Kyoto1 does not - apply to emissions from aircraft.

2.4 The Kyoto Protocol

The Kyoto Protocol ("Kyoto1")approach embodies all of the problems implicit in any country-based approach. But it also includes "flexibility mechanisms" such as the Clean Development Mechanism (CDM) and Emissions Trading.

Emissions Trading allows Annex 1 (industrialised) countries under-shooting their Kyoto Protocol GHG emissions targets to sell their surplus rights to other Annex 1 countries who are exceeding their target.

The CDM allows entrepreneurs to develop projects in the non-Annex 1 countries that reduce GHG emissions (for example, by improving the efficiency of power stations, or reducing industrial emissions of HFC gases) or developing carbon sinks (for example, by the afforestation of bare land). The Certified Emissions Reductions (CERs) so produced are tradeable and may be counted by Annex 1 countries as reductions in their own GHG emissions.

While there is concern at the quality of some CDM projects, many have positive economic and environmental impacts. The greatest area of doubt is the extent to which CDM projects actually cause reductions in GHG emissions.

Currently (March 2007) some 70 percent of CERs to be issued are based on the supression of HFC-23 (trifluoromethane, a GHG 11,700 stronger than CO2) produced as a by-product of HCFC-22 (also a GHG, 1,500 times more powerful than CO2, but excluded from Kyoto1) manufacture for applications in refrigeration and air conditioning. As a consequence carbon trading income from the sale of HFC-23 related CERs are in effect subsidising the manufacture of HCFC-22, and so undermining the use of alternative refrigerants such as CO2 and hydrocarbons with far lower global warming potentials.

Or take the example of a CDM project to increase the efficiency of a power station. The result may simply be that more electricity is generated than before, and with less local pollution, not that less fuel is burnt. While it could be argued that the increased generation would remove the need for the construction of additional generation capacity, this does not necessarily follow. The result could be that the increased profitabily of the generating company would yield additional funds to invest in new generating capacity, which would not otherwise be available, so raising GHG emissions.

So while the CDM may in some cases succeed in achieving "clean [or cleaner] development" it is not clear that emissions reductions will follow from individual CDM projects. Indeed the reverse may often be the case.

It is worth noting in this context that the great majority of CDM projects currently under way are located in India, Brazil, China and Mexico - all countries in which GHG emissions are rising rapidly as a result of rapid industrialisation (and the increased general wealth resulting from it), much of it caused by the relocation of manufacturing industry from Annex 1 countries. The true extent to which GHG emissions have been reduced by the CDM projects is thus open to question.

Another problem inherent in Kyoto1 is that countries not in Annex 1 have no GHG emissions targets to achieve. This may be "fair" in the sense that these countries have contributed little to historic GHG emissions, however it undermines any possibility of achieving a global cap on GHG emissions. It also encourages the relocation of energy-intensive industries into non-Annex 1 countries.

Likewise Kyoto1 does not address emissions from aircraft - a relatively small source of global GHG emissions at present, but one that is very fast growing.

A further problem with the Kyoto1 approach is that while it is in principle legally binding, it lacks a compliance mechanism. As John Topping of the Climate Institute observes, "in the final analysis countries who do not comply with their commitments face no greater sanction than rude press releases from environmental NGOs ... this supposedly binding mechanism runs entirely on the honour system".

2.5 Contraction and Convergence

C&C is an idea that has been gaining a lot of ground over recent years, and it has much to recommend it above the Kyoto1 approach, principally:

the setting of firm global caps on annual GHG emissions - essential in any effective system
the inclusion of all countries within its framework
the "equity principle" implicit in the allocation of emissions rights to countries on a per capita basis. This is based on the idea that the right to emit greenhouse gases is a common right of humanity, not a private right of the rich or big companies.

However it inherits the problems already outlined that are inherent in any country-based system. It also involves a GHG audit and accounting exercise similar to that required by Kyoto1, a source of considerable cost and likely error.

In addition, some of the "equity" promised by C&C may emerge, in practice, as illusory. Intrinsic to the system is the tradeability of the national GHG emissions rights. This will provide poor countries with low carbon emissions, and especially those with high populations, with an income stream. However this will not necessarily raise the quality of life for inhabitants of the countries concerned.

There is no particular incentive for investment in such countries, since their GHG emission rights can be traded away to other countries and provide revenue to government. Indeed the prospect of this income might cause some governments to restrict development, and associated increases in GHG emissions, in order to preserve the income stream.

The income arising from selling emission rights under C&C may also be spent in any way the government in question chooses, rather than on improving the life of the population or reducing dependence on fossil fuels. Countries might simply "capitalise" the projected income stream from C&C by taking on additional debt, funding one-off expenditures which may, or may not, be to the national or global benefit.

In the round, however, C&C is one of the best global policy options. Indeed we propose that it is the best option for controlling GHG emissions from diffuse, non-industrial sources. Those emissions are best controlled on a country basis since their emission can and should be regulated by Governments. A per capita allocation of permits to emit non-industrial origin GHGs to Governments has the benefits of fairness and clarity, and may be acceptable to most Governments.

However for the bulk of GHG emissions that do come from industrial sources the challenge is to find optimal ways of implementing the key objectives of C&C.

Note: a new position paper on Kyoto2 and Contraction & Convergence was posted on this website on 13 February 2007.

2.6 Domestic Tradeable Quotas

Another idea that has recently gained currency, and ministerial support from UK Environment Secretary David Miliband, is that of Domestic Tradable Quotas (DTQs), denominated in kilogrammes of CO2. Under this approach, individuals would be allocated a per capita "share" of the UK's total emissions quota which would be paid into an "account" similar to a bank account. When puchasing an energy product such as gas, petrol or coal, they would have to "pay" the associated number of DTQs, perhaps using a plastic "swipe card". They could also sell surplus DTQs to others with a more profligate lifestyle.

In the original version of the idea, individuals would be allocated 40 percent of the national DTQs on a per capita basis, while the remainder would be sold to companies and other organisations in a Government-run auction. It has since been suggested that all DTQs should be allocated to individuals who could then sell on to organisations. The Tyndall Centre recognises that many would not want to participate in the DTQ market, and proposes that they should sell all their DTQs on receipt and buy back as they buy energy products.

The main disadvantage of a DTQ system is the huge associated accounting exercise. Most people already have trouble enough managing their money and prefer to set aside such matters as tax returns, subscribing to pension plans, or resolving debt problems, for as long as possible. To impose yet another "currency" and associated obligations on the public might - for all but enthusiasts - be a step too far.

However the Kyoto2 approach would be entirely compatible with DTQ arrangements conducted on a national or regional basis. The effect of DTQ regimes would undoubtedly be to reduce fossil fuel use and GHG emissions where in force, and would thus support the objectives of the UNFCCC and Kyoto2.

2.7 Carbon Taxes

Carbon Taxes have the advantage that there is no need to create any new "currencies" in the form of DTQs, CERs or anything else: the cost of GHG emissions becomes a simple cost measured in money. However Carbon Taxes have always been resisted by industry on the reasonable basis that so long as they exist in one country and not in another, energy intensive industries and other GHG emitters in that country suffer a disadvantage, and GHG intensive industries will simply move to where the Carbon Tax is lowest or non-existent. So, to be both acceptable and effective, Carbon Taxes must have a global application.

But who is to determine the tax level? The global policy objective should not be to determine a particular rate of carbon taxation, but rather particular levels of global GHG emissions consonant with expert scientific advice.

And where should the money raised by Carbon Taxes go? At present the proceeds of taxes raised nationally simply go to the Governments concerned. If a Carbon Tax were to be raised globally, a new mechanism for allocating the funds raised would need to be created and agreed upon.

While Carbon Taxes clearly have some merit, the approach is less effective at achieving policy objectives than that described in the following paragraphs.

2.8 Carbon Cap, Auction, Trade

The case for a Carbon Cap, Auction, Trade (CCAT) approach is well advocated by Peter Crampton and Suzi Kerr in their excellent paper Tradeable Carbon Permit Auctions (Energy Policy 30, 2002). The arguments they make are addressed at national policy, primarily within the USA. However the arguments apply equally to a global policy context.

Key features of the auction system they set out include:

"To minimize administrative costs, permits would be required at the level of oil refineries, natural gas pipe lines, liquid sellers, and coal processing plants"
"To maximize liquidity in secondary markets, permits would be fully tradable and bankable"
"A standard ascending-clock auction in which price is gradually raised until there is no excess demand would provide reliable price discovery"
"An auction is preferred to grandfathering (giving companies permits based on historical output or emissions), because it allows reduced tax distortions, provides more flexibility in distribution of costs, provides greater incentives for innovation, and reduces the need for politically contentious arguments over the allocation of rents."
"To increase liquidity in this market, all permits are the same after their date of issue, and permits are bankable ... There is no environmental loss in making permits bankable. Current carbon emissions are reduced to the extent that permits are banked. Given the long life time of CO2 in the atmosphere, short term voluntary banking is unlikely to have significant impacts on CO2 concentrations. Allowing banking further increases liquidity in secondary markets, since all permits are the same after their date of issue."
"permits can and should be auctioned not only for the current years but also for future issue years ... Early auctions would facilitate the development of an active futures and options market, thus improving risk allocation."
Auctions to be held quarterly.
The sums raised from carbon auction to go into general tax revenue, in effect funding tax cuts elsewhere in the economy.

They further point out a major advantage of auction over allocation of carbon permits:

"Advocates of grandfathering usually fail to point out that, if the permits are given to energy companies, consumers will still pay the higher energy prices. It is the carbon cap itself that will determine the price increase. Regardless of whether the government auctions permits or gives them away for free, the same energy price should be expected."

This is precisely what has been observed in the EU-ETS, where Allowances were handed out to large carbon emitters on the basis of historic emissions, giving recipients a huge financial windfall.

As to the form of auction, Crampton & Kerr conclude that an "Ascending-Clock Auction" is optimal for carbon permits. As they explain:

"The auction begins at a low price. With each round, the bidders are asked what quantity they demand at the price posted on the auction clock. If there is excess demand, the price is increased. This process continues until the excess demand falls to zero. The bidders then receive their quantity bid at the final price. This auction generates a uniform price for carbon permits. All bidders get their demands at the market price. A secondary market will allow the sale and purchase of permits as circumstances change. This design assures a highly efficient allocation of the permits."

The CCAT approach is fair, economically optimal and relatively easy to implement. Kyoto2 therefore adopts CCAT in its entirety. The main difference of substance is that it is applied globally, rather than within a single jurisdiction.

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