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Talk:Argument: EU cap-and-trade system is new; difficulties will be worked out

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Revision as of 18:48, 20 March 2009; Aldyen Donnelly (Talk | contribs)
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"Cap and trade" is a solution looking for a problem. Unfortunately, GHG emissions are not the problem that cap and trade is suited to address.

It is essential to recognize that "cap and trade" is a fancy name for simple, old-fashioned Supply Management. "Cap and trade" is a trade protectionist measure, not an emission control measure. Emission reductions derive from facility-level emission limits or product standards. Governments may or may not elect to lay a "cap and trade' regime on top of the foundational emission/product performance regulations. Key pollutants and pollution precursors have never been eliminated or substantially reduced through regulatory measures that only assign emission limits to plants. We have only been successful when we have implemented product standards (regulations that limit lead, sculptural or carbon content, for example, in the products that are SOLD--as opposed to what we produce.) Whether or not the foundational regulations need to include BOTH product standards and point-of-production emission regulations are worth debating. But we have been successful in the past, with only product standards and with coincident regulation of product standards and point-of-production emission limits. But we have never achieved our stated environmental objectives with only point-of-production emission limits, whether or not we have laid "cap and trade" on top of those limits. (For example, consider the failed attempt of the US EPA's CAIR regulation to address the massive leakage issues associated with the US Acid Rain Program and NOx market rules.)

It is not necessary to introduce quota or cap and trade to create a vibrant market for environmental goods and services. Governments can and often do allow distributors of regulated products to "comply jointly" and to bank pollutant content entitlements they don't use in one year for use in future years. The private sector has consistently built robust and reliable secondary markets for pollution credits in response to this kind of regulation. Governments only need to add quota allocations/auctions, registries and trading rules when their primary objectives are to raise public revenues or to interfere with the efficient evolution of market participants competing to deliver new products compliant with the new product standards. By definition, cap and trade introduces market inefficiencies because the whole purpose of the quota allocation is government intervention in and control of the new distribution of market rents.

Central government allocations and reallocations of quota to artificially inflate targeted commodity prices to achieve certain social or environmental objectives, or to favor certain technologies over others, is a very old practice that typically has the same outcomes no matter what market we are trying to influence--historical examples include garment and textiles, municipal taxi services, dairy and other agriculture products, autos and auto parts. Generally, "cap and trade" enhances the market power of incumbents at the expense of new market entrants and results in lower rates of innovation, even when 100% of the new quota units are auctioned (see history of Canadian and Dutch dairy quota auctions, for example). US cap and trade is part of the reason that there has not been a productivity increase in the US electricity market in the last 20 years; even though the rest of the US economy has lead the world in productivity gains.

When governments elect to govern a market with a quota allocation (whether quota is freely allocated or auctioned), economic rents shift from underlying assets to the quota instrument (called an "allowance" in emission markets). A taxicab, a herd of cows, power plants have 0-market value in the absence of quota, so the introduction of a quota regime always affects massive asset revaluations and shifts between balance sheet accounts. If entities are permitted to hold and governments continue to freely allocate or cheaply auction quota to entities even after they elect to stop delivering quota-controlled services/products to the marketplace, then quota hoarders who do not generate any product or services can generate very high earnings at the expense of productive industries. If the profit potential for a quota hoarder is higher than the profit potential for an innovator whose new product does not require quota, then the quota hoarders attract all of the new capital available to the market, not the innovators. This is the current situation in the US Acid Rain program-covered power market as well as in the EU CO2 market.

In the EU CO2 market--parallel to the US Acid Rain market--some 75% of the reported "turnover" of emission quota is in the form of "allowance swaps". (Swaps accounted for over 90% of "turnover" between "economically unrelated parties" over the first 7 years of the operation of the Acid Rain market.) How do these markets work? In the beginning, there is an oversupply of allowances, but some emitters are short and some are very long. Entity A has an allowance surplus and Entity B is going to be short on the regulated allowance/emission "true up" date. Entity A "leases" an allowance to Entity B to cover the true up date on the condition that Entity B returns an allowance to Entity B after the true up date. Both entities attribute a "market price" to the two allowances that will be traded, but the only cash that actually trades hands is a small allowance lease fee that Entity B pays Entity A (this transaction is called a "contract for differences"). Entity A's quota holdings never shrink and Entity B just gets deeper and deeper into a quota deficit as time goes on. Eventually, Entity A acquires Entity B's assets (including emission quota) at a deep discount. Entity A shuts down Entity B's power generation and banks Entity B's continuing quota allocation. This enables Entity A to run up the price charged for the electricity generated at its original assets, while the company uses is increased quota book to engage in further predatory activity. Eventually, the government-determined supply of allowances shrinks and all new market entrants have to buy 100% of the allowances they require to operate from Entity A. Entity A makes more money shutting down production and leasing" quota than can ever be made by either a clean or quota-covered electricity producers. This is the dominant form of trading and trend in the existing EU CO2 market. In the US, this form of quota trading and trend in the US Acid Rain and NOx markets has lead to increased concentration of ownership of power generation capacity. But almost 25% of US power supply is still generated at plants that are over 545 years old and very high emitting. And among OECD nations, the US still has the 2nd worst track records for cutting SO2 and NOx emissions.

Theorists posit that as Entity A continues to eat competitors, cut off power supply and drive up power prices, the market will respond with innovation, filling the gap with innovative solutions that do not require quota. There is not a single real life quota-governed market in which this theory has played out, however. The economic returns Entity A can realize from predatory behavior are always larger than those that can be achieved by the innovative new market entrants. Market share ("install base") is everything in the wealth creation process. So capital investors flock to Entity A, and capital remains inaccessible to or very costly for the new market entrants. As Entity A and a few others accumulate massive market shares, it becomes easier for the cabal of quota hoarders to block innovators, other than innovators that are willing to be acquired by the quota hoarders. This pattern is as obvious in the US Acid Rain Program-covered electricity market as it is in municipal taxi markets around the world. This pattern has been apparent in the EU CO2 market from its inception. That is why EU feed-in tariffs and other clean energy incentives have had to grow in response to the implementation of the cap and trade regime.

Whenever societies have been serious about cutting pollutants or pollution precursors out of our supply chains and consumption, we have introduced point-of-sale product standards (called "performance standards" when applied to emissions). In the CO2 context, distributors of regulated carbon-based products would be obliged to report and reduce the (1) carbon content of the products the sell and (2) carbon releases in their supply chains. Any distributor that underutilizes their regulated entitlements to release and use carbon can bank those entitlements for future use. Distributors can comply jointly.

For the leaded gasoline phase out, Canada and the US adopted identical point-of-sale product standards and deadlines for the elimination of retail leaded gasoline sales. Canadian law permitted gasoline distributors to comply jointly with their lead content limits and to bank any entitlement they did not use this year and use it in the future. The combination of the product standard, the joint compliance option and banking resulted in a robust and efficient secondary market for lead over the phase out. Canada got the lead out or retail sales ahead of schedule and under Canadian rules, no Canadian refiners were making leaded fuel after retail sales were eliminated. We did so at an incremental cost for unleaded (relative to leaded) gasoline under US#0.015/litre.

With the same underlying product standard, the US added the requirement that US gasoline distributors had to demonstrate compliance by surrendering lead allowances covering their total legal releases of lead to the market place. The US government created fixed annual supplies of lead allowances equal to the national caps implied by the gasoline product standards, then freely allocated 100% of the US lead allowances to US refiners. So the day after the US laid "cap and trade" on top of the product standard, every US entity that legally imported leaded gasoline during the phase out had to buy allowances from US refiners to cover the lead content in the imported fuel. Because the obligation to report and cut lead content applied only to US sales, US refineries were encouraged to continue to produce leaded fuel for export markets.

As the Canadian experience showed, it is not necessary to introduce tradable quota to implement an absolute cap and foster a vibrant secondary market for environmental attributes. In the US lead phase out, the sole purpose of adding the allowance allocation trading regime on top of the product standard was to erect a non-tariff barrier to imports. One US Treasury official estimates that foreign suppliers' lead allowance purchases (necessary to maintain their US market shares during the phase out) paid 70% of the US refiners' costs of building unleaded production capacity and that only 30% of the price of allowances was passed through to US consumers as fuel price increases. Nonetheless, the price increase that US consumers paid for unleaded was about US$0.021/litre, more than the price increase born by Canadians. Total US refining capacity grew 25% over the 8-year lead phase out--an unprecedented rate of capacity growth that has not since been matched. But the US refiners initially ADDED unleaded production capacity to their leaded capacity (Canadians REPLACED leaded production capacity with unleaded). US refiners shifted their leaded fuel sales from the US market to export markets and did not start to substitute unleaded for leaded fuel exports until almost 10 years after retail leaded sales were fully prohibited in the US. US refiners did not stop exporting leaded fuel until the late 1990s, and only under regulatory edict. In other words, the US partially financed their transition to unleaded fuels by government-allowed dumping of leaded fuel on the unregulated world.

(As an aside, the EU also adopted the same lead reduction targets and schedule. But the EU member states elected to achieve the goal by introducing a lead differential tax and using the revenues from the tax to finance refinery and auto parts plant upgrades that were needed to make unleaded fuels viable. However, by 1995 leaded petrol still dominated EU petrol sales, even though the premium the market paid for leaded fuel ranged from US$0.23 to US$.70 per litre. Why the tax measure was not an effective environmental measure in the lead context (and why it has been ineffective in the CO2 context) is another very important and interesting story for another day. Suffice to say that in 2000 all but 3 EU member states gave up on the tax measure and implemented Canadian style product standards to force the lead out of petrol sales by 2006. At this time, lead is still in the petrol sold in 3 EU member states, which states rejected the appeal of the other members to adopt the product standard because the states cannot afford to give up their lead tax revenues.)

ALL of the cap and trade climate change strategies currently being considered by US Congressional committees mirror the US leaded gasoline phase out. Producers and importers that supply carbon-intensive goods and services to US consumers will be required to surrender US GHG quota (allowances) covering supply chain (including foreign supply chain) and US domestic end-use emissions arising from their product sales. Then the US EPA will freely allocate and/or auction US GHG allowances to US coal and natural gas producers, oil refineries, aluminum, iron & steel producers, etc. (An 100% auction would change little. The auction rules will still allocate supply by sector and authorize bidders to manufacture Congresses desired distribution of allowances. To the extent that entities that do not operate carbon-emitting plant in the US will be authorized to participation in the auction, their participation will be limited.) The bills that have been tabled in the US Senate and House to date allocate allowances to US coal producers equal to 300% to 600% of their 2007 operating emissions. The allowances earmarked for US oil refineries equal from 150% to 250% of their actual 2007 emissions. But the supply for US power generators is short, between 15% and 30%. (This creation of a short supply for power generators and surpluses for other emitters also characterizes the EU CO2 allowance allocation for 2008 - 2012. But the EU does not require covered sources to account for supply chain and customer emissions, as the US legislators propose.) The excess free (or low cost auctioned) allowances for US producers of coal and oil products, combined with the obligation for US power generators and manufacturers to account for and surrender quota covering supply chain and customer end-use emissions means: (1) between them, US power generators and carbon-intensive product manufacturers have more than enough US quota to continue to produce and consume US coal, petroleum product, cement, aluminum and iron and steel to operate on a Business as Usual basis through 2025. But the day after the US cap and trade rule is in full effect, any US power utility that imports low carbon electricity or natural gas, or lower carbon petroleum products, will have to buy US quota from US coal producers, oil refiners, other GHG-intensive product manufacturers or a US Treasury-administered "International Allowance Reserve" to cover the foreign upstream emissions associated with their imports.

Aluminum produced in Canada is about 50% as GHG intensive as aluminum produced in the US. But US aluminum producers will hold more US quota than they require to continue to operate without reducing emissions through 2020, while US importers of Canadian aluminum while have to buy US quota covering 100% of Canadian aluminum production emissions.

Cap and trade and quota allocation is unnecessary in any nation that implements product standards that are rational and allow obligated parties to: (1) comply jointly and (2) bank unused carbon entitlement for future use. Cap and trade is primarily a trade protectionist measure and a recipe for new global trade wars of unprecedented scale.

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