All environmental policy instruments, including traditional command and control mechanisms, such as performance standards and economic instruments, such as taxes and subsidies can have an impact on private investment decisions. However, market-based measures have the greatest potential to attract profit-minded investors for climate change mitigation. The main idea of market-based mechanisms is to solve environmental problems in an economically efficient way by sending appropriate price signals to private investors to internalize the societal costs of their business decisions and to provide an economic incentive for firms to reduce those costs.
Marked-based measures are sometimes favoured due to ideological reasons; for example, the belief that the government is not capable of or efficient in providing solutions.22 However, markets require clear price signals and a legal framework. Therefore, market-based measures necessarily imply a role for the government. They would not thrive in an environment, entirely free of regulation, where the government does not provide clear rules and frameworking conditions.23
Warwick McKibbin and Peter Wilcoxen argue that mitigation policies, which do not minimize cost, are doomed to failure. For example, they propose coal market reform through reducing coal subsidies and trade barriers as a solution that will generate both economic and environmental benefits. According to their calculations, if western Europe and Japan would remove their coal production subsidies and import restrictions, OECD GHG emissions would decrease by 13 per cent and global emissions by 5 per cent by 2005.24 Whilst price reform of this kind may disadvantage fossil fuel industries, the renewable energy sector can anticipate inflows of capital that would otherwise go to carbon-intensive industries.
Apart from subsidy reform, trading emissions may be an instrument with the greatest potential in terms of climate change mitigation. The first
21 IISD 2003.
22 Anderson and Leal 2001.
23 Stavins 1989.
emission trading schemes were developed in the United States.25 The most well-known programme is the sulphur dioxide trading scheme established at the beginning of the 1990s to tackle acid rain. This system enables firms to buy and sell rights to emit sulphur dioxide in a manner equivalent to buying and selling currencies in a foreign exchange market. The fact that it combines both environmental and economic benefits makes it attractive as a model for carbon trading systems. High penalties have prevented sources from violating the cap level—the maximum amount of allowable emissions. Indeed, since the acid rain programme commenced in 1995 sources included into the scheme comply with their caps at lower costs than predicted at the time the programme was implemented. (Emissions trading is an administrative approach used to control pollution by providing economic incentives for achieving reductions in the emissions of pollutants. It is sometimes called cap and trade.)
The experience has shown that the programme can ensure emission reductions at the least cost to society. This outcome should make it attractive even in the eyes of those who tend not to trust in market solutions. The programme is successful as the trade is beneficial for both buyers and sellers. Sources that have a high cost of abatement can buy additional allowances at a lower price whilst sources that are able to reduce emissions below their cap are rewarded for better environmental performance by selling their extra allowances and making a profit. The total cost of reducing emissions through trading is smaller than that of other policy mechanisms. For instance, it was calculated that the Danish goal of 21 per cent and the European Union (EU) goal of 8 per cent of GHG abatement would be achieved at nine and 24 times the cost, respectively, by using taxation policy than with the use of emission trading.26
With regard to pollution permit trading, there is a clear incentive for decreasing emissions because there is a monetary value attached to allowances. Emission trading systems stimulate research and development, as the business sector can anticipate profitable emissions abatement. Furthermore, emission trading systems provide high flexibility in choosing which type of emission reduction—including investment into abatement technology, fuel switch, energy efficiency measures or utilization of renewable energy sources—is most suitable. In contrast, command and control approaches
25 See Hahn's classic article 'Economic Prescriptions for Environmental Problems: How the Patient Followed the Doctor's Orders' (1989) for a review of early efforts to achieve emission trading and emissions charges in the US and Europe.
26 Svendsen and Vesterdal 2003.
that, for example, specify the types of pollution control devices to be installed do not provide the same degree of flexibility.27
In 2008, a new scheme came into operation, which promises to become the largest emission trading market in the world. The EU's Emission Trading Scheme (ETS) would be applicable not only in the EU, but also in accession countries and the countries of the European Economic Area (EEA). The ETS is designed to contribute to the greenhouse gas reduction commitments under the Kyoto Protocol. The first emission trades have already been agreed to, indicating the interest of private sector actors. For example, Shell Trading will sell a considerable number of allowances to Nuon during the first compliance year.28
Several challenges in developing EU-wide emission trading remain to be addressed, including the harmonization of fragmented national markets, the possibility of interaction between parties covered by the EU scheme with other Kyoto parties on the base of bilateral agreements and building up links with project-based Kyoto mechanisms. There are voices advising against the use of credits from Joint Implementation (JI) and Clean Development Mechanism (CDM) in the ETS. In its letter to the European Commission dated 28 February 2003, the Climate Action Network (CAN) Europe expressed its reservations and demanded to 'Keep the emission trading scheme as a domestic measure for cutting industry emissions!'29 The Network argued that some of these projects are non-additional and even environmentally destructive.30
Two EU countries, Denmark and the UK, have established national carbon emission schemes, already. Lessons learned from the Danish experience indicate that the level of CO2 emissions remains almost the same as in the baseline year. Therefore, Denmark is aware of the difficulty in meeting emission reduction goals with the help of measures, which are used only nationally. Denmark is ready to buy emission credits from other countries, which are below their Kyoto targets. The country is likely to become an active participant in the EU-wide emission trading scheme, as well as in other international schemes and projects aimed at GHG reduction.
A study undertaken by Enviros Consulting, which evaluated the UK carbon trading programme, concluded that the scheme provided local companies with the necessary experience to enter the EU-wide emission trading
27 US EPA 2002.
28 Shell International Limited 2003.
29 CAN 2003.
system and other international carbon markets. At the same time, the study questions the effectiveness of the programme in decreasing UK carbon emissions. However, the authors of the study hope that as the scheme matures it will contribute to the UK Kyoto target more significantly. To improve the operation of the programme, Enviros Consulting recommends changing voluntary enforcement mechanisms into mandatory ones.31
Another major instrument for climate change mitigation is environmental taxation. Several industrialized countries introduced taxes on the carbon content of oil, coal, and gas. This measure is designed to cut the use of carbon-intensive fuels and increase the use of cleaner energy, thereby decreasing GHG emissions. In comparison to environmental taxes, emission trading may be more effective in terms of reaching an emission target, since it sets a strict emission goal. On the other hand, a tax may provide more up front certainty as to the cost of the programme, and it can be used in market segments where the establishment of an emission trading scheme is impractical or unwieldy. A mix of emission trading and environmental taxes may be the most effective approach in many countries. The former instrument is better applicable to large polluters, while the latter better suits small polluters.32
If an emission trading system is implemented at an international level, it could create strong demand for investment projects designed to reduce GHG emissions. Private capital could be mobilized through this mechanism because GHG reduction projects would yield credits that can be sold in the market. Firms that are able to reduce GHGs at a price below the trading price can make a profit out of mitigating climate change. In this way, climate change could become the basis for a growing sector of business activity, ultimately developing into a major economic driving force in the coming decades. Specialists from Natsource, DZ Bank and other organizations involved in climate change mitigation see a big advantage of a carbon market in that it will enable '(...) bringing future revenues from forward GHG contracts to the beginning of the project, rather than payments at the back end'. In their view it will help to get '(...) lots of projects off the ground because of the ability to accelerate cash flow in projects where cash is required in the early stages'.33
There are also critical voices concerning emission trading schemes.34 For example, Martin Tampier argues that the renewable energy sector will
31 Enviros Consultancy 2003.
32 Svendsen and Vesterdal 2003.
33 Innovest 2002b, 28.
34 Victor 1991, for a critical perspective on market-based mechanisms.
not be able to benefit from the ETS since renewables will not be covered. The only possibility for them to get involved is to offer renewable energy to those who might wish to substitute for fossil fuel generation. Moreover, for many firms, paying the non-compliance penalty might be cheaper than reducing their emissions. A low penalty would encourage many firms to prefer non-compliance rather than investing in more expensive clean technologies. Further, an emission trading scheme may not, in itself, be sufficient to achieve broader policy objectives, such as renewable energy development. It is not clear if emission trading will help renewables to cover the gap between production costs and electricity prices, and thereby, to become more competitive with conventional fuels. However, the future may bring a decrease of renewable energy prices and at the same time an increase in the prices for emission credits and energy from fossil fuels.35
Currently, energy efficiency projects may be better suited to take advantage of emission trading, while renewables could benefit from JI. However, this assumption should be subject to further research. The Transnational Institute states that JI and the CDM favour implementation of large scale renewable energy projects since small ones have more difficulties in measuring and identifying energy production. According to Bachram et al., 'This undermines diversity and innovation in the renewable energy sector as a whole.'36
In terms of actual policy developments currently under implementation, the development of a GHG trading system would be an essential component of a reform of incentive structures. If the effectiveness of such a system is not whittled down in negotiation, and if compromise does not result in the lowest common denominator, GHG trading has the potential to mobilize large sums of private capital, especially if combined with carbon taxes and other policy instruments. The question is how to bring these ideas into practice. In order to make GHG markets operate efficiently, the main tasks include producing demand, enhancing buyer confidence in pricing, bringing greater liquidity to the GHG market, overcoming the short-term cash flow problems and creating larger economies of scale.37
The main task for private investors is to incorporate the effects of GHG regulations and carbon price sensitivities into the analysis of project economics.38 The interest among investors will increase if it can be shown that technologies become cheaper as a result of commercialization and that GHG emission markets offer opportunities to create profits from project
35 Tampier 2003.
36 Bachram et al. 2003, 22.
37 Innovest 2002b.
cash flows and advisory fees. The alternative to voluntary action on climate change is higher taxes and stricter environmental regulations, as well as higher indirect costs due to environmental and health damages, which ultimately are paid by households and firms. An important advantage of GHG trading is that it includes incentives based on self-interest, such as for instance, direct profit opportunities for firms, which can reduce pollution at less than the trading price. Thus, GHG trading is not favoured by arguments about enlightened self-interest, although these arguments may be important to long-term profits and business competitiveness.
Market-based mechanisms should not be treated as a panacea for solving environmental problems, since there are cases, which require complementary mechanisms, including economic instruments and command-and-control approaches. However, market-based provisions should be further investigated and exploited when they offer advantages. The US sulphur trading programme has shown that market-based approaches can be cost-effective in mobilizing private capital for clean technologies, which gives ground for optimism concerning carbon trading schemes. Using a mix of measures, climate change mitigation policy can provide a stimulus for speeding up the commercialization of clean energy technologies.39
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