The Prime Ministerial Task Group on Emissions Trading states

By placing a price on emissions, trading allows market forces to find least cost ways of reducing emissions by providing incentives for firms to reduce emissions where this would be cheapest, while allowing continuation of emissions where they are most costly to reduce. This underlines the fact that emissions trading is not an objective in itself, but a means of achieving a certain level of abatement at the lowest cost possible.

This is the reasoning behind all cap and trade systems no matter how the systems are designed. On page 45 of the report there is an example of how the system will operate.

Two companies, A and B, each emit 100,000 tonnes of CO2 each year. The government wants to cut emissions by 5 per cent, and it gives each company an allowance to emit 95,000 tonnes. Each company has the option of either reducing its emissions by 5,000 tonnes or buying up to 5,000 tonnes of allowances from elsewhere. Suppose the market price for the allowances turns out to be $10 per tonne.
Company A can reduce its emissions for half this cost per tonne, so it is reasonable for it to cut its emissions by 10,000 tonnes: if it sells the extra 5,000 tonnes of emissions reductions (for $50,000) it will be able to recover its expenditure.
For company B, making reductions is more expensive, at $15 per tonne. It decides not to reduce its emissions, but instead to buy the 5,000 tonnes of surplus allowances on offer from company A. If company B reduced its own emissions, it would cost $75,000, but if it buys them from company A, the cost is significantly lower, at $50,000.
The end result is that both firms are better off by $25,000 compared to their costs without trading. If they are the only two companies in the country, this means the country’s business sector is able to cut emissions by 5 per cent for $50,000 less than if the government forced both companies to reduce their emissions by the same amount. In a scheme with full international linkages, this example could equally apply to trade between companies in different countries.

There is a fundamental flaw with any cap and trade which will result in under investment in clean technologies. It is assumed that there is a company somewhere that is able to invest so that it can produce the same amount of the product (say electricity) without emissions for the current price of electricity plus $10 per tonne of emissions saved. Various industry commentators say that the price of emissions has to rise to $40 per tonne before investment in alternative emissions free generation of energy will become worthwhile. As the price per tonne is going to be limited to less than $40 and will be set by the government the rational response of any company will be to sell their emissions for whatever price they can get and to stop producing energy. This will have the effect of reducing the generating capacity of electricity which in turn will lead to an increase in energy prices until the price of ALL energy rises to be the equivalent of $40 a tonne. Thus all companies with existing polluting generation capacity will obtain excess profits from their permitted production. It is unlikely that much of this excess profit will be invested in producing clean energy as it is to the advantage of polluting companies to keep polluting as long as possible and at as high a price as possible. Investing and making clean technologies more economically viable is not in the interests of existing polluters.

All cap and trade systems suffer from these flaws. That is, the money from selling emissions will NOT go to investing in clean energy until the price of all energy is the same as clean energy production. There is an inbuilt incentive for companies to keep polluting for as long as possible.

The article The Carbon Folly published in Newsweek March 12th 2007 outlines the dismal record of Emissions Trading. It is very easy to pervert the intent of trading particularly if the scheme is a local scheme. To quote from the article.

Since developing countries don’t have any caps on emissions, companies can take the handsome payments they receive from carbon cuts and use the money to build new fossil-fuel and coal factories.

This will be particularly attractive to a coal exporting country such as Australia.

There is fortunately a way to solve the problem. Any money collected by energy companies from selling emissions permits must be spent on approved ways of producing – or saving – energy. Similarly any money collected by governments from selling permits must be spent on approved cleaner ways of producing – or saving – energy. This will then give rise to a market in clean energy sources. That is, the money will go to the companies that can produce the most clean energy within their emission permits. The money can also go to energy savings technologies and because of market forces it will gravitate to the most economically efficient approved way to reduce emissions.

There is an even simpler way of solving the problem that is much more direct and does not require the setting of any arbitrary cap and will be economically efficient at achieving the target of reduced emissions. Whenever any greenhouse gas is produced then there is a cost applied. This cost is a surcharge on the price of the product but the surcharge stays with the purchaser. The surcharge must be spent on approved infrastructure that will reduce emissions. A surcharge is NOT a tax but is a compulsory saving.

The government has to set the surcharge and approve where money can be spent. If emissions do not come down quickly enough then the surcharge is increased. If it is too quick then the surcharge is decreased.

Approving where money can be spent is very transparent. An organisation that wishes to sell its products has to publicly prove that its products will or may reduce emissions.

As a surcharge is NOT a tax it will have a minimal distortion on the economy to achieve the desired outcome of reduced emissions. A cap and trade system can still be left in place and can operate in parallel with the surcharge system but it is unnecessary.

The surcharge approach is particularly useful for those situations where it is not clear how to measure emissions nor clear how to measure the effect of a new technology on emissions. For example it is difficult to measure the emissions from raising live stock and it is difficult to measure the emissions that might be saved from fundamental research that as yet has no immediate application.

There is an even better way to distribute the surcharge. Rather than give the surcharge directly to the purchaser give the surcharge in inverse proportion to those citizens or organisations that through their actions produce less greenhouse gases as measured by the surcharges they generate. Thus if the average surcharge amount per citizen was $x then the person who generated $x-$y would receive $x+$y while the person who generated $x+$y would receive $x-$y. In effect this rewards people for consuming less. (note this calculation assumes a symmetrical distribution so the formula would need to be adjusted for a non symmetrical distribution)

To return to the example above of the two companies but with the surcharge in place. Let us assume that the only way that the energy surcharge could be spent would be with one or other of these companies. The market determines that the company that could reduce its emissions for the least cost would be the company that would attract the investment and hence the most economically efficient outcome is achieved. The system can be easily extended throughout the Australian economy and the world simply by extending the range of approved places where money can be spent.

A major advantage of the surcharge system is that it can be implemented immediately because similar mechanisms that are currently used to collect taxes can be used to collect and distribute the surcharge. Places where money can be spent will be many and will include all the areas where governments now or are proposing to offer rebates and will include all clean energy ventures.

Compliance costs will be low because people who wish to claim the surcharge will be volunteers. That is, surcharges will not be automatic and a person will have to agree to participate in the system. While this will be easy to do it also means that people can be removed from the system for a period if they are found to abuse it. Similarly merchants and businesses who are approved can have their approvals removed and if they abuse the system they will be taken from the system for a period.

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