Varied interests in the energy and power sector viz., CDM, carbon rating, Monitoring & Evaluation, Energy Management, Rural Development; Energy Efficiency and Renewable Energy related matters; Demand Side Management (DSM), Energy Audits, Distributed Power Generation (Biomass, Wind,Solar and Small Hydro), Participatory Management.

Wednesday, February 11, 2009


Emissions Trading: A brief negative resume

Emissions Trading: A Brief Negative Resume
2.2.09   Ferdinand E. Banks, Professor

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The clock of stupidity is attached to a bell, and it tolls for your descendants

- Donald E. Carr (1976)

Rex Tillerson, CEO of Exxon Mobil (XOM) -- the energy firm that is often Number One on the Fortune 500 List -- has now come to the conclusion that emissions trading (or cap-and-trade) is doomed to fail. Instead, in a speech at the Woodrow Wilson Center, he declared that he was in favour of a carbon tax, which he called "…a more direct and transparent approach."

Direct and transparent and, as a result, featuring (relative) certainty about carbon prices, which is very important for (physical) investment in energy intensive industrial countries. In addition they are an easily understandable alternative for Kyoto-like forums to contemplate and discuss, as compared to relatively complicated options like tradeable emissions permits that feature uncertainty in the matter of pricing, are susceptible to 'gaming', and if the evidence has any significance, cannot be systematized internationally The influential Al Gore, and the climate scientist James Hansen prefer a carbon tax, and British Columbia (Canada) installed this arrangement last year.

An example of quasi-gaming might be useful here: EU firms buying carbon credits from abroad which sell for about 75% of EU permits, and probably less on various occasions. The effectiveness of this option for reducing emissions has apparently been questioned, as well it might, because emissions from enterprises that trade permits continued to rise during the first two years of the system, and I would be very surprised to hear that there was any change before the recent economic meltdown reduced economic activity.

For what it is worth, I am also in favour of carbon taxes, because they are not only direct and transparent but because, ideally, the revenues from these taxes can be used to help finance a new energy 'portfolio', which to my way of thinking should include nuclear energy as the principal component. I will not treat this subject in the present article however, because it is spelled out in some detail in the long survey of nuclear energy that I am completing (2009).

The interesting thing here is that Mr Tillerson – and perhaps most of his executives – have at one time made a point of vehemently denying global warming. Perhaps he has adopted the attitude of this teacher of economics and finance, which is that a new energy 'portfolio' is absolutely essential, regardless of whether excessive global warming is real or fictitious, or will not put in an appearance for another five hundred or five thousand years, and any strategy (or program) for combating global warming that does not explicitly contribute to obtaining that portfolio should be designated suboptimal. This includes carbon taxes.


According to Robert Frank (2006) in his important textbook, "if a single agency had the power to enact globally binding environmental legislation, it would be a straightforward, albeit costly matter to reduce the build-up of greenhouse gases. But in our world of sovereign nations, this power does not exist."

This conclusion can be adjusted. If a miracle had taken place, and the Kyoto delegates had specified that climate issues should be exclusively dealt with by heads of governments and senior civil servants from the major greenhouse gas emitting countries, meeting several times a year, we might already be in possession of the correct environmental legislation, instead of the superficial bunkum affiliated with emissions trading that was eventually put into circulation. Moreover, the cost mentioned by Frank might have been quite tolerable.

My favourite approach to the interior mechanics of emissions trading almost always begins with a perusal of the exchanges for electricity pricing, and in particular the Nordic Electricity Exchange (NORDPOOL), whose endeavours I usually described to my students as a 'scam', and deserving the attentions of serious-fraud researchers in every institution of higher learning in Scandinavia. Let's consider a simple example.

Over the previous year, electricity prices in Sweden almost doubled. The explanation provided by NORDPOOL turns on the increased cost for emissions permits by electricity generators in the north of Europe, as well as the increased price of energy inputs for power stations. But since all except seven or eight percent of Swedish electricity is generated with nuclear and hydro, emissions permits and e.g. higher oil and coal prices should be, ceteris paribus, largely irrelevant for the remaining ninety-two or ninety-three percent of Swedish electric generators. Even so, Swedish ratepayers are faced with higher prices due to the presence of fossil fuel based equipment in other countries associated with NORDPOOL, as well as the occasional appearance of a very high demand for electricity in those countries.

Now consider the situation in the future where emissions permits are concerned. Regardless of good intentions by fossil fuel users and politicians, fossil fuel consumption will (ceteris paribus) still increase by a large amount because estimates are that in the next twenty-five years, the global output of electricity might increase by fifty percent. Even if Sweden were to restart the two nuclear reactors that were shut down, increase the number of windmills in this country by the absurd amount desired by the industry minister, and force a large part of the electricity intensive Swedish industry to leave the country, an increase in the demand for fossil fuel based electricity exterior to this country, and a possible rise in the price of emissions permits to various enterprises outside Sweden, would almost certainly boost electricity prices in Sweden. What this means is that emissions trading functions as an unjustified tax on the good citizens of this country, and the same might apply to the citizens of any country who have their electricity priced in an exchange of the NORDPOOL variety.

Given these circumstances, it should be made clear to all interested persons that at best emissions trading reduces to a highly efficient way to get rid of excessive carbon dioxide (CO2) emissions in what the game theorist Ken Binmore calls a "toy market", by which he means a textbook market that is devoid of annoyances like risk (or uncertainty), monopoly, irrationality, spillovers (i.e. externalities), dishonesty and anything else that prevents a few simple equations from being put on a blackboard for the delight of drowsy teachers and students in some storefront university. Despite a statement in Newsweek that in order to suppress excessive CO2, the United States needs a cap-and-trade system of the kind providing 'magnificent' results in Europe, the sad truth is that the European arrangement is a cynical deception that mainly benefits the brokers and 'intermediaries' who expect to get rich by playing games with 'emissions credits' or 'carbon trading' or marketable emissions permits or whatever bizarre and/or misleading term that charlatans in the financial districts of North America and Europe dream up in order to make this activity appear socially beneficial. Mr Francis Sullivan, the environmental adviser at the large European bank HSBC, spent a few months evaluating the market for 'carbon credits', which led him to suggest that the police and their experts should look into the trading of these permits. To his way of thinking, irregularities in this market are so great that people might lose faith in them. This is naiveté, because I have taken the same approach with NORDPOOL, however that organization is sailing along at a more relaxed pace than ever.

An interesting short account of the flaws of emissions trading originates with Emma Johansson (2003), who points out that "…a utility that runs fossil fuel-fired plants will be exposed to an additional price risk that affects risk and return. As a result the classic spark spread (price difference between the price of electricity and the price of the fuel used to generate the electricity) will have an additional component." What Ms Johansson forgot to add was that according to mainstream economic theory, this increase in risk will almost certainly reduce the investment in physical capital, and therefore many of the new electric generating plants that are essential for maintaining our standard of living later in this century might not be constructed. After reading the Johansson paper interested parties can scrutinize a short article by Uwe Maassen in the same publication, which examines some further inconveniences that can come about if an unreasonable confidence is placed in 'carbon trading'.

According to Andrei Marcu of the International Emissions Trading Association, "Europe is now clearly committed to action on climate change, whatever happens to the Kyoto treaty." I'm sure that he is sincere in this belief, because his salary (and bonuses) will depend on the trading successes of carbon permits, and not the fate of the Kyoto Protocol nor a reduction in the stock of physical carbon in the atmosphere. For him and his collaborators, cash comes first, and carbon in its various forms somewhere to the rear. Another heavyweight player in this burlesque, Professor Michael Grubb of London's Imperial College, as well as the ludicrously named 'Carbon Trust', informed The Economist (UK) that "Kyoto was designed for the rich countries to miss their domestic targets. That's why we included international emissions trading." (April 3rd, 2004). The identity of the "we" to whom he was referring was not clarified, however for the purpose of the present contribution it could apply to everyone with expectations of a first-class ticket on what they hope will become a carbon-trading gravy train.

That brings us to a scrutiny of the truth of emissions trading in Europe, as compared to the fantasies that evidently have been foisted on the new American president and his 'energy team' by energy-economics know-nothings.

It is often argued that the most effective device for reducing harmful emissions is via a tax on emitters, which in the theoretical literature is called a Pigou tax – after the Cambridge (UK) economist Arthur Pigou. Japan and France have adopted this approach, however it was ignored at Kyoto because the delegates at that meeting did not want to lose access to future talk-shops by being accused of adding to the tax woes of citizens in the most important industrial countries, and especially the United States.

In the chapter on the environment in the next edition of my energy economics textbook, I intend to extend Pigou-like schemes beyond their present use in the countries mentioned above. I might also spend some time examining present and/or intended emissions trading in Europe, where in the interest of expanding this practice, the European Union Emissions Trading Scheme (ETS) was established. Apparently this clumsy arrangement has been pictured as theoretically attractive and operationally successful, which is an egregious departure from the truth. The emissions permits that (in theory) were to be auctioned off were instead provided free, and since estimates of carbon emissions by the authorities and their 'experts' were grossly inaccurate, it was impossible to establish a stable market – by which I mean a market in which a (dynamically) sustainable or nearly sustainable supply-demand equilibrium was established, and therefore the 'natural' volatility of prices was minimized.

For instance, permit prices were at times so low that instead of investing in superior technologies – which was the object of the exercise – heavy polluters resorted to buying permits, which enabled them to continue generating a heavy flow of pollution. In addition, some of them were undoubtedly able to raise the price of their output by enough to pay or almost pay for these permits. What about auctioning these permits off, as Lord Turner – head of the UK's Climate Change Committee – has mandated for his country, and the European parliament is in the process of specifying for all EU countries? Given the lack of information about the sources of pollution and the districts that are most polluted, the impossibility of combining meteorological information with economic data, and the shortage of relevant economic training on the part of the individuals who will work with these matters, it is likely that we have another example of what Jean-Paul Sartre called "a fire without a tomorrow".


The governor of California would not take kindly to this presentation, because he has formed an international emissions trading 'syndicate', however his focus is on show business rather than economics. Moreover, I often receive mail from critics, whom I immediately inform that I would be genuinely overjoyed if they appeared in Uppsala some fine day for the purpose of ventilating their objections in an open forum. But if they did, I would have no choice but to make it clear that the directors of many energy intensive companies in Sweden – despite their traditional preferences for market-based solutions – have for the last few years informed friends and neighbours in this country and elsewhere that emissions trading is one of the worst ideas ever hatched, and may cause irreparable harm to consumers as well as the Swedish industry. Never forget that thanks to the presence of NORDPOOL, some energy intensive industries in this environmentally superior country will have to pay unreasonably high prices for emissions permits, and in addition would experience a higher price for the electricity they consume, despite much of it being generated in 'emissions-free' facilities.

Unfortunately, I can remember failing to convince one of my former mathematical economics students in Australia that he should accept the above assertions at face value. That gentleman wanted some 'algebra', but what I gave him instead was some primary school arithmetic in conjunction with a touch of intermediate economic theory. A few years ago the Swedish government planned to issue one group of companies emission permits for 250,000 tonnes of CO2 per year. The emissions from these companies were 450,000 tonnes the previous year, which implied that if those enterprises wanted to maintain the output of the previous year, then they would have to go into a 'market' (or perhaps better what the prominent New Zealand economist Owen McShane called a "pseudo-market") and purchase – at an unknown price – emission permits that gave them the right to emit about 200,000 tonnes of CO2.

Purchase at an unknown price! Isn't this the kind of short-sighted dilemma Emma Johansson was talking about, and which may be one of the reasons why even Jerry Taylor – senior fellow and environmental researcher at the conservative Cato Institute (in Washington D.C.) – has expressed a preference for carbon taxes over cap-and-trade foolishness. Perhaps, like me, finds carbon taxes more efficient, because among other things it may be possible to design a system in which tax revenues can be returned (in some simple or complicated way) to the aggregate of enterprises paying these taxes.

What kind of system do I have in mind? I could say, but I doubt whether I am more competent where this issue is concerned than President-elect Obama's energy team, even though I persist in calling them an 'environmental team'; and while they are working this out, they can also produce a calculation which shows that when all relevant factors are taken into consideration, a slightly larger nuclear commitment should be the foundation of a new energy policy for the United States, and every country with a serious and intelligent government, while any involvement with emissions trading, carbon trading or cap-and-trade should be dumped and forgotten as soon as possible.

Gopinath S
+91 99161 29728


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