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WEALTH OF NATIONS

Focus Climate Talks On Carbon Price

Kyoto was the wrong approach from the beginning. Its error was trying to set hard targets.

Carol Browner, the top White House adviser on energy and the environment, recently told a conference hosted by our sister magazine The Atlantic that the president was unlikely to sign a climate-change law before the next big international meeting on the subject, in Copenhagen in December. "That's not going to happen," she said. The American negotiators should have a bill to work from -- quite likely more than one -- but no new law. This will be an embarrassment. It will hamper the Obama administration's efforts to claim global leadership on the issue.

But for those who seek effective curbs on carbon emissions, the news is not all bad. It matters more to get the right kind of agreement -- one around which global cooperation on carbon abatement can work -- than it does to meet the December deadline. And it may be that the United States is inching, after all, toward the kind of measure that could serve this purpose.

 

It is important to understand that the 1997 Kyoto Protocol, whose successor the meeting in Copenhagen is intended to create, was a failure. This is not just because the United States and many other big (mainly developing-country) emitters of greenhouse gases chose not to participate. Even the countries that did ratify it, taken together, failed to curb their emissions. The plan had too many loopholes, too many bogus national targets, too many promises that nobody intended to keep.

It looked impressive, and the United States gave the Kyoto countries a propaganda coup by standing aside, taking the blame for the failure on itself. For that reason alone, many deemed it a success: If a new international agreement is going to flop, at least organize the thing so that it looks like America's fault. Yet the fact remains that the pact did not alter the trajectory of global carbon emissions. Kyoto was the wrong approach from the beginning.

Its main error was trying to set hard national targets for emissions. This is a complicated business -- much more complicated than an effective climate-change agreement needs to be. In advance, it is impossible to say how costly it will be to comply with any given cap on emissions. Some countries will find it easier than they thought to meet their targets. Others will find it harder, or even impossible. This means squabbles about parity of treatment, both before the agreement can be signed and during its implementation. It also requires the design of safety valves. With sufficient ingenuity, these can subvert the whole project -- as they did after Kyoto.

 

For instance, Kyoto set an emissions target for the former Soviet Union that was looser than a "business as usual" forecast of emissions. Without doing anything to comply, those countries had, as it were, surplus reductions. Other countries could use these to justify milder efforts on their own part.

Supposedly binding quantitative targets, formed in ignorance of how circumstances will change and how costs of compliance will vary from country to country, take ages to negotiate, and in the end just do not stick. If there is one lesson to learn from the failure of Kyoto, this is it.

Rather than devise an overly rigid set of quantitative targets certain to crack under pressure, countries should sign on to a framework that is flexible at the outset. The ideal is a scheme that can accommodate differing circumstances and sudden surprises -- assuring the signatories that nobody will get a free ride, and that their own commitments will not turn out, because of some unforeseen change in conditions, to be crippling. A system based on the price of carbon, rather than quantitative targets for emissions, has this basic advantage. An explicit carbon tax is one way to do this, but not the only way.

Critics of a price rule correctly point out that coordinating international efforts around a carbon price guarantees no particular outcome in terms of quantities -- and that, at the end of the day, the quantity of carbon is what matters. But the idea that quantitative targets offer any such guarantee is an illusion. See Kyoto. The world will get more of what it needs from a price-based system, because it will be easier to negotiate and easier to implement.

 

Under cap-and-trade systems -- like in the House's Waxman-Markey climate-change bill and the Senate's new Kerry-Boxer measure -- permits are created to allow a fixed level of emissions. The initial allocation of permits will be a politically contentious matter, but the permits can then be traded. The tighter the cap, the more expensive the permits will be. As is well known, cap-and-trade, compared with a simple cap, has the great virtue that it lets producers reduce emissions where it is cheapest to do so. If it is very costly for a firm to reduce its emissions, it will buy a permit to emit; if it is easy to cut its emissions, it will do that instead, and save the expense of buying an allowance.

Obviously, the trading reveals an implicit price of carbon: That is what the price of a permit represents. The key question is what you do with this information. Under pure cap-and-trade, the answer is nothing. The price comes out at some number, and that is that. The cap is the policy variable. To turn cap-and-trade into a price-based system, you have to let the price adjust the cap.

In practice, reflecting the same political and economic realities that dished up the Kyoto Protocol, if the permit price gets out of line, governments will change (or simply ignore) the cap even if they have promised otherwise. In other words, if the cap turns out to be tighter than envisaged, the permit price will soar, energy producers and consumers will scream, and ways will be found to loosen the cap.

In planning a carbon-abatement regime, you can either ignore that fact or take it on board. There are huge advantages in recognizing it, making it explicit up front, and building it into the design, rather than letting it happen ad hoc. Formalizing the connection between cap and price makes it much easier for energy producers and consumers to plan their investments. Knowing the government's target price of carbon removes a major cause of business uncertainty.

Most important -- again, remember why Kyoto failed -- it provides an organizing principle for effective international coordination. Governments should be able to agree on a target price for carbon much more easily than agreeing on a country-by-country set of emissions caps. And once they have agreed to it, they have no excuse for failing to stick to it.

Waxman-Markey and Kerry-Boxer are quantity-based measures: They both aim for stated cuts in emissions -- of 17 percent and 20 percent respectively, comparing 2020 with 2005. Putting that aside for a moment, both have other defects as well. Rather than auctioning permits, for instance, Waxman-Markey mostly gives them away. This forgoes a lot of revenue that could have been used to reduce other taxes or pay down the budget deficit. It also weakens the incentive for carbon reduction, because much of the permits' value will be fed back to energy consumers in the form of lower energy bills. Kerry-Boxer leaves the question of allocations unanswered for now.

Governments should be able to agree on a target price for carbon much more easily than on emissions caps.

Both bills also give plenty of scope for so-called carbon offsets -- which allow firms, in effect, to pay others to reduce carbon emissions rather than doing it themselves. Depending on exactly how they are designed and policed, offsets can promote efficiency, serve as a useful safety valve, or render the entire exercise pointless. Kerry-Boxer seems to provide for closer scrutiny of offsets, to make sure they represent genuine reductions. Europe's experience with offsets under the Kyoto Protocol underlines the importance of supervision.

The most interesting innovation in Kerry-Boxer is the formal adoption of a so-called price collar -- a range within which the permit price will be confined. Under the current draft, the price of permits will be kept between an initial floor of $11 per ton of carbon and a ceiling of $28 per ton. The thresholds would then be increased over time according to a set inflation-plus formula. If the price fell below the floor, the cap would be tightened; if it pushed through the ceiling, the cap would be loosened. It is still cap-and-trade, but (keep this quiet) with economic features that make it much more like a carbon tax.

The price collar is an excellent idea. To see why in more detail, read "A Copenhagen Collar" by Adele Morris, Warwick McKibbin, and Peter Wilcoxen of the Brookings Institution (at www.brookings.edu).The price-collar aspect of Kerry-Boxer makes sense in purely domestic terms, because it mitigates business uncertainty. Most important, though, it offers a fruitful way forward for international negotiations. The more these talks focus on the price of carbon rather than on country targets, the more effective the post-Kyoto regime will be.

Perhaps America can take the lead in this process after all.

This article appears in the October 10, 2009 edition of National Journal Magazine.

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