Larson B collapse in Antarctica (Photo: Wikimedia Commons)
International efforts to control air pollution have created a market in pollution credits. Experience with such credits under the Kyoto Protocol's clean development mechanism (CDM), sulfur dioxide credits in the US and credits for greenhouse gases in the EU has shown that such devices can create market incentives to reduce air pollutants. It has also shown that they can in some cases create counterproductive incentives. And they can provide opportunities for greedy and/or unscrupulous operators to get a financial windfall from public property.
The Kyoto Protocol established the CDM mechanism of emissions credits, known as CDM credits, that began operation in 2005. The CDM credits are designed to create economic incentives for companies to invest in emissions reduction technology. The EU set up its own system of carbon credits in pursuit of the Kyoto carbon goals, with the initial trial period running from 2005 to the end of 2007. This is not at all an exotic idea. The US has had such a system of emission credits in place since the 1990s for sulfur dioxide to reduce the acid rain problem.
The idea of such CDM credits is that facilities are allowed a certain level of emissions. If they are operating below that level, they are allocated a certain number of credits. Above their allowed emissions level, they are in a deficit position and have to get credits from companies that are below their own emission level.
One method of acquiring those credits is for one company to buy them from another. This is known as the "cap-and-trade" method. Another method is for a company to earn credits by investing in emission-reduction technology elsewhere. Such investment in developing countries are thus encouraged because investments there are often cheaper. This is known as the "offset exchange" method. In both approaches, producers of emissions have an economic incentive to invest in equipment and technology to reduce emissions somewhere in the world. And the assumption of the Kyoto processes in that the total amount of CO2 produced is decisive for affecting global climate change, not the particular source.
David Victor and Danny Cullenward of the Stanford Program on Energy and Sustainable Development (PESD) evaluate the experience to date with CDM emissions credits in Making Carbon Markets Work, Scientific American Dec 2007. Weirdly, the actual print version is behind subscription at the Scientific American Web site. But the extended version of the article linked here, dated 09/24/07, is available there in full. Strange. The Stanford PESD is sponsored by BP and the Electric Power Research Institute.
Not unlike regulation of financial markets, the emissions credit market functions within structures and regulations created by government. For markets to work effectively, transparency and a basic amount of stability are required. These markets are created much like the market for cell-phone bandwidth was created, an example Victor and Cullenward use. The airwaves are considered public property in the US and licenses to use certain parts of the bandwidth were auctioned off to companies seeking to acquire them. In this case, market mechanisms were very much at work in setting the initial prices for the licenses, because companies bidding for them could run their own economic analyses of the "net present value" of the expected benefit of the slice of bandwidth for which they were bidding.
Focusing on the EU's experience with emissions credits these past two years, Victor and Cullenward note that what governments do when they create such credits is that they create a new market where none existed before. As the types of emissions credits increase, there will be more market data to use in setting initial prices. The air and public waterways are common property, or common resources. This is a familiar notion in the economics of pollution. Because an emitter of air pollutants doesn't own the air and is not directly responsible for cleaning it up from the pollutants it emits, in the economics of the enterprise the cost of that pollution is called an "externality", which means that it's someone else's problem, not that of the facility who causes it. Emissions credits are one way to make pollution an "internal" economic issue for businesses producing pollutants.
But, as everyday experience shows, even though most academic economists seem to be stubbornly oblivious to the fact, markets aren't the solution to everything. Specifically, the results they produce aren't universally good. Markets have imperfections, a formulation economists will admit, though their theological belief in their supply-and-demand curves suggests that all problems could theoretically be solved by improving the purity of markets. One problem in the way the EU's emissions credits worked is that governments were successfully lobbied "to give away most of the credits for free to existing emitters". As Victor and Cullenward write, such a public giveaway of property (emissions credits) to polluters can have the beneficial result of kick-starting the market for such credits. But it also means that essentially the government creates private property out of a public good, effectively licensing air or water to individual businesses, making it "valuable property where none existed before." Just giving those credits away to businesses rather than auctioning them off and getting some revenue from them to be used for public purposes is a very un-Jacksonian result. Among other problems, it allows companies that get into the market early to manipulate it to the unfair detriment of later entries.
Other issues in the actual functioning of the emissions-credit market have also appeared. A baseline emissions level has to be set around which the issuance of credits has to be calculated. Problems in setting the baseline can cause too many credits to be issued, reducing the overall market price and therefore counteracting the market incentive involved. The EU, according to Victor and Cullenward, is currently setting the quality standards for the credits. But the EU also allows its companies to purchase credits from some countries where the standards may not be as strict, i.e., where there's less assurance the anti-emissions investment goals which the credits are designed to promote are being met. The baseline-setting process can sometimes be gamed to set a high baseline which then can be met by relatively cheap emissions-control measures, which has the effect of creating a market incentive to delay such investments.
Victor and Cullenward have five basic recommendations to address some of the problems that have appeared so far, as the US and other countries consider expanding emissions credits: (1) rely more on tax incentives which, they believe, will provide more predictable cost projections and better serve emissions-control investment goals that emissions credits do; (2) tighten regulations under cap-and-trade systems to set maximum prices on the credits and also require new credits to be issued by auction rather than as corporate giveaways; (3) developed nations should take the lead in setting tighter standards to require that all credits traded in their markets meet minimum quality standards; (4) supplement market mechanisms by direct regulation; (5) expand public investment in developing emissions-control technology. I'm not as convinced about the value of tax incentives as they are, because what starts out as a meaningful incentive can evolve into a simple tax loophole. But their points about better regulation of the international emissions-credit markets and the auctioning off of the pollution credits rather than making them giveaways by taxpayers to corporations make a lot of sense to me.
Larson B collapse in Antarctica (Photo: Wikimedia Commons)
