An extract from Nukenomics: The commercialisation of Britain’s nuclear industry copyright 200

Carbon Trading (the basics)

22 June 2009

The importance of creating a market-based system for limiting carbon pollution from energy producers was first signalled in the British government’s July 2006 report, The Energy Challenge –Energy Review Report 2006. Previous energy white papers had dealt with the government’s usual priorities of economic growth, rising energy demand and lower prices for consumers. But this review was different. The first chapter focussed squarely on the issue of the decade –valuing carbon. The government rightly argued that the only way businesses could realistically be expected to reduce their carbon emissions was if an international system of carbon trading was created, operating worldwide on a level playing field. The reason that carbon dioxide emissions have risen to near dangerous levels is because the Earth’s atmosphere is used and abused for free by industry. The government realised that to prevent climate change, society needs to put an economic price on carbon pollution. In effect what the government had proposed was to partially privatise the atmosphere.

Governments generally have four main options for reducing carbon dioxide emissions produced by business activities: they can ban carbon emissions completely; they can limit them through tighter emissions regulation; they can heavily tax the emissions; or they can charge polluters for the right to carry on making emissions. Different policy solutions work better in some situations more than others. In the transport sector for example, where sources of carbon pollution are spread amongst a European fleet of 224 million vehicles (87 per cent of them cars), the European Commission (EC) plans to set strict limits on carbon emissions from new cars produced by vehicle manufacturers. The British government already taxes vehicle owners annually according to a sliding scale based on their carbon emissions.

The energy sector is different because major sources of carbon dioxide emissions from power stations and heavy industry are concentrated amongst a much smaller group of just 11,000 businesses spread across Europe. The best solution for cutting carbon emissions from these businesses turns out to be a market-based carbon trading system, which charges polluters for the right to carry on polluting. In 2005 the European Union (EU) designed a continent-wide carbon trading market called the Emission Trading Scheme (ETS), a mandatory ‘cap and trade’ system for European businesses. The idea of a cap and trade market is that national governments set a fixed cap on the maximum amount of carbon dioxide that can be emitted each year, and polluters trade their emissions allowances with each other. Businesses that can easily reduce their carbon emissions through low cost pollution control investments, can sell on their excess emissions allowances to other European businesses who cannot cut their own carbon emissions without paying for major decarbonising investments. This means that the most cost-effective solutions can be taken up first by businesses who are the best placed to adopt them. At the same time, the annual emissions ceiling is gradually reduced centrally by the EC so that total carbon emissions across all EU states continue to fall.

In theory the carbon market should be a highly efficient and low cost way of reducing carbon emissions because it gives a financial incentive to lazy polluters who can easily cut their emissions, while at the same time allowing carbon-intensive businesses to carry on trading albeit with higher operating costs from purchasing emissions permits. If emissions cuts prove costly demand for permits will rise, driving up their selling price. On the other hand, prices will fall if low cost ‘end of pipe’ technologies for abating pollution appear or if slow economic growth weakens the major industries that produce carbon emissions.

The genius of the European carbon market is that it created valuable property rights quite literally out of thin air, avoiding the usual blunt policy instruments of taxation and regulation that are normally imposed by governments to cut unwanted emissions. Moreover, the degree of emissions cuts achieved will depend on the price of carbon, so that the market itself will drive emissions reductions. Around 80 per cent of the total volume of carbon trading deals between companies are arranged on the European Climate Exchange (ECX), which operates much like a stock market, trading carbon permits instead of shares.


The carbon market gives a financial incentive to lazy polluters who can easily cut their emissions, while at the same time allowing carbon-intensive businesses to carry on trading albeit with higher operating costs from purchasing emissions permits.

One of the stranger consequences of belonging to an international carbon trading scheme is that emissions may not necessarily drop in Britain. If investment in reducing carbon emissions remains expensive relative to more modern EU plants, then it will be cheaper for British companies to buy carbon permits from other European businesses. In economics language, the marginal abatement costs (MACs) of reducing pollutants vary between different countries. The total carbon emissions output will be cut across Europe as a whole but the downside is that buying foreign permits could potentially push up costs for British businesses, making them less competitive than similar European firms. On the other hand, carbon emissions may fall anyway as Britain increasingly shifts away from heavy industry towards a de-industrialised knowledge-based economy. Carbon trading may ultimately hasten the decline of Britain’s manufacturing base, leaving energy production as the remaining major industrial source of carbon pollution.

The market’s actual experience of carbon trading has been patchy since the European ETS began its first trial period that ran from 2005 to 2007. The EC’s Directive 2003/87/ECruled that most allowances should be allocated to installations free of charge, at least 95 per cent during ETS Phase I and at least 90 per cent during ETS Phase II. Emissions permits were allocated to companies according to their historic emissions levels –a process known as ‘grandfathering’. Unfortunately, governments grandfathered these permits rather too generously to firms based in their own home countries, resulting in a carbon price crash in April 2006. When carbon markets are created it is important that the quantity of emissions permits must match the real output of carbon emissions from firms, which can be difficult to verify. If too many permits are allocated, a fall in the value of each permit eventually results, which is what happened in 2006 when the over-allocation was discovered by European carbon traders and prices crashed from about EUR30 per tonne to EUR10 per tonne.

The EC is gradually tightening the rules on carbon trading for Phase II of the ETS running from 2008 to 2012. The Commission’s ‘soft landing’ market reforms include centralised scrutiny by the EC of permit allocations granted by individual governments, with an intention to eventually auction 100 per cent of permits to the energy sector under ETS Phase III by 2013 rather than allocating them to energy companies freely. European carbon permits are currently trading at around EUR22 per tonne (£17 per tonne) under ETS Phase II as of April 2008.

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The carbon market's incentives
The carbon market gives a financial incentive to lazy polluters who can easily cut their emissions, while at the same time allowing carbon-intensive businesses to carry on trading albeit with higher operating costs from purchasing emissions permits.

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