System problems with Emissions Permits Trading

Systematic problems with Emissions Permits Trading and other forms of carbon trading

At present the cost of energy from renewable sources is higher than the cost of energy from burning fossil fuels. Emissions Permits Trading puts a price on emissions so that the cost of energy from burning fossil fuel will rise to be the same or greater than the cost of energy from renewables. This is then meant to spur investment in renewable energy sources which will replace fossil burning energy sources.

Scenario 1

Let us assume trading in permits works in encouraging investment in renewables. If it works then we will construct many renewable energy systems and due to technological advances the cost of renewables will go down. This means the price of emissions permits will go down. What business person will buy emissions permits today knowing that the price is likely to be lower tomorrow? If everyone thinks the same then we will see wide fluctuations in the price of emission permits with a corresponding instability in energy prices which leads to economic inefficiencies.

Scenario 2

Let us assume that the system gets going and existing energy producers purchase just enough permits to meet their current production. As the number of permits is reduced so the price of permits will rise well above the price needed to encourage renewables. This means that the price of all energy will rise to be just below the price of energy produced with high costing permits. This means that existing permit holders will get super profits and will not sell their permits but rather reduce their production which will in turn increase their profits because of the higher prices of all energy. This means it is in the interests of existing permit holders to make the cost of permits high and the best way of doing that is not to invest in renewables but to put the excess profits elsewhere.

Scenario 3

If the market in emissions permits works as in theory it is likely to be very volatile. Other financial markets such as exchange rates show a great range in prices for currencies even though we would expect that the relative values of currencies should be slow moving. As soon as the cost of energy rises well above the cost of renewables there will be political pressure to either increase the number of permits, ignore the permits or fiddle with the market in permits so that the price remains low. This will then defeat the idea of having a market in permits because the market will no longer be free.

Scenario 4

For emissions trading to work the cost of fossil fuel burning energy should rise to be greater than the cost of renewables. Assuming all the extra money collected from emission permits goes towards building renewable energy sources the cost of building enough renewable energy sources for a given reduction in emissions must be greater using this approach than a more gradual slower investment approach. This is because more money is spent earlier than later with permits because we know that the technology of renewables will become cheaper due to economies of scale and from learning how to better build plants. That is, emissions permits trading MUST be more expensive for a given reduction in emissions than a slower more gradual investment approach.


The above may or may not happen as suggested – or they all may happen to some level. Whatever the future of trading holds we can be assured it will not work the way predicted by computer models because trading involves decisions by many people many of whom can influence and change the rules. What we do know is that the system will be modified to try to keep it to its objectives of reducing emissions and not distorting the economy. The real problem with emissions permits trading is that we are not sure it will work at all. The evidence of other attempts at imposing global economic changes are not good. The ozone hole started to reduce but now appears to be increasing in size. The early attempts at European carbon trading failed. In Australia the attempts at carbon trading have failed. We can all postulate in retrospect why the systems failed but the most likely reason is that the underlying assumptions are flawed. The probability is high that any carbon trading system will fail. We cannot afford the time to experiment with systems that may or may not stop global warming.

A guaranteed solution to the problem

There is a guaranteed solution to the problem available to us. It is very simple and is built on existing systems that we know will work. The system operates as follows.

1. Put a flat tax on all carbon emissions.
2. Use the money from the tax to build renewable energy sources or to invest in energy saving methods or in ways to absorb carbon.

The argument against this approach is that governments are not good at spending taxes and we need markets to decide the best way to invest. This argument is a good one. The solution to the problem is to create a market to spend the taxes.

One way to do this is to give the tax money back to the people from whom it was collected but require them to spend the money on infrastructure that will reduce greenhouse gas emissions. We can make this even more effective if we give the money collected to those whose lifestyles produce few greenhouse gases . This means the distribution of money will have a secondary benefit of encouraging behaviour changes and of rewarding people whose lifestyles produce few greenhouse gases. As these people are often the poor the system is socially equitable.

This approach does not require ANY new economic systems. It only requires a system to keep track of the redistributed money and ensure it is spent in reducing emissions as agreed when it was given.

As the system involves a redistribution of money it makes no difference to the GDP of the country. What it does do is to force investment in renewable energy systems and in other ways of reducing greenhouse gas emissions and diverts money from other consumption.

It does this through a market in sustainable technologies so solving the issue of governments directing expenditure. Instead it allows the market to direct expenditure.

Emissions Permits Trading inferior to…

This blog entry has been submitted to the Garnaut global warming review.

Emissions Permits Trading versus Direct Investment

Recommendation 1: The Australian government develop a plan to introduce a nation-wide surcharge on the retail cost of all energy with the money collected to be redistributed to those whose lifestyles generate few greenhouse gas emissions.

Recommendation 2: The Australian government immediately trial the system in the ACT by funding a surcharge on electricity to be distributed back to frugal consumers of electricity.

Claim: A direct investment market-based approach to reducing greenhouse emissions will cost less to produce a given reduction in emissions than will any form of carbon or emissions permits trading.


To reduce greenhouse gas emissions we require investment in ways to generate emissions-free energy.

Trading in emissions permits or carbon credits are indirect means of encouraging investment in ways to reduce greenhouse emissions. The systems work by increasing the cost of emissions-producing energy so that it is priced higher than energy generated without emissions. Once the price rises high enough organisations will find it profitable to produce emissions-free energy and so the market will encourage investment in emissions-free energy to replace the emissions producing energy generation.

An alternative approach is to encourage the existing market in emissions-reducing technologies to flourish by supplying potential buyers with money to invest in the market. This direct approach will cost less to reduce emissions – by any amount – than would the indirect permits or credits system.

The reasons for this are twofold:

1. For an emissions permit system to work effectively requires an increase in the cost of emissions, enough to make emissions-free energy competitive with energy created by burning fossil fuels. If the price of all energy is not the same as emissions-free energy then investment is unlikely to happen on the scale needed to make a significant difference.

2. In the main, fossil fuel burning technologies are mature, while renewable technologies are still emerging. We know that the cost of renewable energy production is likely to drop as it is introduced. This also means that in the future the value of emissions permits will drop as less incentive is needed to encourage investment.

With a direct investment approach to emissions reduction, the cost of investment required to achieve a given level of reduction can be estimated and investment can proceed over many years at a lower average cost. Modelling shows that to achieve the same level of emissions indirect investment, through emission permits trading, is at least 20% more costly than direct investment and is likely to be twice as expensive.

The other advantage of direct investment is that it is certain to work. We know how to produce emissions-free energy – it is only a matter of funding.

The argument against a carbon tax is that it stifles market development, because the government has the money and governments are not good at picking the best places to invest.


In the past the solution would have been for a government to impose a carbon tax and to build emissions-free power plants, such as occurred with the Snowy Mountains scheme. Economic orthodoxy says that this approach leads to an inefficient allocation of resources, not withstanding the fact that the existing fossil fuel burning energy industry was established this way. Economic orthodoxy says that markets are needed to allocate resources efficiently and there is much evidence to show that when markets operate fairly, this is true.

There is good evidence to suggest that the most efficient allocation of funds will occur in a market place where there are many buyers who can freely choose from many sellers of the same product. This same result will occur even when the market place is disturbed by external events such as the introduction of a completely new technology.

Given this, if we distribute the money collected by a carbon tax so that it is spent in the market place of energy-saving infrastructure or to generate emissions-free energy, we will have the least cost method of achieving any level of emissions in any time frame.

Energy Rewards is one way to create a market place with many buyers with money to spend.

It is a fair system where a surcharge (not a tax) is put on all fossil fuel energy. This surcharge is redistributed back as Rewards to those consumers whose lifestyles generate few emissions. Amongst the people whose life styles generate few emissions are those whose per head household consumption of mains electricity is below average. Rewards must be spent in the market place of green infrastructure. As the money is a redistribution (and not an expenditure item) there is no change to the GDP of any country adopting this system – just a redirection of investment away from consumption to renewable energy infrastructure.

Existing sellers of appropriate infrastructure will flourish because there will be many buyers wishing to buy. New technologies will develop because there are potential buyers of these technologies.


It is estimated that Australia could have zero net emissions within ten years with a 30% surcharge on the retail cost of energy redistributed as Energy Rewards.

Policy Implementation through Market …

Topic: The future of Australian governance

Policy Implementation through Market and Choice Mechanisms

The 2020 summit could be extended to bring choice and “a market place of ideas” into policy formulation, selection and implementation.

2020 is a way to obtain ideas. The conference is meant to sort through the submissions and give the government a set of ideas worth considering. The next step as we understand it, is for the government bureaucracy to develop the ideas selected and decide on those worth implementing. The final step will be for the government to either implement the policies themselves or to tender the implementation of the policies to other organisations.

The problem with this process is that it is a one-off, and that choice and variety is reduced as the process continues. What is needed is a continuing market place for ideas, evaluation and for implementation.

Rather than the government evaluating the ideas or appointing a commission or study and selecting those worth considering
, why not put the evaluation process up for tender? Let the government appoint three groups from the bidders and make their evaluations available for public scrutiny and comment. The government could then select the recommended bidder and ask that it prepare a tender for implementation. The selection process could be extended to involve interested groups who could give their input and their selection. The government and the group that prepared the tender then selects the most appropriate organisation – which could be an internal government body – to implement the system.

Every step – from submission of ideas to evaluation and implementation – could be developed into a continuous and ongoing process. It could be tried immediately on itself with the task of formulating policy on how to make the best use of the ideas from 2020.

Ken Henry letter on water pricing

Ken Henry (CT March 5th) puts the case for a realistic price for water. Most would agree with his article.

Unfortunately it will not happen in the ACT because ACT Treasury supported by all political parties are not willing to give up the taxes that come from being a monopoly water supplier. The arguments against a free market in water are that it is efficient to have a single supplier, restrictions are socially equitable and that the extra money we get from the scarcity value of water is spent on socially desirable services like hospitals and schools. ACT water restrictions can be removed tomorrow if we increased the price of water to high consumers, give all the extra money collected to low water users and require the money they receive to be spent on water supply infrastructure as a surrogate market for water. This would be socially equitable, would get wide spread support, is simple and cheap to introduce. It does not happen because all political parties are unwilling to give up monopoly taxes. In a true market the money collected from the scarcity value of water would go to increasing the supply of water but the ACT Treasury calls this hypothecation and does not let it happen. So Ken Henry’s call for a market based water supply system will remain just a call while his State Colleagues continue to believe taxing water is better government policy than a free market in water or the surrogate water infrastructure market.

The idea of emissions trading has a c…

Emission permits trading is said to offer a solution to greenhouse gas emissions. Under such a scheme an organisation will require a special permit before releasing green house gases. Permits are allocated, sold to or traded between organisations whose activities cause greenhouse gases. The effect is to increase the price of goods whose production causes the emissions of greenhouse gases. Other ways of producing the same goods with less gases will naturally arise because they will become price competitive. At first sight this line of reasoning appears to offer a sound solution to the problem of reducing greenhouse gas emissions.

I recently asked a number of experts why it is going to take until 2010 to set up an Australian emissions trading system. This seems a long time to wait given the immediacy of the problem. I was told the reason for the delay is that setting up an emissions permits system is difficult, with the major problems including defining the property rights associated with permits; how to issue permits; what to do with the money raised from permits; enforcing the property rights; and understanding the effect of the system on the economy. This is going to take at least two years and we are still unsure whether, at the end of that time, it will achieve a reduction in greenhouse gases.

As someone who builds information systems for a living I know that any information system (and an emission permits system is an information system) that takes two years to define is not going to work as expected. An emissions trading system is complex. We know that it is best to build complex information systems incrementally. We start with the simplest possible system that will achieve the minimum usable objective, we build it and see what happens. We learn from our mistakes, make incremental changes and allow the system to evolve as we add increasing complexity.

I then asked how the system was going to be tested. I was told that this was done by modelling the system on a computer. Economic computer modelling is carried out by building a theoretical model on how an economy works. Unfortunately the record of computer models of economic systems is problematic when they are asked to include human behaviour. It means we are testing how emissions trading will work with simple computer models not with humans. This is almost guaranteed to give results that will be difficult to trust because human systems are not static computer models. People invent new rules and continually change the systems they use.

This then set me thinking about the objective of emissions trading and to think of a better way to achieve the objective of reducing greenhouse gas emissions through an incremental adjustment of existing economic systems rather than creating a whole new regime of property rights.

The underlying purpose of emissions trading is to direct investment to ways of producing goods without greenhouse gas emissions (like energy).

A solution to this starts by putting a price (any price) on carbon and to use the money raised to invest in ways to produce goods (like energy) without creating greenhouse gases.

This is a well known and standard approach to the problem of reducing greenhouse gases. The argument against this is that it is not market-driven. This is a problem because markets are acknowledged as the best way to efficiently allocate resources. The market for the goods produced already exists, as does a market in greenhouse-reducing infrastructure, so there is no need to invent any new market to distribute resources on infrastructure to reduce greenhouse gases.

What we don’t have are buyers for greenhouse-reducing infrastructure because it is not economically sensible to purchase goods that involve lower greenhouse emissions. At present such goods cost more than competitive products created using emissions-producing technologies.

So the problem is not the money, not the sellers but the buyers. We need buyers who want to, or are required to spend in the market place of greenhouse-reducing infrastructure.

Why not create some money that has to be spent in the market place of greenhouse-reducing infrastructure? Secondly why not give the money collected from a carbon levy to those people whose lifestyles produce few greenhouse gases on the proviso that they use the money to invest in greenhouse-reducing infrastructure. That is, the buyers will have money but they have to invest in geosequestration facilities, solar thermal energy farms, insulation for houses, windmill energy generators and so forth.

If we do this we will still pay more for goods that generate greenhouse gases, but we will give the money collected to those whose lifestyles consume few greenhouse gases. These frugal people will invest in further ways to reduce greenhouse gases. We have created a positive feedback loop where saving greenhouse gases generates more savings. This is guaranteed to reduce greenhouse gases because it solves the missing part of the market-driven equation. It creates a group of buyers, with money, ready to spend.
We can quickly and easily set up an experimental system to test if the approach works. We already have the information systems to support the infrastructure market and the distribution of money is a well known problem. We can start experimentation immediately.

The system is socially equitable, will not change the GDP because the money used on greenhouse gases is merely a transfer from other expenditure, not a reduction in expenditure. The system can be introduced incrementally and refined through use. We can start it tomorrow. Best of all it is guaranteed to work. We know it will achieve a reduction in greenhouse gases. We do not know the rate but through experimentation we can soon discover how much we need to spend to achieve any particular emissions target.