Market Mechanisms for Emissions Trading Full of Holes

Although better than the Bush plan of doing nothing, the Kyoto Protocol has its share of problems. The European Union in particular has relied on market mechanisms to achieve the goal of holding carbon emissions to 1990 levels by 2012. The plan works like this: Governments and Treaties set the level of emissions allowed by a region. Government bureaucrats then divide up this level of emissions into "emissions allowances" for individual emitters. That emitter then has the ability to emit to its full allowance, or cut emissions below its allowance and sell its remaining allowances on the open market. A coal plant may, for example, be given allowance to cover only its current level of emissions. If it wants to increase production, it needs to either purchase more allowances from another emitter or find ways to increase production with fewer emissions. To accommodate this trading, exchanges have sprung up to broker emissions allowances. However, some bureaucrats have demonstrated in this space their woeful lack of understanding of how markets work.

The framework looks good on paper. Rational businesses will try to at least save money by not facing required purchases of additional allowances. At best, they will try to optimize their emissions efficiency so they can make money by selling their allowances. The overall level of emissions can be dictated and managed down to the end goal (1990-level emissions) by rewarding the good players and punishing the bad players with those allowances.

The problems come in when you add the demands of a regulated, global, and liquid market for exchanging those allowances. Emissions allowances become a de-facto currency, and as any African despot can attest, a currency is only as good as the trustworthiness of the issuer. That's why dollars, euros, and yen account for most economic activity in the world, and not Venezuelan Bolivars and Cuban Pesos.

This gives both the participating countries and the individual emitters enormous room to cheat. The first order for keeping the allowance currency sound is to ensure compliance with emissions volume. This is harder than it sounds, since there is no national infrastructure in place to monitor smokestack emissions. Most countries rely on the companies' word. Think about that. How many companies would fudge numbers if they knew that telling the truth results in a fine?

The second order of business for keeping the allowance currency sound is to keep a tight lid on the issuance of new allowances. Just as turning on the printing press debases a national currency, issuing new allowances willy-nilly decreases their value. For this, you can blame the bureaucrats, especially in a loose confederation such as the EU, where every country expects the others to make up for their own shortfall. Unfortunately, we have a real life example of this. According to an MIT Technology Review article, in the European Union Greenhouse Gas Emissions Trading Scheme, member countries issued 3.4 percent more allowances than was needed in its first year of existence. Central banks would scream bloody murder if a national currency was debased that much in a single year. The result was that the bottom fell out of the price of a CO2 allowance, falling two thirds in April. Now, an allowance for 1 ton of CO2 emissions can be purchased for 10 euros, reducing for everybody the punitive cost of over-emitting.

In order for a market mechanism to work, you need to have buyers AND sellers. In emissions trading, in order to ensure buyers, the compliance mechanisms must be strengthened and the punitive measures for not complying must be painful. Without these, you only have a one-sided market -- sellers. When you have a one-sided market, the price tanks. When the price tanks, there is no value to cutting emissions in the first place.