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Carbon Capping – What the U.S. Can Learn From Europe’s Experience

When US President Barack Obama and Canadian Prime Minister Stephen Harper met in Ottawa last week, North Americans learned that a continent-wide cap-and-trade system for limiting greenhouse gas emissions was officially on the political agenda after years of speculation. This was reinforced a few days later when President Obama addressed Congress and asked for “legislation that places a market-based cap on carbon pollution”. [1] [1]

By definition, a “market-based cap” increases the costs faced by any form of manufacturing or production that emits carbon dioxide gas. Naturally, businesses are not in the habit of taking on extra expenses without passing the cost on to consumers and this is the real fly in the ointment – no one can argue against the merits of pollution reduction, but how can pollution be reduced without pricing goods and services out of the reach of a large segment of the population? It is this unknown that causes the most trepidation, and looking to Europe where a cap-and-trade system has been in place for nearly four years, provides little comfort for those vulnerable to cost increases as the first few years of the carbon capping scheme has resulted in wide-scale price increases.

How Does Cap-and-Trade Work?

The basic idea of a cap-and-trade system is that CO2 emitters are given a quota that represents how much CO2 they may emit without penalty – this is the “cap” part. For those firms that do not require the full amount they have been allotted, surplus credits can be listed on a carbon exchange where firms that are in danger of exceeding their cap, can buy credits. This is the “trade” part.

Increase in European Energy Rates

The European Union created the first greenhouse cap-and-trade system under the European Union Emissions Trading Scheme (EU ETS). Almost overnight, consumer prices jumped and no product was impacted more than the price of electricity which skyrocketed from one end of Europe to the other. Strangely enough, as consumer prices rose, so too did corporate profits – in fact, for the first few years of the carbon market, electrical utilities realized record profits.

When pressed for an explanation as to why utility rates jumped so quickly, Lars Josefsson – CEO of European utility giant Vattenfall and a key advisor to German Chancellor Angela Merkel – dismissed the criticism by saying that high electricity prices were “the intent of the whole exercise – if there were no effects, why should you have a cap-and-trade system”. [2] [1]

Initially, the cost to buy additional carbon credits increased, but as the economic crisis grew in intensity, carbon credit prices began to fall, losing 60 percent in the last two years alone. This depreciation can be traced directly to the effect of the global recession as a lower demand for consumer goods has decreased the need for production capacity, and as companies have scaled back production, they have been able to operate within their caps.

Colette Lewiner – an energy consultant with Capgemini – explained in a recent Business Week article how carbon credit price volatility has thwarted efforts to reduce carbon dioxide emissions:

“When the price is so low, it plays no role in investment decisions concerning lower CO2-generating power plants. But when prices are too high, it doesn’t provide an impetus to go green as it is simply cheaper to pollute.” [3] [1]

In fact, some companies that had made gains in carbon reduction when the program was first implemented, have actually reversed much of their progress as carbon credits became cheaper to purchase. According to Oliver Lejeune of New Carbon Finance, many of Europe’s utilities initially switched to natural gas to produce electricity when carbon credits were at their most expensive, but when credits dropped to less than half their value, many reverted back to the much cheaper coal. The savings available using coal over natural gas more than offset the additional cost of buying carbon credits. [4] [1]

The big question of course, is what has all this actually meant for the environment? Unfortunately, according to an April 2008 article in the Wall Street Journal which quoted analysis by Oslo-based Point Carbon, emissions for the first three years of the program actually increased 1 percent a year on average. Much of the blame lies with governments providing overly-generous initial cap limits, but the collapse in the price of carbon credits as discussed earlier is also a major factor. [5] [1]

Imports from Non-Carbon Taxing Countries

European firms are also dealing with the issue of imports from countries that do not attach a price to carbon. Because these foreign-produced goods can be produced more cheaply, they often undercut domestically-produced goods. As a result, demands for tariffs to make foreign-made goods more expensive relative to domestic products have grown as firms struggle to compete with the cheaper competition increasing the threat of trade wars within the European Union.

Besides the huge profits realized by utilities, the other big winners under the cap system have been the firms whose primary business is the trading of credits. The European Climate Exchange (ECX) is Europe’s largest carbon-trading platform and has seen a 68% increase in trading from January 2008 to January 2009 representing over $90 billion traded and market speculation has been cited as being partially responsible for the carbon price volatility.

Where is the US Headed?

There is no denying that President Obama is committed to introducing a cap-and-trade system within the next two years. The $787 billion stimulus package recently signed into law sets aside billions for renewable energy while his budget plan released last week even assumes $78.7 billion in new revenue from the sale of greenhouse gas emissions by 2012.

Despite the Bush administration’s rejection of Kyoto and Canada’s reluctance to follow through on its own ratification of the Kyoto protocol, it appears that attitudes have changed in both countries. For the US, this is obviously a policy shift while for Canada, it may have more to do with accepting the inevitable and understanding that it is in the country’s best interests to be part of the plan from the beginning rather than have its largest trading partner dictate new policies that could dramatically affect Canada’s exports.

What’s Next?

To be clear, this commentary is not an argument against the need for emission controls or a denial of climate change. There is no question that the US – indeed the entire planet – must do more to reduce greenhouse gas and pollution in general; the point being made here is that the US can learn from Europe’s implementation of a cap-and-trade system as even the most ardent environmentalist can see that the European version of a market cap system has not brought about the desired results.

Despite the urgency, simply rushing ahead with an ill-conceived and poorly-executed approach that fails to address the root problem is unacceptable. To allow a cap-and-trade system to be nothing more than a means to gouge users with no perceptible benefits, not only fails to serve the environment, but also fails the people.

  1. ↑ [2] President Barack Obama – speech to Congress, February 24th, 2009
  2. ↑ [3] Europe’s Problem Color U.S. Plans to Curb Carbon Gas – Washington Post, April 9, 2007
  3. ↑ [4] Carbon: Europe’s Lessons for the U.S. – Business Week, February 19, 2009
  4. ↑ [5] Carbon: Europe’s Lessons for the U.S. – Business Week, February 19, 2009
  5. ↑ [6] EU Greenhouse Gas Emissions Rose 1.1% Last Year – The Wall Street Journal, April 4, 2008

About the Author

Scott Boyd has been working in and writing about the financial industry since the early 1990s. As a technical writer and project manager with several of Canada’s leading financial institutions, Scott has produced educational materials for investment system end-users including portfolio managers and traders. Scott now administers and contributes to OANDA FXPedia and regularly provides commentaries for the OANDA FXTrade website.

This article is for general information purposes only. It is not investment advice or a solicitation to buy or sell securities. Opinions are the author’s — not necessarily OANDA’s, its officers or directors. OANDA’s Terms of Use [7] apply.

Scott Boyd
Scott Boyd

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