How to confront the carbon crunch

ANALYSE - The Emissions Trading System the EU established to reduce carbon emissions is far from perfect. What are alternative solutions?

Emissions of damaging carbon dioxide within the EU have fallen over the last two decades, but not primarily due to climate action policies. The de-industrialisation of much of the continent and increase in goods imported from countries such as China has been a much greater driver of the reduction. Worldwide, carbon emissions continue to increase.  The 1997 Kyoto Protocol has made little impact, partly because – despite being legally-binding – it is not really enforceable, and partly because it seeks to address carbon emissions arising from production. It should instead address emissions arising from consumption.

At a recent CER meeting, Dieter Helm, a professor of energy policy at Oxford University and a leading voice in European energy policy, outlined a possible new approach to EU climate action. (These were based on his new book, ‘The carbon crunch: how we’re getting climate change wrong – and how to fix it’.) Helm favours market mechanisms, such as price signals, over direct state intervention, such as governments deciding whether we should use gas or offshore wind power to heat our houses. The EU has established a market-based mechanism to reduce carbon emissions, the Emissions Trading System (ETS), but it does not work.

The ETS has not lead to a significant reduction in emissions, nor to much investment in low-carbon energy technologies. The main reason is that the EU has handed out too many permits to pollute to EU-based companies. As a result, the carbon price has been too low to encourage companies to become greener.

Opting for a carbon tax creates carbon leakage

In 2008, the European Commission implemented a number of useful steps to fix the system: it started auctioning permits rather than handing them out for free and it set a Europe-wide cap for overall emissions, rather than leaving each EU country to set its own. But then the EU economy plunged into recession, economic output fell and the number of permits once again was much higher than needed.  The carbon price has fallen to around €8 per tonne of carbon dioxide, far below the €30 that experts say is needed to have an impact. The Commission has rightly proposed that permits now need to be withdrawn from the market. But EU member-states are reluctant to put pressure on their companies in the middle of the downturn.

Helm argues that instead of trying to fix the system, the EU should opt for a carbon tax. A carbon tax , levied on each source of carbon pollution or on retailers of, for example, transport fuel, would introduce much greater certainty and predictability than the ETS has done. The EU could introduce the tax at a low level but with a pre-announced escalation.

However, faced with a higher carbon price, many European companies would relocate yet more of their production to countries that do not impose a price on pollution. Climate experts refer to this process as carbon leakage. Europe would consume the same amount of goods. But these goods would be produced in countries that are less energy-efficient and often use more of the most polluting fuel, coal. Add the carbon emitted through transporting these goods back to Europe and it becomes clear that carbon leakage increases global emissions. For the world’s climate it does not matter where emissions occur.

Kyoto’s flaw

Helm therefore argues that the 1997 Kyoto Protocol has a central flaw: it seeks to reduce greenhouse gas production in signatory countries. It should instead address greenhouse gas emissions resulting from consumption. If goods are manufactured in, say, China but then imported into, say, Europe, the emissions caused by the goods’ manufacture and transport should be attributed to Europe, not China.

Helm would address this problem through imposing a tariff on goods that incorporate a high carbon content, a so-called border tax adjustment. To avoid falling foul of World Trade Organisation rules, any country that imposes a carbon price would be exempt from these border taxes. Countries around the world would then have a strong incentive to establish a carbon price, to gain free access to the world’s single biggest internal market.  As Helm points out, governments will prefer to collect revenue from carbon taxes or a version of an ETS rather than seeing the EU collect the revenue through border taxes. So this approach could help to spread carbon pricing.

Political context

Helm’s solutions are well-thought out and intellectually coherent. He is right to argue that a bottom-up approach based on carbon pricing and carbon consumption would achieve more than the defunct ETS and the top-down carbon production targets of the Kyoto Protocol. But he fails to take into account sufficiently the political context in which such solutions would have to be implemented.

Helm is not alone in advocating carbon taxes. Many economists do so. Indeed, Jacques Delors, perhaps the most persuasive president the European Commission has ever had, argued strongly for a carbon and energy tax during his tenure from 1985-1994. Then, as now, the governments of the member-states insist that tax is a matter of national sovereignty and each country has a veto over EU proposals. The UK in particular is categorically opposed to the EU getting involved in tax policy, even if its purpose is to help the climate. This is why the EU then opted for the ETS – which as a trading system could be established by qualified majority voting.

A more promising route would therefore be to add a carbon floor price to the ETS to push carbon prices up and imbue them with the stability needed to trigger investment in new technology. The floor price would be a ‘safety net’ rather than a tax so it would not require unanimity.

An effective ETS would still need to address the issue of carbon leakage. The Commission explored the idea of border tax adjustments in 2008, when it last amended the ‘emissions trading directive’. Nicolas Sarkozy, then French president, was a strong supporter. But Germany and other exporting nations feared reprisals from international trading partners and a generally negative impact on global trade. The Commission shelved the idea.

The current Commissioner for Climate Action, Connie Hedegaard, says that border tax adjustments should not be ruled out, but she has little support in the rest of the Commission. There is, however, an example of EU proposed action on border taxation. The EU has recently included emissions from airplanes in the ETS. All airlines will be required to buy permits for emissions generated by flights to and from Europe. Since this increases the price of flying from say, Dallas to Paris or from London to Shanghai, it is a de facto border tax adjustment. Chinese and Indian airlines in particular have threatened reprisals. The Commission has agreed to postpone the operation of the new system until the autumn of 2013 to see if international agreement on a carbon price for aviation can be reached. But Hedegaard made clear that if no agreement is reached, the EU will proceed with the inclusion of aviation in the ETS.

Germany is key

What are the chances of EU governments agreeing an ETS floor price and border tax adjustments? Countries such as Poland, which burns a lot of coal, would oppose a floor price but the threat of being outvoted would make them more likely to compromise. The French government would support this approach, given France’s reliance on low-carbon nuclear energy and its predilection for industrial policy and managing trade flows. The UK government has introduced its own ETS price floor, but it is increasingly hostile to anything proposed by ‘Europe’.

Germany’s position will be key. The country’s decision to phase out nuclear power will inevitably increase its greenhouse gas emissions, at least in the short to medium term where it will rely more on coal. So it might be cautious about imposing a higher price on carbon. Berlin also remains hostile to any interference in international trade.

The Germans could, however, be brought round if the economic arguments stacked up in favour. Michael Grubb of Climate Strategies calculates that if an ETS price floor of €15 per tonne was introduced in 2015 and raised €1 each year, the cumulative revenue by 2020 would be €150-190 billion, depending on how many permits were given out for free. Around a third of this revenue would go to the German government. Germany could do with this extra money to finance its so-called Energiewende – the very costly transition from nuclear, coal and gas to renewables. Other countries, such as the UK, would also use the extra revenue to keep energy bills down despite the mounting costs of renewables.

A Berlin-Paris-London coalition in support of a stronger ETS and border tax adjustments is unlikely in the near future but not inconceivable. All those concerned about the global climate – and about European economies – should support Helm’s proposed path the tackling the carbon crunch.

Stephen Tindale is an associate fellow at the Centre for European Reform.