Going once, going twice . . . .

As the American Clean Energy & Security Act (ACES) 2009 (i.e. Waxman-Markey) shows itself, it reveals some different thinking on emissions trading to that in Europe, notably in the area of allowance distribution.

An emissions trading system is designed to establish an alternative fiscal flow through the economy, favouring low carbon goods and services and directing investment towards low emission and emission reduction projects. It does this by establishing a price for emitting CO2 through the creation of emission allowances, with one allowance required for every tonne of CO2 emitted. A virtuous fiscal loop is created, which sees government auctioning a decreasing pool of allowances to emitters, the emitter pricing goods and services to reflect some portion of the cost of allowances (over time the emitter will only be able to pass through the CO2 cost of the best performer, as in any competitive market) and the consumers using their purchasing power to favour lower carbon footprint products, supported by a return of the government auction revenue through lower taxes. This return compensates for the overall general cost increase of most goods and services as a result of the CO2 price. The end result of this process is that the more carbon intense products become uncompetitive over time and emissions in the economy decline.

For example, in the building industry cement and steel are both carbon intensive products to manufacture. In the new cap-and-trade world the price of cement will again be set by the new lowest cost operator (but taking into account the CO2 price), but it may also turn out that steel becomes relatively more attractive to the architect as a building material, so there is also an overall drop in the use of cement – or vice versa. Of course the declining industry might find it can install carbon capture and storage and thus lower the price of its product, changing the competitive balance again.

So that’s the theory, but practice is turning out to be very different. Auctioning of allowances has become a political football, and as in the game itself, American and European varieties are very different.

Rule number 1 says that if you can pass the CO2 price through the value chain to the consumer, i.e. higher prices, then you must buy the allowances that you need. The flip side of this is that if you cannot pass some portion of the CO2 price along, for example if market prices are set by competitors not subject to a CO2 price for their emissions (e.g. importers), then the government will give you some number of allowances for free – at least until the imported product also falls under a CO2 pricing regime.

Rule number 2 relates to the value of the allowances themselves. If the government auctions allowances what should happen to the money? This is where the EU and US have diverged markedly. Although the EU Trading Directive says that some of the auction revenue should be used for clean technology development, the reality is that most EU governments will channel this money through their treasuries and then make annual spending decisions as part of the normal budget process. By contrast, ACES makes many of those decisions up front and distributes allowance value to states for energy efficiency measures, to low income consumers, to utilities (to protect consumers from rate hikes) and to trade exposed industries or instructs the government how to spend the auction revenue – e.g. international assistance to address deforestation.

Whilst these may be laudable uses of the money and in reality are perhaps necessary to ensure passage of the bill, arguably this process undermines the performance of the emissions trading system. For example, allocating for free with the express intent of limiting price-pass-through to the consumer (so as to protect them) means that one of the mechanisms which makes emissions trading work is removed, namely the increasing price of carbon intense goods and services (which in turn drives down demand for that service). This means that although the cap remains the same, the lowest cost outcome to achieve it is not delivered, as it may have been the case that the most cost effective route to emisssion reduction was to use less, rather than to install a more expensive upstream mitigation project.

A second issue that arises is that we may not be able to judge today how government money is most efficiently spent to address climate change in 10 or 15 years time. That is why there is a budget process each year. For example, ACES specifies that some money should be reserved for adaptation. It is certainly true that adaptation will be necessary and money will be required, but in a given fiscal year it may also be far from clear how that should be spent- but it will be spent because it is there.

Spending auction revenue on clean energy deployment initiatives may not be the most efficient way forward either. After all, the reason we have installed a cap-and-trade system in the first place is to let the market make those decisions, so why second guess it.

As ACES develops in the USA, these are some of the issues that are going to have to be grappled with. The revenue available from allowances is substantial and it is true that it may be much easier to fund certain critical initiatves via the allowance route than the annual budget process. A good example of this is the set aside of 300 million allowances in the EU expressly for funding the EU CCS Demonstration Porgramme (10-12 large scale projects). But in the process of trying to satisfy all parties, we should be careful not to undermine the very instrument we are putting in place to achieve the objective of reducing emissions at lowest cost to the economy.