Climate – Carbon Tax more effective than Cap&Trade?

Should we just tax greenhouse gas emissions or should we just allow the “Cap & Trade” markets to do the job?

This conundrum was “solved” for us by the Kyoto Protocol in 1992 that set the world up for “Cap & Trade” markets – where standardised greenhouse emission allowance can be bought and sold like in any stock market. 

It took decades  to agree on how this would be handled, but in the EU, we now have almost 13 years of “Cap & Trade”. European Union’s  Emissions Trading System (ETS) was the first large greenhouse gas emissions trading scheme in the world where companies who pollute our air with carbon dioxide must buy Carbon Allowances to set off their emissions of carbon dioxide. 

Under the ETS, EU Member States agree on national emission caps which are approved by the EU commission. They then allocate allowances through auctions or for free to their industrial operators, and track and validate the actual emissions in accordance with the relevant assigned amount. The allowances to be retired after the end of each year.

The operators within the ETS may reassign or trade their allowances by several means:

  • privately, moving allowances between operators within a company and across national borders
  • over the counter, using a broker to privately match buyers and sellers
  • trading on the spot market of one of Europe’s climate exchanges

Like any other financial instrument, trading consists of matching buyers and sellers between members on recognised exchanges where companies and private individuals can trade through brokers.

This whole trading system is complex and is dominated by a very small number of big investment bank traders and hedge funds who buy and sell these allowances to make trading profits or for speculative investments. The FT recently reported the following: “A select group of specialist traders at hedge funds and investment banks, including Morgan Stanley and Goldman Sachs, are churning bumper profits from a once niche commodity that has risen phoenix-like from a decade-long slump.” Like gold and other commodities these traders and investors create no value for society with this trading except income and profits for the owners!

At the start too many allowances were granted for free and the price of these alliances did very little to get industrial operator to invest in emission reductions. In fact they were able to buy cheap allowances from developing countries that in turn did not always invest in clean technologies or plant new forests. Criminal gangs have hacked into trading systems and stolen allowances and traded them without  paying due taxes.

Allowances remained at very low levels because of the financial crisis during this last decade and have done little to reduce our emissions. Although the EU continues to state that emission will be cut by 20% by 2020, so far the result is just 8%, and we do not know how much is attributable to trading because many countries have their own pollution taxes!

More recently the price of emission allowances has shot up because of fewer allowances being made available for free under ETS, and because of Germany’s moves out of nuclear plants and more heavy reliance on fossil fuels, more extreme hot weather in Europe over the summer, lower hydropower levels in Scandinavia, and lower wind levels in Germany.

These matters cause energy prices to be very volatile, up and down, and make it challenging for energy companies to plan for investments that reduce greenhouse gases. Trump’s short-sighted policies for supporting fossil fuels and his rejection of the climate change agreements are just making matters worse for the world since they are the biggest polluter.

So should we continue with expensive and complex “Cap & Trade” solutions or should we simply tax emissions? It is relevant to ask the same question about transport – should we go to the expense of GPS tracking  for fossil fuel vehicles or should we just charge a fuel tax. The latter is so obviously correct that any other discussion must be viewed to be led by the oil companies who would benefit from the huge delays in implementing any complex and expensive GPS tracking system!

The former Fed boss, Ms. Yellen has also supported the idea of taxes on greenhouse gases at source: “Climate change is a very critical problem that we need to address,” she told the Financial Times. “When the central problem is the damage caused by greenhouse gas emissions, the cleanest and most efficient way to address it is to tax those emissions.”

… and there are also other unintended consequences with “Cap & Trading” schemes. A Norwegian trader managed to cause over €100 million in losses when speculating that German and Nordic electricity prices will converge on the Nordic NASDAQ. He was wrong because one of the reasons was the big hike in Carbon Allowance prices, and Fortum, a member of Nasdaq, now must pay in €20 million to cover these losses, along with the other members of the clearing house. These self regulated clearing houses are at risk for such losses. If a small single trader can cause such losses then what about the really big players? Are they “too big to fail”. 

You do not have to look too far for the next taxpayer bail out. Trusting the regulators and supervisors should not give us much comfort because they only know about losses afterwards. These same regulators and supervisors were happy to allow the clearing houses to be self-regulating! What is so wrong about an energy or greenhouse tax? Taxpayers would not be on the hook for big losses and they get to have cleaner air earlier, rather than waiting for decades when nothing much happens.

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