This is why carbon trading doesn’t work

July 11, 2012

We need a price for carbon. Preventing climate change requires that we find a way of minimising our emissions of carbon dioxide and its equivalents, and by far the best way is by assigning a price to those emissions, providing an incentive to people to innovate their way round the difficult process of decarbonising our economy. However, I’ve always been slightly ambivalent about how we do this. There are, broadly speaking, two options:

  • A market for emissions permits, making the right to pollute a tradeable good. This is exemplified by the EU’s Emissions Trading System. This has the advantage of – if the number of permits are set correctly – setting a price for carbon that genuinely reflects the cost of displacing emissions, as markets are excellent at price discovery.
  • A tax on emissions, providing a flat cost (rising under some models) per tonne of CO2 produced. This has the advantage of being set at an appropriate social cost of carbon, reflecting it as an externality rather than the technical difficulties associated with no longer emitting it.

I have always found it difficult to decide which mechanism I prefer. The first allows us a clear way of reducing emissions to zero, while the second appeals to the classical liberal in me. However, the news today that Poland has been claiming emissions permits for coal plant that doesn’t exist has decided me.

An ETS provides an incentive to ‘invent’ sources of emissions that can accrue free permits if free permits are permitted as a result of political pressure to not over-burden sections of the economy. Conversely, a carbon tax provides an incentive to conceal sources of emissions. However, concealing sources of emissions is difficult for one very clear reason: they continually release big clouds of smoke.

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