Three key observations
Last week I started to assess what I termed the “mysteries and mystifications of global carbon-trading.” Three key carbon markets were briefly introduced. Following from this I would like to begin this week with three observations about carbon-trading, which are central to a close assessment of the LCDS. First, carbon-trading is the end-game of the LCDS. And, climate exchanges are more highly developed in the European Union (EU) than elsewhere. One reason for this is that, as a grouping, the EU is presently the world’s third largest producer of noxious greenhouse gases, after the United States and China. Because the United States is not a signatory to the Kyoto Protocol, it is not legally committed to binding reductions of its carbon dioxide emissions. I believe that it is for this reason that pressures to develop carbon-trading in the United States have not been as severe as in Europe, even though as we shall see there are voluntary carbon markets in the United States. As for China, it is not a developed market economy like the EU and the United States and mainly an account of this, it has shown little inclination in developing carbon-trading markets.
The second observation is that readers should constantly keep to the forefront of their considerations that carbon markets have largely developed in response to the calls for flexibility in EU member states and their covered entities, to enable them to meet the carbon emissions limits, the EU legally imposes. Thirdly, readers should be reminded that the stated goal of carbon markets is to have these develop as a complement, and not an excuse for reducing sustained and systematic domestic action directed towards limiting greenhouse gas emissions.
GAO assessment
Before we proceed to examine other key features of carbon-trading as pioneered in the EU, it would be useful to note the general conclusions of an evaluation of the European Union’s Emissions Trading Scheme (ETS) and the Clean Development Mechanism (CDM) developed under the Kyoto Protocol, as conducted by the United States Government Accountability Office (GAO). The express purpose of that evaluation was to see what lessons could be learnt in order to inform legislative proposals in the US Congress.
First, it is instructive that while the GAO recognised a functioning market for carbon dioxide allowances has in fact developed in the European Union (EU), its positive effects on 1) continued carbon dioxide emissions 2) the European economy and 3) technology investment in the environmental sector, are doubtful and are not supported by the available data. Second, it found that in regard to the CDM mechanism, which involves developing countries only (and has been explicitly designed to provide the “flexibility” mentioned above, the evaluation is equally mixed. The GAO has found that while the CDM appears to have provided international offsetting, which has become one of the largest and most established sections of the carbon-trading market (accounting for about three-quarters of its total value), deep doubts remain about the validity of the offset credits traded. There are other significant concerns expressed in the GAO report, which I share. These, however, will be taken up later as my analysis of carbon-trading proceeds.
Mechanics of carbon-trading
There are several other basic features and characteristics of carbon-trading markets, of which readers need to be aware. One of these is that while the market trades in carbon-dioxide emissions, these are neither the only nor the most noxious greenhouse gases, which pollute the atmosphere, produce global warming, and climate change. In the scientific literature, reference is routinely made to at least six primary greenhouse gases.
Apart from carbon dioxide (CO2), these include: methane, nitrous oxide, plus three synthetic gases (hydrofluorocarbons, perfluorocarbons and hexafluoride). Carbon dioxide, however, is the most prevalent form generated through human activity. And, it has become the standard unit by which all greenhouse gases are measured. In other words all other greenhouse gases are converted into standard units of CO2. Thus nitrous oxide has 298 times the polluting effect of CO2 over a 100-year time horizon, and HFC23, 14,800 times the effect of CO2. Based on the rulings of the Intergovernmental Panel on Climate Change (IPCC), global warming is expressed in CO2 equivalents and the formal expression used for trading purposes is the equivalent of 1 metric ton of CO2 that is, 1tCO2e. This holds good for trading in both emissions allowances and carbon credits/offsets.
At this juncture readers should note that for a commodity to be acceptable for trading on global commodity markets it must have several essential properties. One is that it is divisible and therefore easily measured, so that everyone buying or selling the commodity can get it with certainty in whatever multiples they desire. Another is that the commodity should be homogenous. This gives certainty to what is being traded. Then there are other features like non-perishability, storability and permanence during the duration of the contract for purchase/sale. Above all these, however, is that the legal codification and enforcement of contracts must be certain. Carbon emissions permits and carbon credits fulfil these characteristics.
Conclusion
With such features as described above, carbon-trading will always result in a price being placed on carbon emissions. In the EU climate exchanges this price is dependent on both the supply of emissions allowances and the demand for them. The latter is determined by the cap set by the EU in its cap-and-trade mechanism. An example would show how important this is. Let us suppose the EU makes an administrative error and is far too generous with the emissions allowances it provides to member states and their covered entities. Because of this over-supply relative to demand, the price of emissions allowances will collapse bringing down the entire edifice of the cap-and-trade market system.
Next week I shall continue this evaluation of the role of carbon-trading exchanges in the effort to prevent global warming and climate change.