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Whatâ??s the Best Way to Handle Future Climate Change?

Carbon markets, carbon taxes, technological push, or economic growth?

Ronald Bailey
December 8, 2009

This week representatives from over 190 nations began gathering in Copenhagen to try to hammer out a global treaty to handle the problem of man-made global warming. As a long-time reporter on environmental issues, I, for many years, doubted the severity of the issue, but as the various temperature data sets (satellite, surface, balloon) began to converge, I became persuaded that man-made global warming is real and a potential problem. Global average temperature trends in recent decades suggest that the planet is warming up at a rate of about 0.13 per decade. (Interestingly, recent temperature data finds that while the last decade has been the warmest on average in modern records, global average temperatures have not been increasing since 1998.) So the question is: If global warming is a problem, what are the smartest policies to address it? 

Unfortunately, the current model for controlling the global emissions of greenhouse gases like carbon dioxide is a cap-and-trade scheme devised under the Kyoto Protocol. To comply with its obligations under the Kyoto Protocol, the European Union implemented with its European Trading Scheme (ETS) back in 2005. The ETS covers the output of about 12,000 big emitters, whose CO2 amounts to roughly half of the European Union’s total emissions.

Under cap-and-trade schemes, governments set a limit on how much of a pollutant, in the case of man-made global warming chiefly carbon dioxide, utilities and other enterprises can emit and then allocate permits to them. The permits can then be bought and sold on an open market. Manufacturers, for example, that can cheaply abate their emissions will have some permits left over. The cheap abaters can sell their extra permits to other enterprises that find it more expensive to reduce their emissions. In this way, a market in pollution permits is supposed to find the cheapest way to cut emissions.

Carbon Market Follies

Carbon Market BalloonsThat is the ideal, but implementing the ETS has been far from ideal. For example, in May 2006, an audit showed that several EU governments had issued permits for 66 million tons more CO2 than was actually being emitted. Traders immediately realized that the supply of permits was not scarce, so the price of carbon dioxide allowances promptly collapsed to less than 9 euros per ton. By February 2007, an allowance to emit a ton of CO2 could be had for less than a euro. European governments later tightened limits on carbon dioxide emissions and permit prices recovered in the second trading period until the advent of the financial crisis in 2008 forced a dramatic economic slowdown.

The steep decline in economic activity has lowered CO2 emissions, producing a surplus of carbon permits among companies in the EU's emissions trading scheme. Consequently, as carbon dioxide emissions fell, so too, did permit prices, reaching a new low of under 10 euros per ton in February, 2009. Since then carbon dioxide permit prices have recovered slightly to over 13 euros per ton.

The main point is that such price volatility means that companies have great difficulty in planning their infrastructure investments. There is very little evidence that the ETS has driven large-scale capital investments in energy production aimed at reducing the emissions of greenhouse gases among firms and facilities subject to the system. If carbon dioxide trading does not induce those kinds of investments, then it clearly has failed.

So if carbon trading has really been an effective tool for encouraging investments in low-carbon and no-carbon energy production technologies, German electric power utilities would not have announced plans in 2008 to build more than 20 new coal-fired electric power plants. And just before the financial crisis hit, The New York Times reported in 2008 that European countries were planning to build about new 50 coal-fired plants over the next five years. It is true that the planning for and construction of many these plants are now on hold due to the global financial crisis, but those construction projects will likely revive once economic growth resumes. The main point is that European carbon dioxide trading is not working as intended because it has not noticeably encouraged utilities to invest much in alternative low-carbon energy technologies.

In addition to being ineffective at encouraging investment in low-carbon energy technologies, the way that permits have been distributed has provided billions of euros in windfall profits to polluters. How does this work?  Beginning in 2005, the ETS cap-and-trade scheme handed out nearly all of its emissions permits gratis. Hold on, you might say: If the emitters are getting permits for free, why don't they pass along the lower costs to their customers?

Think of it in terms of an analogy put forward by left-leaning economists James Barrett and Kristen Sheeran: Tickets from scalpers for the last World Cup Soccer championship games were going for more than 200 euros, about double their face value. Would the price have been lower if a scalper had found them on the ground? No. "The supply and demand for tickets is the same no matter how much the scalper paid for them, and so the price he charges you will also be the same no matter how he got them," note Sheeran and Barrett. Or think of it this way, if someone gave you a bundle of cash worth a thousand euros, you would not be inclined to sell them to another person for less than a thousand, would you? The same thing is true of carbon dioxide emissions permits.

Giving away permits for free is largely equivalent to a carbon tax in which the tax revenues are given to energy company stockholders, not spent on behalf of consumers and taxpayers. Before the carbon market collapse in April 2006, the consultancy IPA Energy estimated that permits granted to British and German utilities fattened their bottom lines by 1 billion euros and 6 to 8 billion euros respectively. And British and German consumers paid more for their electricity on top of that.

One way to correct the most egregious flaws in current cap-and-trade schemes (including the one proposed in recent Congressional legislation in the U.S.) would be to adopt cap-and-auction instead. Auctioning permits is very much like imposing a carbon tax. In this case, the government sets an overall emissions limit and emitters have to buy allowances from the government every year. The chief difference between a cap-and-auction scheme and a carbon tax is that the price of the allowances will vary from year to year. Once again, this variability in permit prices introduces uncertainty in the infrastructure planning of firms.

Why Not A Carbon Tax?

Carbon Tax mage Many economists think that a better option for rationing carbon would be a gradually rising tax on fuels that emit carbon dioxide. As the tax increases, industries and consumers would cut back on their use of more expensive fossil fuel energy and switch to using energy produced by low-carbon and no-carbon technologies. This process would lead to lower carbon dioxide emissions over time.

Leading economists like Harvard University’s Gregory Mankiw and Yale University’s William Nordhaus advocate imposing a tax on all kinds of carbon-base fuels at the wholesale stage, as far upstream as possible. Utilities and refiners who take raw coal, oil, and natural gas as inputs would pay a tax on these fuels. The extra cost would get passed downstream to all subsequent consumers. Thus carbon taxes would encourage conservation and low-carbon energy innovation. Since the tax is levied on how much carbon a fuel contains, it would make fuels like coal less attractive compared with low-carbon fuels like natural gas or even renewable energy like solar and wind power. Ideally, carbon tax revenues would be used to cut individual domestic income taxes, thus offsetting some of the pain of higher energy prices.

Internationally, one of the big advantages of a carbon tax is that it avoids the baseline quandary that bedevils carbon markets. For example, signatories to the Kyoto Protocol are supposed to cut their emissions of greenhouse gases by 7 percent below what they emitted in 1990. Why? That goal has no relationship to any specific environmental policy objective. In fact, achieving the cuts specified by the Kyoto Protocol goals would reduce projected average global temperatures by only a minuscule 0.07 degrees Celsius by 2050.

As the thorny international negotiations about what to do after the Kyoto Protocol expires in 2012 show, it is very difficult to set new global emissions baselines. Also, where should baselines be established for rapidly growing economies like China, India, and Brazil whose energy use and emissions are expected to more than double by 2030? Under the Kyoto Protocol, the natural baseline is what emissions would be without any restraints. However, calculating or predicting what a country’s emissions will be 20 to 30 years in the future is impossible to do with accuracy.

Under a pollution tax scheme, argues Yale economist William Nordhaus, “The natural baseline is a zero-carbon-tax level of emissions, which is a straightforward calculation for old and new countries. Countries’ efforts are then judged relative to that baseline.”

Another advantage is that the tax could be phased in as the average incomes of poor countries reach a certain threshold. For example, carbon taxes might start to kick in when national income reaches $7,000 per capita, which is slightly higher than China’s current level. More generally, having a defined tax rate makes it easy for firms in developed and developing economies alike to predict the future impact of climate policy on their bottom line—something that is considerably harder to do when the government is handing out permits every year.

A tax avoids the messy and contentious process of allocating allowances to countries internationally and among companies domestically. For example, nations could negotiate a much more transparent treaty than the Kyoto Protocol and establish a system of globally harmonized domestic carbon taxes. Harmonized taxes offer relative price stability and taxes on carbon emissions can be raised gradually and predictably over time so that governments, industries and consumers all see what the price of carbon-based fuels will be over future decades and make investment and purchase decisions accordingly.

Nordhaus argues that carbon markets are “much more susceptible to corruption” than are tax schemes. “An emissions-trading system creates valuable tradable assets in the form of tradable emissions permits and allocates these to different countries,” writes Nordhaus. “Limiting emissions creates a scarcity where none previously existed and in essence prints money for those in control of the permits.”

A carbon tax offers less opportunity for corruption because it does not create artificial scarcities and monopolies. Of course, governments can engage in chicanery by dispensing tax breaks and subsidies to favored companies and industries. But Nordhaus analogizes carbon allowances to quotas in international trade and carbon taxes to tariffs: overall, it’s been a lot easier to manage tariffs than quotas.

However, as John Locke Foundation economist Roy Cordato has explained: "A higher tax today means lower production and output of goods and services tomorrow, making future generations materially worse off. In setting a carbon tax you must show that future generations would value the problems solved by reduced global warming more than they would value the goods and services that were foregone." Cardato argues that it's not possible to know the preferences of future generations, but providing them with more wealth and better technologies will give them more options to express whatever preferences they have.


Fast Breeder reactor schematic Climate change is a technological problem. After all, the goal of all carbon rationing schemes—limiting permits or imposing taxes—is to encourage the development of low-carbon and no-carbon energy technologies as substitutes for fossil fuel energy technologies. So why not aim directly at fostering the development of advanced energy technologies? In a fascinating recent report, two McGill University economists, Isabel Galiana and Christopher Green, look at the benefits and costs that an energy technology research and development push might yield.

In the report done at the behest of the Danish think, the Copenhagen Consensus Center, Galiana and Green argue that climate change negotiations are engaged in what they call "brute force" mitigation strategies (e.g., carbon markets and/or taxes), and that those strategies have already proven to be losing propositions. "Attempts to directly control global carbon emissions will not work, and certainly not in the absence of ready-to-deploy, scalable, and transferable carbon emission-free energy technologies," assert the authors. "The technology requirements cannot be wished, priced, assumed, or targeted away."

Why won't brute force mitigation strategies like carbon markets and taxes work? Galiana and Green point out that current proposed emission targets imply vastly faster rates of reduction than have been the case in past decades. Consider a global emission reduction target of 80 percent by 2100. That would require carbon emissions to fall by 1.8 percent per year. But say economic growth averages 2.2 percent between now and 2100: That implies a 4 percent average annual decline in the amount of carbon-based fuels used to produce goods and services.

To date, Galiana and Green note, the annual global average rate of decarbonization, the amount of carbon that is emitted per unit of goods and services produced, has been 1.3 percent. To illustrate the economic consequences of trying to boost the rate of decarbonization through brute force mitigation, they generously assume that the decarbonization rate could rise to 3.6 percent annually. But this would still entail a cut in global economic growth from 2.2 percent annually to 1.8 percent. Such a reduction in economic growth would cost an undiscounted $86 trillion in 2100 alone and add up to an undiscounted $2,280 trillion over the next 90 years. And without new low-carbon energy technologies, the authors argue that the assumption of 3.6 percent rate of annual decarbonization is just a fantasy. So the likely economic damages will be even larger. "Climate change is a technology problem," Galiana and Green conclude, "and the size of the problem is huge."

Their solution is spending $100 billion per year on energy research and development financed through a $5 per ton tax on carbon dioxide emissions that would be funneled into Clean Energy Trust Funds. The tax would be scheduled to double every ten years as a way to give a forward price signal to encourage the deployment of the new low-carbon energy technologies that they hope will emerge from the labs. They calculate that every dollar spent on new low carbon energy R&D would avoid $11 in climate damages.

"It is much easier to spend on R&D than assure the monies are well spent," Galiana and Green admit. They also acknowledge that much current government R&D funding is politically directed and largely wasted. Robert Fri, a former deputy administrator of both the U.S. Environmental Protection Agency and the Energy Research and Development Administration, told Chemical & Engineering News: "The government is very good at starting energy projects that it believes will solve energy problems, but it is not very good at generating the intended results."

To overcome this problem, Galiana and Green somewhat naively suggest creating a system of research competition overseen by a panel of independent experts. Oddly, they do not consider deregulating energy markets so as to provide greater incentives for private R&D and investment in new energy production and improvements in efficiency. In any case, Galiana and Green make a very strong case that current energy technologies cannot meet the ambitious emissions reductions goals being advocated by the Obama Administration in the U.S. and by the United Nations bureaucrats at the Copenhagen climate change conference without clobbering the global economy.

Interestingly, there may a current technology that could go a long way toward reducing carbon dioxide emissions, fast breeder reactors. Since they do not burn fossil fuels, they produce no carbon dioxide. Fast breeders are nuclear power plants that can produce more fuel (about 30 percent more) than they use. Basically, they operate using a fast neutron chain reaction that transforms abundant non-fissile uranium-238 to fissile plutonium-239, which can then be reprocessed for use as nuclear fuel. An additional benefit is that they can be configured to produce electricity by burning up highly radioactive nuclear waste and the plutonium removed from nuclear weapons.

And it gets better; the radioactive wastes generated by fast breeder reactors after their fuel is recycled decays in only a few hundred years instead of the tens of thousands it takes to render the wastes from conventional reactors harmless. Because the reactors produce more fuel than they use, humanity would be able to transforms the thousands of tons of refined uranium it now has into fuel and therefore not have to mine any more for thousands of years. And new fuel reprocessing technologies have largely allayed concerns that the plutonium produced by fast reactors could be diverted and used to produce nuclear weapons. In other words, fast breeders could be the ultimate in renewable energy.

The Progress Solution

Future city schemaComedian Groucho Marx once famously quipped, “Why should I do anything for posterity? What has posterity ever done for me?” Many people are worried about “intergenerational equity” with regard to how global warming will affect future generations. But perhaps Marx had the right question.

Consider that University of Groningen economist Angus Maddison calculates that annual per capita incomes in real dollars in 1900 for Finland averaged about $1,700 and for Denmark were around $3,000. Today average incomes are $28,000 per capita in Finland, and in Denmark are $33,000. In other words, contemporary Finns are 16-times richer than they were three generations ago, and modern Danes are 11-times better off.  The true intergenerational equity question becomes: How much would you have demanded that your much poorer ancestors give up in order to prevent the climate change we are now experiencing? We stand in exactly the same relation to people who will be living in 2100.

According to Maddison, total global GDP in 1900 in real dollars was about $2 trillion. Today, the World Bank calculates that in 2008 global GDP stands at $60 trillion. In other words, global GDP increased by 30-times over the past century. Dividing the World Bank figure up by the world’s population of 6.8 billion, one finds that global average per capita income is around $8,800. Of course, it is not equally distributed among people.

What about the future? If global economic growth continues at around 3 percent per year, total GDP in real dollars would reach $860 trillion in 2100. Many scenarios, including those used by the U.N. Intergovernmental Panel on Climate Change (IPCC), suggest that world population will stabilize or even fall below 8.5 billion people by 2100. This yields an average income of over $100,000 per person in three generations. So should people living now and making a global average of $8,800 per year be forced to lower their incomes in order to boost the incomes of future generations that in some IPCC scenarios will have incomes in 2100 over $107,000 per capita in developed countries and over $66,000 in developing countries?

Let’s take the worst case scenario devised by British economist Nicholas Stern in which global warming is so bad that it reduces the incomes of people living in 2100 by 20 percent below what it would otherwise have been without climate change. That implies that global GDP would rise to only $688 trillion by 2100. That would reduce average incomes in 2100 to only $81,000 per capita. In other words, people living three generations hence with the worst consequences of climate change would still be about 10-times richer than people living today are. Another way to think of that much future climate damage is that it is equivalent to reducing global economic growth from 3 percent to 2.7 percent over the next 90 years.

So finally, it is surely not unreasonable to argue that if one wants to help future generations deal with climate change, the best policies would be those that encourage rapid economic growth. This would endow future generations with the wealth and superior technologies that could be used to handle whatever comes at them including climate change. In other words, one could argue that, in order to truly address the problem of climate change, responsible policy makers meeting in Copenhagen should select courses of action that move humanity from a slow growth trajectory to a high growth trajectory, especially for the poorest developing countries.

Ronald Bailey is Reason's science correspondent. His book Liberation Biology: The Scientific and Moral Case for the Biotech Revolution is available from Prometheus Books.

This article is a slightly edited version of an article that appears in the Swedish magazine NEO. This column first appeared at

Ronald Bailey is Science Correspondent

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