Carbon trading game – understanding the difference between the three basic types of environmental policy

I’ve developed a game that explains the differences between three key policy options for reducing emissions: command and control, tax and cap-and-trade. There are other games like it, but I think this one works really well and we like to use it with clients to explain the rationale behind the current preference that many governments have for cap-and-trade policies.

‘Command and control’ is when the government simply tells industry to reduce emissions by a set amount. ‘Tax’ involves levying a charge on each tonne of pollution. ‘Cap-and-trade’ is a policy type that allows companies to buy and sell emission credits, and therefore choose who makes the necessary reductions. Here’s how the game works:

Up to six participants (or six teams of two or three) are cast as the CEOs of large, carbon-intensive companies. They have asked their business analysts to prepare reports on how they can reduce their carbon emissions. These reports are shown at the top of each worksheet (you can download the worksheets here). Each company can implement two projects. You don’t have to implement an entire project – you can do half of it for the half the cost.

The facilitator (who is cast as the government), then asks each company to work out how much it will cost them to meet emission reductions under a command and control regime (i.e. you must meet the reduction target, and you can only implement your own projects). The facilitator asks each company to report how much money they spent and the emission reductions they achieved, and writes totals up on a flipchart.

Next, a tax regime is used. Each company will be charged £40 for every tonne of carbon that they miss their target by. Again, they report the results.

Finally a cap-and-trade scheme is used. Each company decides how many credits they would buy or sell at four price points (using auction ‘order books’, which you can download here). The data is fed into a spreadsheet that works out the optimal clearing price and shows who buys and who sells (the spreadsheet is available here). It’s called a French auction and it’s just like real carbon markets.

The exercise shows that:

• Command and control achieves the desired emission reductions, but at a high price;
• Tax is cost efficient, but unpredictable in terms of emission reductions; and
• Cap-and-trade is cost efficient and achieves the desired reductions.

The game involves huge simplifications, of course, but does outline some basic economics behind these policy choices.

Cap and trade in the context of shrinking production

Questions are being asked of the two working installation-level cap and trade schemes in light of economic recession. The EU ETS – the world’s largest carbon market – is trading at about 16 Euros per tonne and is volatile because no-one is quite sure of the impact of shrinking production. Analysts believe that all reductions could now be met through purchase of CERs. Essentially this means that industry within the EU ETS has lowered its output and can comply with the cap by offsetting rather than making additional internal reductions.

The other scheme, RGGI, a scheme covering power plants in north-east US, held its second pre-compliance auction on 18 December and sold 31.5m allowances at a price of $3.38 per short ton (up 31c from the first auction, which is surprising given the commentary that follows). An article on BusinessGreen says:

… the auction came amid fears that the economic downturn meant the US scheme could repeat the mistakes evident in the first phase of the EU’s emissions trading scheme by setting the cap too high – a scenario that led to a glut of available emission permits and a collapse in the price of carbon.

Non-profit policy thinktank Environment Northeast released RGGI Emissions Trends & the Second Allowance Auction, a report which said emissions were currently 16 per cent below the cap. It pointed to skyrocketing fossil fuel prices earlier in the year as the primary reason for a lower than expected emissions rate.

“RGGI was negotiated back in early 2003 through 2005, and at that time everybody thought the trend would be up,” said Derek K Murrow, director of policy analysis at Environment Northeast. “Since it was negotiated we’ve seen a signfiicant decline, which is really a good thing. Now the question is whether that trend will continue as the programme starts up in 2009, in which case the cap might need to be bought down more quickly after the first compliance period. Or will emissions return to their historic levels, in which case the cap would be constraining?”

Comments like this suggest that cap-and-trade must deliver a carbon price that is neither zero nor unbearably high, and also force emission reductions beyond anything that happens ‘naturally’ (as a result of lower consumption or developments in eco-efficiency, for example). These characteristics sound more like tax than cap and trade. Cap and trade provides an absolute limit for emissions and a price crash indicates that the limit can be met with no unusual investment. Equally, if emissions rise unexpectedly, a cap and trade market will force decisions about where additional reductions will be made.

That’s the strength of cap-and-trade: unforeseeable events that effect emission levels are reflected in the permit price. If the price crashes due to unforeseen cuts in emissions, the cap and trade scheme is not a failed policy.

Lack of CDM progress at Poznan will be the major sticking point for negotiations over the next year

CDM reform didn’t get anywhere at Poznan. To me, this is the most worrying outcome of the conference. Although technical discussions and low-level negotiation planning were all anyone expected, there is now very little time to do something about the CDM before the Kyoto Protocol runs out.

There was a lot of discussion about Forestry and CCS. Forestry is unsuitable for the CDM – partly because there are issues with calculating the volume of carbon dioxide a forest absorbs, and mainly because forests would produce far more CERs than Annex I countries could buy (essentially we wouldn’t be able to buy enough carbon credits to protect the forests).

The situation with coal is similar in that the CDM couldn’t support the volumes required (I haven’t done the maths on this but the IEA forecasts that to stabilise at even 550ppm we will require 10 new CCS plants every year), except that CCS will be neither operational nor affordable before 2020. Most estimates show that a carbon price of EUR 40 – 75 will be required to make CCS commercially viable, and CERs are unlikely to enter that range.

There was also discussion on making the CDM more transparent and efficient. These discussions didn’t progress either, but we really need a new approach to technology transfer and funding rather than tweaks to a process that can’t demonstrate additionality.

Despite encouraging statements from China, Brazil and Mexico, the developing world will not sign up to quantified emission reductions without a clear understanding of how rich countries will support them. The ethos behind the CDM needs to switch from reducing the cost of compliance endured by Annex I to structural funding for the developing world to pay for abatement.

EU should insure long term carbon prices to push the climate and energy package through

Some industries are claiming that carbon costs could lead them to move outside the EU, which would harm the internal economy and prevent emission reductions. Eurogypsum – the trade body of gypsum manufacturers – is claiming this, but it’s not clear whether the issue is the absolute cost of carbon or the uncertainty over price.

In an interview with Euractive the president of Eurogypsum said:

I cannot challenge the fact that we have to decrease the energy content in our product. But I can also say that in the thirty years that I have been in the industry, we divided the cost of energy in our products by two. And there is still room for progress. So, it is our job in managing the business. Having an incentive to push us to accelerate is okay.

What I am afraid of is the free market for the CO2 tickets because it is out of control. We do not know. When we make a simulation at a certain level, we have no vision of the carbon price. So that is one of the main issues is that the system that they are going to adopt is a system that will give us no vision of what could happen. Maybe it will cost nothing. Maybe it will cost a big amount. So we may take decisions on something that will never happen? They should be conscious about that…

When you have to choose in between certainty or uncertainty, you avoid the uncertainty.

EUAs trade out to 2012 on derivative markets, but not ten years out like Eurogypsum is thinking, and there are no readily available financial products that can transfer that sort of risk.

Over the next few months, as traders speculate on the extent of the recession and talks in Poznan and Brussels hopefully provide some clarity on Phase III, the EUA price is going to be volatile and those pushing back against the climate and energy package are likely to use this as a lever.

France (as EU Council president) is putting together a big package of concessions for industries in central and eastern Europe in an attempt to push the package through. One that I would throw into the mix is a publicly backed long-term carbon hedge. This would hopefully knock on the head the argument “we’re all environmentalists and we don’t mind paying for carbon, it’s the uncertainty that messes with our business models”.

Don’t worry Connie Hedegaard, I have an answer for your CDM problem

I went to a talk about the UNFCCC’s Copenhagen 2009 conference by Connie Hedegaard and Hilary Benn at the LSE last night (transcript). Connie is Hilary Benn’s Danish counterpart and has responsibility for organising the conference.

She was reassuringly dedicated to an ambitious global agreement. But there were points she raised that made it look like the negotiators have a tall order.

• She did not seem entirely convinced that the EU climate and energy package could be completed in time for Europe to lead the negotiations. The UK is attempting to water down the package and Hilary Benn did not offer much reassurance on this.
• While she felt cap and trade markets in Annex I countries were developing and offer the best available way to arrange carbon finance, she recognised that the CDM is not a good method of technology transfer and needs to be reformed. She did not seem to have any ideas, however, and 14 months seems like a very short length of time to get something in place.

I am fond of having random stabs at reformed CDM designs. Here’s my current scheme:

Cap and trade auction revenues are channelled into several privately managed technology transfer funds. Companies and non-profit entities in developing countries can apply to the funds for grants or cheap finance for projects that reduce emissions. The funds would be evaluated on their ratio of emission reductions to funds allocated, and they would be awarded more or less funds in the following year as a result.

Every country would have an emissions cap (i.e. would be allocated AAUs), with the global cap representing a safe limit. Linking between carbon markets in Annex I and Annex II countries would be limited or banned (to force internal reductions in the developed world), and the fund mechanism would reduce the burden of the reductions for the developing world.

This system makes the problem of additionality internal to the fund mechanism rather than a question of effectiveness in climate mitigation terms. It is also likely to allocate funds much more efficiently in the developing world. The CDM has squandered billions on cheap or ineffectual projects.

UK should ringfence EUA auction proceeds

HM Treasury just announced that Defra is going to hold the UK’s first EUA auction on 19 November. I’m not sure how many will be auctioned on that day, but over phase 2 the government will auction 85 million (7% of the UK’s total allocation). Assuming an average price of EUR 25, that’s over EUR 2 billion of revenue.

The UK government is consistently opposed to any type of hypothecation (ringfencing of revenue for particular purposes) and will not promise to use this money for any climate-related purpose. The EUR 2 billion is ultimately passed down to consumers. Given that the government has no obvious ownership of the climate, EUAs do not seem like an appropriate source of general public funds.

In an economist’s perfect world, the money would be recycled to consumers who pay the EUR 2 billion through embedded carbon costs. This is difficult to do, of course, and the next best thing is to use the money for environmental projects.

Two good options for the money would be

• a fund for retrofitting domestic property with insulation and energy efficient heating systems. This would be a reasonable way to compensate for the incremental increase in energy bills resulting from emission trading. It would not create net emission reductions (energy generation is within the EU ETS, so lower domestic energy use means that other sectors can use the EUAs no longer required), however.
• investments in public transport. This would be my favourite option. While it has less symmetry with the costs imposed by the trading scheme, it does encourage reductions outside the EU ETS.

Europe: irrationally inefficient

McKinsey published a report today (pdf) today that shows how all our energy and carbon targets can be met through productivity improvements alone (i.e. our energy supply does not need altering). And even better – unlike most GHG abatement technologies, all energy productivity improvements are reported to have a positive NPV.

Improving energy productivity involves things like energy efficient buildings and recovering heat from industrial processes.

The chart below from McKinsey’s report shows just how important energy productivity is. When we compare with CCS, which has the potential to deliver 3% of Germany’s GHG abatement potential and according to most industry estimates requires a carbon price of EUR 40 – 75 to be commercially viable, it seems obvious that our obsession with clean coal being necessary to deliver safe levels of emissions is misplaced.

So why isn’t the market delivering these improvements? Even with no carbon price, energy productivity makes economic sense. According to McKinsey, most productivity gains are dispersed among consumers who have insufficient capital and information to make the right investments. Product standards are the only way to address these barriers.

It feels like there’s something missing to me – it just seems like too big a market failure. I’m afraid I don’t have an answer right now but will mull it over.

Are aviation taxes too high already?

Apparently the government has concluded that tax paid by the aviation industry is worth more than the environmental damage it causes. The British Air Transport Association commented:

The Government now admits that UK air travel more than covers its climate change costs. But they still seem intent on increasing the environmental taxes that air travellers are forced to pay.

Does the aviation industry more than cover its climate change costs? Asking two questions might indicate that the statement does not have a lot of meaning:

1. Do the taxes have an appropriate impact on the level of aviation consumption? The airlines are arguing that the increases in Air Passenger Duty (or other tax) mean aviation should not be included in the EU ETS. Cap-and-trade delivers defined emission reductions – the effect of taxes on pollution depends on demand elasticity, which is unpredictable.
2. If the taxes do cover the ‘climate change costs’, are they redistributed to the people upon whom the costs are imposed?

These questions a bit facetious, of course – the point is that climate change mitigation can only be measured in emission reductions, not just charges.

Finally, APT and other aviation taxes are not really environmental taxes. Although they are often framed in environmental terms their actual purpose is unclear. They are essentially sales taxes.

Australia – combining fuel tax cuts with cap and trade

The design of Australia’s cap-and-trade scheme is emerging. It is likely to include petrol and among the details is a “cent for cent” fuel tax cut to balance the costs for motorists:

If motorists pay 5c extra a litre for petrol as a result of the scheme, fuel taxes will also be cut by 5c under the measure that will be reviewed in 2013.

If retail petrol prices don’t reflect carbon costs consumption won’t respond. This is not necessarily an environmental issue (unless you think the car culture is a problem beyond its current emissions) because the cap will ensure cuts are made elsewhere instead. The inflation that the tax cut purports to address will simply be pushed to other parts of the economy. To be fair: the tax cut is designed to sweeten the pill rather than make economic sense economic so perhaps this criticism is a bit crass.

As a micro-aside, the question I’d ask is how are they going to make fuel taxes so dynamic that they can respond to moves in the carbon costs embedded in petrol?

As a macro-aside, we should step back and look at how far Australia – recently a maligned Kyoto-dodger – is now blueprinting a scheme that by its own estimates will increase the average price of goods by 1% within a year of implementation.

Energy 2020: Closing remarks

There were two things I heard consistently today:

1. The support of the public is essential – both to get the right planning and policy decisions and because individuals are directly responsible for a large part of the UK’s carbon footprint. In some cases, the speakers seemed to have a point that individuals don’t have enough information to make a judgement about what is in their best interest. Average homeowners are not in a position to calculate the impact of microgenerators on their energy bills and the value of their home, for example. But I’d say that most people do have sufficient information about their energy costs and act quite rationally. The issue is that their demand is inelastic. When fuel prices go up, people continue driving. This is why cap-and-trade (either upstream, like the EU ETS, or downstream, like the personal carbon trading scheme being designed by the RSA) is an attractive mechanism: the price at which people are prepared to change is discovered. If people had carbon rations they would start taking note of their meters.
2. The planning process is jamming up the whole renewable industry and needs to be reformed. Everyone was politely horrified with the UK’s planning and it seems an obvoius place to start if the UK is to achieve its target.

Thanks to the RSA for inviting me to blog at this important Summit. I’d encourage you to take a look through the Energy 2020 Action Plan.

Energy 2020: Resource availability

Sir Ben Gill, Hawkhills Consultancy. Where is the resource going to come from? 3 places:

1. Virgin materials – there is an enormous untapped resource from forests. The most wooded area of the UK is the south-east, and these woods could provide woodchips for biomass plants. Energy crops still have high potential – for biomass energy and transport biofuels. Virgin materials also could be used much more extensively in construction and manufacturing.
2. Non-virgin materials – many things thought of as waste are useful resources. Up to 10m tonnes of timber are being put into landfill each year – this could easily be turned into energy. Energy from manure and the organic elements of packaging and other types of waste can be extracted through combustion, digestion etc. Food from wasteful processing, homes and supermarkets has a lot of embedded energy.
3. Other renewable sources – waves, tidal power, rivers etc. are abundant in the UK.

Energy 2020: Major infrastructure

Stephen Balint, RES. The UK has good natural resources and could even exceed the 2020 target, but revision of the UK’s infrastructure is a prerequisite.

The planning process must be driven by the renewable energy strategy. Many applications have been stuck for 6-7 year. Public buy-in is critical to making these plans work and is key to planning decisions.

The National Grid is not delivering for new renewable generation – there is a long queue for connection.

The price-cap regulation for energy is stifling investment. Ofgem needs to prioritise sustainability. These changes will affect consumers – but in the long term, the switch to renewable energy will reduce consumers’ exposure to volatile energy markets.

The 2020 targets are only a milestone and plans must look beyond this (other speakers echo this).

Energy 2020: Decentralised energy

Benet Northcote, Greenpeace. The energy system we have today is incredibly wasteful, because energy is generated a long way from where it is used. That means that a huge amounts of heat is lost from power stations. Some electricity is lost in transmission and a large quantity is wasted in the home. People are not aware of how much energy they are wasting.

It’s the heat being wasted at the point of generation that we need to look at. The vision for 2020 – where microgenerators are on every home and CHP plants are used everywhere – is within our reach. We just need the will!

Energy 2020: Consumers and Waste Energy

Phillip Sellwood, Energy Saving Trust. Consumers are key – transport and domestic sources are 45% of our current CO2 emissions – but we’re spending 25% of our time looking at them. Without consumer support, real progress will impossible.

Consumer action means modifying day-to-day behaviour: choosing energy efficient products, how and when we travel, the source of energy we use, our use of water and how we deal with waste. It doesn’t mean radically different lifestyles.

Consumers are vital across all the sectors being discussed in this summit. Transport in particular needs tackling urgently. If everyone chooses the most efficient car, individual carbon footprints would go down by 25%.

Energy 2020: Transport

Brian Robinson, IMechE. (Note energy use by transport is included in the 15% target.) The main contribution that transport can make is through demand reduction. The government’s focus should be on the road vehicle fleet – the fuel consumption hasn’t gone down since the mid 90’s (“a national disgrace”). There is also a role for demand reduction in freight.

Investment is required for a modal shift, especially in freight. We could be using boats to transport goods round the country to much better effect, for example. These networks don’t exist so investment is required.

Biofuels are also an important area of development. Growth will be driven in part by the long term price of oil. They have been unfairly demonised – some are sustainable and they have an important role to play. 10% biofuels in transport is attainable.

Consumers must demand efficient cars – manufacturers will move fast to block legislation but even faster to meet their customers’ wishes.

Energy 2020: Central and local government

Andrew Cooper, REA. Local government is a big sector with a lot of potential for better energy management, but there are a range of barriers to it delivering energy efficiency. Councils are quite siloed and the departments often don’t feel they have control over the energy they use. Many large councils will be under the Carbon Reduction Commitment, but they have a poor understanding of what carbon is and their exposure to the mechanisms. The way investment decisions are made often only take account of the revenue impact of the project and exclude the environmental impacts. They’re limited by funding constraints (especially districts). Building control is not well enforced (perhaps the fault of building regulations rather than councils). There’s a lack of knowledge, skills and political will.

So with all that doom and gloom, what can they do?

A whole range of things, from free cavity insulation (Kirklees) to CHP (Southampton). There is a big overall potential – local authorities have a huge estate and broad channels to communicate with local communities, but they need direction from central government.

Funding CCS through proceeds from government EUA auctions

Many people think that proceeds from EUA auctions should be hypothecated (ringfenced) and spent on projects that reduce emissions, rather than going into general government funds. The CBI believes that EUA proceeds should be used to fund carbon capture and storage demonstration plants.

Given that coal power stations are within the EU ETS, any reduction in emissions achieved through CCS will allow the coal industry to sell EUAs (or buy fewer), so there would be no net reduction in emissions from CCS specifically (assuming that EUAs are scarce). Public support for CCS would allow other industries within the EU ETS to release more carbon dioxide into the atmosphere and depress the EUA price. It would amount to a subsidy to the coal industry, which, given the rosy outlook for coal over the next few decades, does not seem sensible.

Pragmatically, though, CCS is felt to be necessary for meeting overall emission targets and it is unlikely that the coal industry would do it alone. If governments go ahead and provide funding – whether from EUA proceeds or otherwise – they should build in provisions to reclaim and cancel EUAs matching the avoided emissions from the power stations.

A different option would be to offer auction proceeds as debt finance for CCS (or any long term project that reduces emissions within the EU ETS) and allow the project owners to sell any surplus EUAs. This would encourage industries within the EU ETS to take on riskier, long term reduction projects.

(Or just use the money as grants outside the EU ETS, of course.)

Just for reference – Green NGOs are sceptical about CCS – see see WWF and Greenpeace – pdf.

CDM criticism heating up – non additionality could wipe out reductions in the EU ETS

The Clean Development Mechanism is receiving criticism from high profile quarters. The cover story in yesterday’s Guardian was “billions wasted on UN climate programme”, which drew evidence from studies by International Rivers (pdf) and Stanford University’s David Victor and Michael Wara (pdf).

Victor and Wara’s study is worth reading. Once again, additionality is identified as the main issue.

All new hydro, wind, and natural gas fired capacity [in China] is applying to claim credit for emissions reductions under the CDM… Under the rules of the CDM, each new dam, wind farm, or natural gas power plant applies individually and makes the argument that it would not have been constructed but for the financial incentives produced by the sale of carbon offsets… Taken collectively … these individual applications for credit amount to a claim that the hydro, wind, and natural gas elements of the power sector in China would not be growing at all without help from CDM. This broader implication is simply implausible in light of the state policies [to support clean generation].

…At root, the CDM and other offset schemes are unable to determine reliably whether credits are issued for activities that would have happened anyway while also keeping transaction costs under control and assuring investor certainty…The CDM is structurally unable to engage developing countries in ways that would actually make a dent in emissions.

Victor believes that between one and two thirds of reductions made by the CDM would have happened anyway. The EU ETS allows the EU to purchase 278 million CERs per year, or 13.4% of the overall cap. If one to two-thirds of those CERs are not additional, between 93Mt and 186Mt of CO2e would leak out per year. To put that in perspective, the reduction between 2005 emissions and the annual Phase 2 cap – 131Mt – is well within that range.

More debate needed on command and control

Much of the debate on climate policy has been around whether a carbon tax or a cap-and-trade scheme is a better way to achieve efficient emission reductions.

This is interesting and useful (well, tax-versus-cap-and-trade might be getting a bit stale lately) but what is missing from the debate is how command and control polices will support and complement trading. Command and control might offend economists, but, being pragmatic, it will be core to achieving 60%, 80% or 90% by 2050.

The California Air Resources Board believes that:

carbon trading is only going to produce about 40% of the reductions the state needs. The other 60% will be produced by old-fashioned sector-specific regulations.

Duke Energy, an American generator, has just signed a deal to build 16MW of photovoltaic solar panels in response to a state law requiring utilities to generate a rising proportion of their electricity from renewables. It seems unlikely that any market-based intervention could get things done so quickly.

The EU’s target of 20% renewable energy generation by 2020 shows that the EU does not believe carbon pricing alone will deliver the right type of investment in clean technology. The target needs to be supported by detailed national plans.

Command and control is expensive. There needs to be a lot more debate on how it can be outcome focused (i.e. designed to reduce emissions), politically acceptable and as efficient as possible.

Feed-in tariffs defeated: not such a bad thing

The government got a bit of kicking on Wednesday night when 33 Labour MPs voted for feed-in tariffs to be included in the Energy Bill. The government did not want the amendment, and in the end, it got its way and feed-in tariffs were left out.

The amendment would have required energy suppliers to buy renewable electricity from homeowners and businesses at fixed, long term premium prices. The UK’s level of renewable generation is miserably low and many think (e.g. FoE – pdf) that a FIT is essential if the UK is to stand any chance of meeting its EU target of 15% renewable energy generation by 2020 (the proposed directive is at this pdf and is supported by the UK).

There is not much doubt that a FIT would increase microgeneration. But is it a good way to reduce emissions? Questions that need answering include: how will the new capacity work with core electricity supply? What are the capital emissions associated with manufacture and installation? What is the likely cost to energy consumers per tonne of GHGs avoided?

Because FITs are an intervention based on a type of solution (small scale renewables) rather than outcomes (lower emissions), questions like this must be addressed.