First-mover disadvantage

Buttonwood

Jul 5th 2005
From The Economist Global Agenda

Europe and its new carbon-emissions trading system are doing their bit to make pollution history. Where is everyone else?

WHILE aircraft laden with G8 leaders screech down British runways, ready for the climate-change dust-up at Gleneagles, something else is screeching up. The price of traded carbon-dioxide emission allowances in Europe—permits to pollute, if you like—has increased fourfold since January, touching €29.35 ($34.90) on Monday July 4th, a record.

The amounts involved are small—less than 1m tonnes a day, on the exchanges—compared with the 2.2 billion tonnes a year in European permits issued. But they have grown surprisingly quickly since Europe launched its emissions-trading system for carbon dioxide—the biggest of the Kyoto treaty’s six greenhouse gases—in January.

New markets are popping up: Austria’s Energy Exchange was the most recent, on June 28th. And others are consolidating and innovating: on June 24th, for example, France’s Powernext and the European Climate Exchange in Amsterdam teamed up to offer spot and futures contracts side-by-side. Over-the-counter contracts sold by brokers account for about two-thirds of total business, but the exchanges (especially the increasingly dominant European Climate Exchange, offshoot of the Chicago Climate Exchange, a voluntary emissions market) are picking up market share. Spot and futures contracts are on offer, and options are emerging. Rising prices are tempting in more sellers. Even hedge funds are interested.

Thanks to the Kyoto treaty on climate change, which came into effect in February, most rich countries regulate emissions of carbon dioxide in some manner. Mandatory emissions trading is only one way to help countries and companies switch to using less, and cleaner, energy. But it has two particular huge merits. The first is that it is, or should be, efficient. Under “cap-and-trade” schemes, firms are allocated tradable allowances to emit so many tonnes of carbon a year. A big polluter that is overshooting its limit can buy surplus allowances from light polluters. Thus is virtue rewarded and pollution checked at an overall cost that is less than if each firm were required to meet an individual target. The second merit is that the system is market-based. Buyers and sellers receive and send clear price signals to inform business decisions.

That’s the theory, at any rate, and history suggests that it is well founded. America has cut in half its sulphur emissions (the key component of acid rain, the global warming of its day) over the past ten years by imposing mandatory caps with tradable allocations. That approach was the inspiration for Europe’s carbon-trading system. In Britain, oil giant BP set up a trading scheme among its own companies in 1998 and in three years reduced emissions by one-fifth. Other voluntary trading experiments are producing positive results.

The European Union now has the world’s most advanced trading system in place. There are, however, problems to resolve: participation is not as high as it could be, with new member states in central and eastern Europe among the conspicuously missing, and uncertainty about the next round of allocations is holding back companies in western Europe too. It could be also be argued that the system has so far helped companies to make superficial, time-buying changes rather than the longer-term investments in technology that would allow them to reduce dependence on dirty fuel more fundamentally. Nonetheless, the market is growing and companies are taking it seriously, factoring carbon prices into their business decisions.

There the good news ends, for European firms are beginning to fear that the price of pioneering is too high. Europe has signed up to Kyoto, and its companies face fines if they exceed their emissions caps. America, the world’s biggest polluter, has not. And China, the second biggest, and India, which is coming on strong, are exempt from its provisions. Greenhouse gases result in global, not local, warming. The upshot of all this is that Europe’s companies are at a competitive disadvantage as they shoulder the cost of something that should benefit the whole world. And now, because of the high price of oil and gas, that disadvantage is looking a lot bigger than it did.

When Europe launched its emissions-trading scheme, oil cost $42 a barrel. Today the price ranges between $55 and $60, and it looks likely to stay high for quite a while. When oil and gas are expensive, Europe’s utilities burn more coal instead of gas. Because coal is dirtier, they need to get their hands on more carbon allowances to compensate, and that necessity is driving up their price. And it is likely to go up still more. Point Carbon, a research firm based in Oslo, reckons that the market-clearing price for carbon is “considerably above the current market”.

Some companies are talking of moving offshore to avoid the mandatory caps. Others, more interestingly, are trying to persuade G8 leaders to fix the system, establishing a global emissions-trading framework that will last until at least 2025. Uncertainty is casting a shadow over not only the tradable emissions market but also moves to reduce dependency on carbon fuels more generally.

Kyoto is up for renewal from 2012, and the short horizon is a problem in itself. Worse, countries are going ever more separate ways in seeking to curb emissions. Norway, Canada, Switzerland and Japan, for example, are thinking of setting up some sort of domestic trading schemes, but only Norway's is likely to be fully compatible with the EU's in the first instance.

It is America, of course, which matters most. Some companies and some states (California, the north-east) are moving ahead on carbon controls. But neither George Bush nor America’s Senate is in any hurry to establish mandatory controls across the country. Mr Bush’s claim that to do so would destroy America’s economy is nonsense. Pointing out that fast-growing China and India have yet to accept Kyoto is not. Britain’s Tony Blair wants to jawbone the Chinese and Indians into falling into line on climate change, but given the failure of friendly persuasion to move the yuan one iota, the chances of talking China into increasing its costs of production in this way look remote.

What can possibly come out of Gleneagles on climate change? Not much, in all honesty: especially after the high-testosterone charge of Live8, most attention will probably be given to the easier issue of aid for Africa. What could be agreed, however, is an unglamorous but necessary commitment to work for a common set of fundamentals—an assertion, as Andrei Marcu, president of the International Emissions Trading Association in Geneva, puts it, “of the political will to make countries around the world develop basic building blocks in parallel so that in future there is enough commonality to converge.” Easier said than done.

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