Friday, December 22, 2006

Market Inefficiencies

Since moving to Virginia, it often takes me an extra day to catch up on stories from the New York Times, because the Washington Post and Wall Street Journal now both take precedence. But even if I'm tardy on this item, I can't let an article in yesterday's Times on the problems of market-based mechanisms for reducing greenhouse gas emissions escape comment. Emissions trading in its broadest definition, involving the transfer of emissions reductions made by one party to another party needing to reduce, is a key element of the Kyoto Treaty, and of the kind of cap-and-trade system recently enacted in California and contemplated for the entire US. From the start, though, this concept has been controversial. Yesterday's article illustrates several concerns about emissions trading, including the risk of paying for cuts that would be made anyway, the possibility of causing unintended, adverse consequences, and high transaction costs. While these are all serious issues, they do not outweigh the substantial benefits of trading.

The Kyoto Protocol provided two primary mechanism by which emissions reductions made in one country could offset emissions in another: Joint Implementation and the Clean Development Mechanism (CDM.) The Times focuses on the latter, which is intended to foster emissions-reducing investments in developing countries, with credit for the cuts flowing back to the investor and counting against its national emissions target under Kyoto. Should we be concerned that many of the initial projects have apparently focused on a narrow segment of emissions--albeit one with greatly disproportionate impact--in a small number of countries, and at a higher effective cost than the actual cost of the projects? Since all GHG emissions are essentially equivalent, and the ones in question represent classic "low-hanging fruit," they are appropriate early targets and ideal trading opportunities.

As to cost, the proper basis of comparison is not the underlying cost of reducing the emissions in country X, but rather the alternative cost of achieving equivalent cuts in the investor's home country. If a ton of CO2 can be eliminated in China at a price to the investor of $20, when the cost of cutting the investor's own emissions would be $40, it is irrelevant if the Chinese reductions cost only $5 to achieve, with the difference flowing to various middlemen. The net result of this little demonstration of capitalism still reduces twice as many emissions as would be cut for the same expenditure elsewhere, and the entire planet is better off.

Another concern raised by the Times is harder to dismiss. In the case of the Freon plant in China, it appears that the project to reduce its emissions might have the undesirable effect of prolonging or expanding production of a substance that is meant to be phased out under the Montreal Protocol on ozone depletion. This example reflects either a loophole in the system, or the misapplication of the "additionality" standard for CDM under Kyoto by the parties certifying the emissions reductions. I don't see that as an argument against trading per se, but rather as an issue affecting the rules under which trading is conducted, and thus meriting further investigation and discussion.

Readers of the Times might be tempted to conclude from this article that emissions trading is mostly smoke and mirrors, and doesn't advance the cause of reducing greenhouse gas emissions nearly as much as its advocates claim. If that interpretation were to undermine suggestions for implementing such a system in the US, then it would be a costly conclusion, indeed. The alternative to this kind of trading is reducing our emissions the hard way, at every US source. That would take much longer and cost much more, resulting in a faster accumulation of atmospheric greenhouse gases and more rapid climate change. As the market for emissions reductions develops, participants must work to drive out the inefficiencies and close loopholes, to ensure that we get the most emissions reductions bang for the buck. But that is no reason to turn our backs on a tool that will save us billions of dollars, either in up-front costs or in averted climate-change-related damage, later.

Energy Outlook will observe the Christmas holiday next Monday and resume postings on Tuesday. Seasons Greetings to all my readers.

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