Carbon trading and other policies

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The environmental benefits of a cap and trade scheme will be largely determined by the stringency of the cap. But the existence of a cap also has important implications for other climate policies that affect the emissions covered by the scheme. It is not widely recognised that the coexistence of a cap and trade scheme with such policies implies that the latter will contribute nothing to global CO2 reductions during the trading period in which they are introduced; and will only contribute to global CO2 reductions during subsequent periods if they lead to a corresponding increase in the stringency of the cap (Sorrell and Sijm, 2003).

To illustrate the logic behind this argument, assume that the second policy is a tax on the fuel used by a number of trading scheme participants. As a consequence of this tax, the affected participants are likely to reduce fuel use (and hence emissions) further than they would under the trading scheme alone, which means that they are likely to either sell more allowances or purchase fewer allowances. The aggregate emissions from participants in the scheme will not have changed, since other participants can be expected to purchase and use any 'freed-up' allowances to cover either increases in emissions or reduced emissions abatement.5 As a result, worldwide emissions will not have changed either and the environmental benefits of the tax will be zero in the short term.

At the same time, the reduction in allowance prices will make it easier for other participants that are not affected by the tax to comply with their targets. In theory, overall abatement costs will have increased6 and the participants subject to the tax will be subsidising abatement by (possibly competitor) participants that are not.7 If all participants were to be subject to the tax, the primary effect would be to increase overall abatement costs and lower the allowance price.

In the case of the EU ETS, these conclusions apply both to policies that affect the direct emissions from participants and to those that affect electricity demand or the carbon intensity of electricity production, such as support mechanisms for renewable electricity. In principle, these policies will raise the cost of meeting the EU ETS cap without delivering any additional emission reductions, at least in the short term. However, policies that affect emissions that are not covered by the EU ETS may contribute emission reductions independently of

(and in addition to) the scheme. For example, policies that affect household fuel consumption should contribute additional emission reductions, while policies that affect household electricity consumption will not.

In practice, emission caps may be tightened in subsequent trading periods. The contribution of other policies to long-term emission reductions will then depend upon how these caps are established. The promotion of renewable electricity, for example, should lower the carbon intensity of electricity generation and could in principle contribute to the negotiation of more stringent emission caps for the generating sector in the next trading period. By this process, support for renewable electricity may contribute to additional emission reductions in the longer term compared to a counterfactual scenario in which such support is not provided. Conversely, it is possible that the absence of such support would have made no difference to the stringency of the subsequent caps. In this case, the support for renewable electricity would not have contributed any additional emission reductions, although it could have stimulated technological development, thereby affecting the cost of future emission reductions. But the important point is that the existence of the cap removes the straightforward link between a particular policy and/or investment and the resulting emission reductions. These expected emission reductions only translate into real, global emission reductions if they subsequently lead to a proportionate reduction in the relevant cap. The common assertion of policy X reducing emissions by Y tonnes of CO2 is thereby undermined.

Nevertheless there may still be legitimate grounds for introducing or maintaining such polices, even if their net contribution to emission reductions is zero in the short term and ambiguous in the long term. Sorrell and Sijm (2003) identify four such grounds:

(i) Overcoming market failures that inhibit the diffusion of cost-effective, lower carbon technologies (for example, minimum energy efficiency standards for domestic appliances);

(ii) Overcoming market failures in the area of technology innovation and diffusion (for example, support mechanisms for renewable electricity);

(iii) Delivering objectives other than efficiency, such as equity, supply security and political feasibility (for example subsidising the insulation of fuel poor households); and

(iv) Compensating for deficiencies in the trading scheme design (for example using a tax to compensate, very imperfectly, for the absence of allowance auctioning).

Given the multiple market failures that exist in many sectors, the case for such policies is frequently very strong. For example, the adoption of energy efficient technologies by households is inhibited by numerous barriers, which make the price elasticity of household energy consumption relatively low. Since allowance prices would consequently need to be very high to have a significant impact on behaviour and emissions, the associated distributional impacts are likely to be unacceptable. Hence, in most cases it is not a question of either a trading scheme or traditional regulatory measures: both are likely to be required.

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