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The amount of damage associated with global warming remains uncertain, but there is some risk that it could be large, both in terms of economic impact and survival of species. In order to reduce that risk there is widespread agreement that the growth of CO2 emissions should be curbed - ultimately limiting those emissions to a level that would stabilize atmospheric concentrations - which would involve costs that are also uncertain but could be substantial. The Stern Review 2006 advocates that the benefits of strong, early action to stabilise the atmospheric concentrations of greenhouse gas (GHG) would outweigh the costs¹. Johnson and Stern (2008 page A) underline the uncertainties surrounding the scale of the potential problems and stress their opinion that the scale and importance of the risks and costs associated with climate change are larger than was thought at the time of the Stern Review.

This drives us towards conclusions which put mechanisms which limit quantities of emissions at the centre of a policy framework. (Johnson and Stern 2008: page A)

Previously, polluters have been able to burn fossil fuels without taking into account the costs to society at large of their actions (the externalities argument – see Etheridge and Leicester 2007: 189). This is a global problem and the challenge for governments is to find ways to ‘internalise’ the social cost and as a result to influence the behaviour of individuals and companies towards making more climate-friendly choices and consequently lowering the level of CO2 emissions (although it must be said that human behaviour is never easy to predict).

Stern recommends that three elements of policy for mitigation are essential: a carbon price, a technology policy and the removal of barriers to behavioural change.

The Stern Review suggests that a carbon price is an essential foundation for climate-change policy, and may be established through tax, trading or regulation. He believes that, by putting an appropriate price on carbon, individuals and businesses will be faced with the full social consequences of their actions, which will encourage them to modify their behaviour in favour of more climate-friendly activities, goods and services.

The two major market-based alternatives are carbon taxes, and cap and trade. These are summarised by Russell (2007)  as follows:

• Carbon tax: Fix the price and monitor what happens to the quantity or;
• Cap and trade: Fix the quantity and monitor what happens to the price

These are examined below.

1. CARBON TAX

Carbon tax is essentially a pollution tax. It is charged on the amount of carbon emissions from the production, distribution or use of fossil fuels, which is approximated by the carbon content of fuels (Fullerton et al 2008: 24). The carbon tax is included in the selling price and therefore passed on, through the supply chain, to the final consumer. The logic is that consumers then attempt to minimise costs by choosing products and services with a lower carbon content.

Those in favour of carbon taxes believe that they have the following advantages:

• predictable carbon prices;
• simple to administer, using existing tax collection mechanisms and the fact that the carbon content of every form of fossil fuel is accurately known;
• can apply to both individuals and businesses;
• easier for the taxpayer to understand;
• encourage alternative energy by making it cost-competitive with cheaper ‘dirty’ fuels;
• the tax raised may be used to subsidise environmental programmes, or be issued as a rebate; and
• it is suggested they are quick to implement.

Disadvantages include:

• there is no limit imposed on the amount of carbon emissions, so a tax would not on its own be able to achieve targets for reductions of emissions;
• an effective tax is seen as being potentially very high and therefore politically risky, few politicians would support it;
• lack of public confidence in the ability of governments to spend wisely the tax raised;
• it is a flat tax and therefore regressive (i.e. has a proportionately greater effect on the less affluent);
• it is usually imposed at source, therefore may be less visible to consumers;
• a rate of tax that was effective during a boom may be excessive during a recession; and
• a difficulty with a tax on emissions is that it is not based on a market transaction.

As was briefly mentioned in Chapter 2, in order to counteract the regressivity, there are suggestions that carbon taxes should be revenue-neutral, i.e. little if any of the revenues raised from the taxation of carbon emissions would be retained by government. Fullerton et al (2008: 30) suggest that the additional revenues could be used in a revenue-neutral package to provide higher transfers to poorer households, and the package can be designed to at least leave the poor no worse off.

Nordhaus (2007: 90) believes that international harmonisation would be easier with a carbon tax, and ‘because of its conceptual simplicity, a harmonized carbon tax might prove simpler to design and maintain than a quantity mechanism like the Kyoto Protocol’. However Fullerton et al (2008: 5) note that a number of European countries introduced carbon taxes during the 1990s, but ultimately failed to achieve agreement on an EU-wide carbon-energy tax.

1.1 Feebate

Feebate works by charging a fee on something that is to be discouraged, while the proceeds are used to pay for rebates on better alternatives, thus helping these alternatives gain market share.

Johnson (2006) describes Sweden's nitrogen oxide (NOx) program as a successful feebate-type policy, which has motivated power plant operators in Sweden to reduce NOx emissions far below levels achieved in the US and other industrial countries. He suggests that a key to this success has been the fair and efficient manner by which the refund is distributed, and suggests that a similar approach could be applied to automotive vehicle feebates (for greenhouse gas reduction), making it possible to overcome limitations of political acceptability and greatly improve policy effectiveness. He gives alternatives for distributing refunds: one method would distribute refunds in proportion to vehicle mass (rather than at a fixed rate per vehicle), so that the refund has an approximate correlation to vehicle utility and economic value. A second, alternative approach would apply separate feebates to multiple weight classes comprising limited, but overlapping, weight ranges, so that each feebate covers vehicles having similar transportation utility characteristics.

Another example is Green Building Feebates² targeted to encourage energy efficiency and reduction of water use. This has been suggested in Portland, Oregon, United States where for new commercial buildings over a certain size, the proposal sets up a feebate system. The City expects the program to be self-sustaining, with the fees from lower-performance buildings financing incentives for higher-performance buildings.

2. CARBON CAP-AND-TRADE

The basic operation of this system is that the state ‘caps’ total CO2 emissions and issues that number of permits³ annually. The number of permits declines each year until the target level of emissions is reached. Companies must acquire permits in order to emit CO2 or import it. Companies can buy and sell permits, hence ‘trade’.

Permits are broadly allocated in one of two ways: grandfathering (the free allocation to firms based on past emissions levels); and sale or auction. The option of grandfathering does not raise revenue for the government and has the potential disadvantage that the estimation of previous emissions may be open to error and manipulation. The firms may then trade the permits and thus raise revenues themselves, but as Fullerton et al (2008: 17, 18) point out, the policy erects an ‘entry barrier’, because new firms have to buy permits to sell their product in this market. Where an identical number of permits are auctioned, this has the advantage of raising revenue for government, and there is equal treatment of new and existing firms.

The advantages suggested for cap and trade are:

• predictable carbon emissions, therefore suitable for use in a strategy designed to achieve targets in reductions of emissions;
• fewer political obstacles than a tax;
• revenue can be returned via rebates and/or used for public goods;  and
• revenue rises as emissions decline.

Disadvantages include:

• the current schemes apply only to businesses (but see below re personal carbon trading);
• unpredictability of price; and
• market imperfections may occur as a result of the design of the system.

2.1 The Kyoto principle

The first binding international agreement on climate change was the Kyoto Protocol⁴, which came into effect in 2005. It was established to limit the growth in the emissions of greenhouse gases. Under the Protocol, industrialised countries and those in transition to a market economy took on a binding agreement to limit or reduce their emissions of six greenhouse gases (GHG). These targets are set relative to a country’s GHG emissions in 1990, the base year. They define the amount of GHG that the countries are allowed to emit in the 'commitment period' of 2008 to 2012. These targets represent either a cut in emissions or a lower rate of increase in emissions.

To achieve emissions targets, those countries are expected to implement initiatives that will reduce domestic greenhouse gas emissions. They can also make use of the three 'Kyoto Mechanisms' to assist in reaching its targets.

The three Kyoto mechanisms are:
1. Joint Implementation (JI): emission reductions which arise from project investments in other countries with their own Kyoto emission targets
2. Clean Development Mechanism (CDM): emission reductions arising from project investments in developing countries which don't have their own Kyoto emission targets. This allows rich countries to use credits from investments in emissions reductions in poor countries to offset against their own emission reduction commitments.
3. International Emissions Trading: portions of a country's emission allowances can be bought and sold on an international carbon trading market.

The principle on which the mechanisms are based is that the benefit to the global environment is the same wherever greenhouse gas emission reductions occur, so it is better to reduce emissions where the cost is lowest. The inherent assumption in this principle is that the country hosting the project will directly benefit and that the project should provide sustainable development in the host country. Companies have been able to use certified emission reductions (CERs) from CDM projects for compliance from 2005 onwards, and credits from JI projects (ERUs; emissions reduction units) from 2008 onwards. Credits from CDM and JI projects have been historically cheaper than EU allowances, so allowing them into the EU Emissions Trading Scheme (ETS) may make it less expensive for participating companies to meet their targets than it would otherwise have been.

Fullerton et al (2008: 20) set out the targets: under the Kyoto Protocol the EU is committed to reduce greenhouse gas emissions by 8 per cent by 2008-2012, measured against a baseline of the 1990 emissions level. Within this overall EU target, the UK is required to achieve a 12.5 per cent emissions reduction. In addition, however, the UK unilaterally stated a policy goal of reducing emissions of carbon dioxide, the principal greenhouse gas, to 20% below 1990 levels by 2010. The 2003 Energy White Paper stated a further ambition to achieve a 60% cut in CO2 emissions by 2050, ‘with significant progress by 2020’.

The EU ETS is the largest emissions trading scheme at present and covers the power sector and CO2-intensive industries such as iron and steel, cement, pulp and paper. It began operation in 2005, for a first three-year trading phase (2005–07) during which all permits were issued for free by governments. Phase two (January 2008 to end 2012) coincides with the Kyoto commitment period, and is now in progress. In this phase a proportion of allowances will be auctioned. Allowances can be traded within phases, but not between phases, and the cost of allowances reflects the cap on emissions set in each phase. Criticisms of EU ETS are that for phase one the allowance cap was regarded as having been too permissive, policymakers had over-allocated emission allowances and the allowance price plummeted when this became evident. The phase two cap, however, is more restrictive Although allowances were distributed free to existing firms in phase one, and only some 7% of allowances are scheduled to be auctioned by the UK in phase two, Fullerton et al believe the allowance price has much the same effect on abatement incentives and on marginal costs as a tax. The EU has announced that a third phase will follow in 2013, and has indicated a wish to move to 100% auctioning of permits in that phase.

The CBO report (2008: 25) discusses the lessons learnt from the warm-up phase of the ETS. They report that member states had insufficient historic emissions data for some participating installations, with the result that some member states based their allocations of allowances on estimates rather than actual emissions. The resulting inaccuracies led to caps that were less stringent than anticipated, and the market price for allowances dropped significantly when that over-allocation became apparent. The EU has learnt from early difficulties and amended later phases.

However Nordhaus (2007: 28) is more critical: ‘Notwithstanding its successful implementation, the Kyoto Protocol is widely seen as a troubled institution.’ Originally 66 percent of 1990 world emissions were included in the Protocol, but that number declined to 32 percent in 2002, primarily with the withdrawal of the U.S. from the Protocol, but also because of strong economic growth in excluded countries, principally developing nations. He suggests that strict enforcement of the Kyoto Protocol is likely to be observed mainly in those countries and industries covered by the EU ETS, and as their emissions today account for only about 8 percent of the global total, if the current Protocol is extended at current emissions levels, models indicate that it will have little impact on global climate change. He also finds that the Kyoto Protocol is highly cost-ineffective.