Surplus to requirements?

Emissions trading is the market's solution to carbon reductions, but the scheme has already hit snags. And does it really make a difference?
Drax power station
Drax power station

When Sir Nicholas Stern presented his climate change review last year, he said the world was facing not only a potential ecological disaster but also the greatest market failure it has ever seen.

The review stressed that the market, businesses and individuals should feel climate change in their pockets through a strong carbon price, making clear the social cost of continuing to pollute. A price can be enforced through regulation or imposed by a tax, but the cheapest method available is through emissions trading - so far the EU's favoured approach to reduce its cut of global emissions.

Louis Redshaw, head of environmental markets at Barclays Capital, says direct government regulation relies on the assumption that the state knows enough about what each company can do to reduce emissions. "But governments can't understand exactly how every industry works, and how much it would need different industries to reduce emissions," he explains. "And firms are always trying to pull the wool over the eyes of the state to make emissions reductions look like they cost more than they actually do."

In contrast, placing a price on a tonne of carbon means the businesses themselves can assess the cost. Reductions may be cheaper than first feared and can be turned into potential profits by selling on any unused allowance - making it an incentive to reduce emissions.

Sanjeev Kumar, emissions trading scheme co-ordinator for the charity WWF, says the system gives companies two options: "Either you make the cuts yourself or, if it's more cost effective, you can help fund someone else's reductions by buying an allowance. You end up with the most reductions possible. It's a cheaper way of reducing emissions."

The concept has proven so popular with US corporations that they have formed a pressure group - Uscap - to lobby Congress to introduce an America-wide cap-and-trade scheme.

Meanwhile, the EU's own emissions trading scheme became the first international carbon trading market in 2005. Firms with major energy-intensive installations, including power stations and oil refineries, are obliged to take part. Phase one, which runs until the end of this year, covers around 40% of the union's emissions. Each country is awarded a cap by the European Commission, which is then handed out by each government to individual companies.

"The cap controls the amount of emissions that are in the system, so emissions reductions are effectively included within the European trading scheme," says Kumar.

But the European scheme has not been without its hiccups. Its first phase was derailed by an oversupply of allowances, where member states were given larger allowances than they needed. Once news got out the market collapsed.

However, Redshaw says more emissions reductions were seen during phase one than there would have been without the scheme. "When the price was as high as €30 a tonne there was an incentive for firms to switch from coal to gas electricity generation," he says.

"We saw that firms burned less coal and more gas in 2005. The trouble was that the gas price was going through the roof - so for firms to switch, the carbon price needed to be high. Coal use eventually increased in 2006, but if the EU scheme wasn't in place it would have risen even further."

German companies were also reported to have switched from lignite - or brown coal - to conventional black coal, which emits less carbon. Those who made the transfer could make savings and sell their excess allowances.

Further emissions reductions could be secured if the phase two caps, which will run from 2008 till 2012, prove to be tighter than during phase one. Kumar says the European Commission has set allowances that are 5%-6% lower than in 2005.

But phase two has not even got off the starting blocks without attracting criticism. A report by the WWF earlier this year said phase two would allow for almost 80% of savings to be made through offsets.

Offsets, which can come in the form of Kyoto Clean Development Mechanism credits, allow carbon users to reduce their net emissions by funding an emissions-reducing project abroad. The projects have been highly controversial - a Guardian investigation reported in June this year that 20% of emissions offset reductions could be in doubt.

Kumar says the charity was worried the large allowance for carbon offsets could allow polluters to continue polluting without making any green investments for the future: "These offsets are much cheaper than trading allowances, and if you're a profit-making company you're going to buy the cheaper credits first. On one hand the polluter is paying but it allows them to continue without investing in renewables in the long term."

In contrast, Redshaw says the problems that have made headlines had not affected offsets generally. "It's important that we have as many sources as possible for emissions reductions to help build an efficient emissions market," he says. "If we have a way of reducing emissions that is very cheap we should take advantage of it."

The view is shared by the head of the UN Framework Convention on Climate Change, Yvo de Boer. He said in August that it was not realistic to expect rich nations to make all emissions reductions, and suggested some should be able to buy their way out of their responsibility - a comment that caused consternation among environmental NGOs.

The WWF believes the EU trading scheme may not be out of teething trouble until the third phase, beginning in 2013, but Kumar nevertheless held that the concept was one of the best ways of making reductions a reality.

"At the moment the cost of carbon does not feature in any company's account book," he says. "Through carbon trading we are simply making firms realise the cost of climate change and that they need to take responsibility for it."