Cap and trade vs. cap and trade
American Senator Lindsay Graham created a buzz at the beginning of the month by pronouncing economy wide cap and trade dead. The still-not-released Senate version of the climate and energy bill purportedly contains a cap on the electricity sector, a cap on certain heavy manufacturing sectors to be phased in around 2016, and a tax on fuel to be leveled at the refinery level. The level of the tax is rumored to be set according to some formula dependent the price of carbon resultant from the trading system.
The House version of the bill, H.R. 2545, capped liquid fossil fuels upstream. I.E., for every ton of carbon emitted from their product, producers would be required to surrender allowances. So, superficial details don’t look terribly different from what the Senate is proposing on the guise of ‘killing economy wide cap and trade.’ It still remains for the final version of the bill to be released, but it is interesting that after so much time, sound, and fury, the carbon-reducing mechanisms in this bill don’t look radically different from that of the House. But maybe it just needs to be proclaimed dead and reborn for the optics of supporting it to be acceptable to a Republican Republicans.
Imaginary Numbers-China talks tough on verifying targets?
Yesterday the Chinese government announced through Xinhua that it put in place ‘statistical monitoring and assessment system to ensure greenhouse goals are met’. The Chinese government previously has stated that it has a goal of cuttings its energy intensity by 40% of 2006 levels by 2020. The Chinese have continually resisted international monitoring and verification of their emissions, and the latest announcement shows no change in their policy of obscuring their pollution behind a miasma of statistics and verbiage.
This announcement is unlikely to impress anyone familiar with China’s standards for statistics. Statistics from GDP, to energy, environmental, are collected and estimated though non-transparent means. The parties who generated them consistently over or underestimated statistics to their advantages. Unless the government makes the methodologies used to generate official statistics transparent, its 40% target will be meaningless.
China’s last emissions inventory was completed in 2004 for 1994 emissions using a top-down estimation estimate approach. Rigorous emissions monitoring requires careful aggregation bottom-up facility level input, which each type of facility uses a standardized measurement techniques. Without this kind of assessment, the base year and emissions and reductions are imaginary.
China is not the first country to have deal with issues of monitoring and measurement, however it has the worst track record for official statistics among major nations who are making a large push to reduce emissions. Phase I of the European emissions trading scheme was over-allocated and ineffective in reducing emissions because unverified estimates of emissions proved incorrect. Since verified data has become available Europe has corrected the problem by targets for Phase III off of 2005, a year for which it has real, measured data.
U.S. gross annual emissions are also estimated using the best available combination of bottom-up and top-down techniques for each sector. U.S. estimates are also far from perfect, however all assumptions used in deriving these estimates are transparently available on the EPA’s website. While this top-down measurement may not be accurate, it is clear where the weaknesses are and third-parties are easily able to critique applied methodologies.
Further, despite the poor record of the United States on setting emissions reductions targets, the U.S. government and EPA recognizes accurate and real measurement (vs. estimation) of baseline emissions are an important precedent to understanding where and how to reduce emissions, and ultimately if they are being reduced at all. To this end, last year the EPA issued a comprehensive greenhouse gas reporting rule requiring direct measurement of conservative, bottom-up estimation of baseline emissions across 85% of the U.S. economy. Reporting is mandatory in 2010, and will be an important foundation for whatever shape U.S. legislation takes. This U.S. has done this because it recognized what China has not—that reliable reductions require real measurement.
China wants to be perceived as a global leader in cutting emissions. Its pledge of a 40% energy intensity reduction by 2020 target is a part of this campaign. It is not encouraging that after monitoring and verification became such an issue at Kyoto, the Chinese government’s answer, after several months, is to come up with an announcement that vaguely mentions of ‘statistical measurement’, and appears to be aiming towards a system that still leaves behind where the United States (a laggard in emissions controls) has been for years.
The Chinese government often operates by issue vague directives that are later carried out at the regional level the form of ‘implementation regulations’, or sometimes not. In this case, the government needs to give local clear standardized procedures on how to measure emissions, otherwise the numbers will be meaningless. If past experience is any indication, the odds of the Chinese government stepping up to this task are low.
One can get an idea of what the problems of reducing emissions without clear standards might look like by looking, on the micro level, at the Tianjin’s energy efficiency trading scheme, a pilot energy-intensity based cap-and-trade system launched last month. Citigroup and Gazprom Marketing and Trading are early participants in the scheme. Published details on the scheme are vague. Neither the press release nor the Climate Exchange’s web page sufficiently have any substantial information about the trading scheme. Citigroup’s press release states that credits will be awarded to “heat suppliers whose emissions intensity is below the cap”.
But how big is the cap? How was the cap determined? Does it only cover heat suppliers? As virtually all residential heat in northern cities in China, by law, supplied by natural gas, how is energy intensity even being measured, or even attributed to the supplier? For example, the emissions intensity of a heating system in a building is a function of the fuel mix used to heat the building, the efficiency of the boiler(s) in the building, the efficiency of the distribution system, and the insulation of the building. The fuel mix, as earlier stated, is regulated by the government. Barring that, the remaining variables (efficiency, insulation, etc) are controlled by the building owner. It is therefore not clear what activities the building owner is getting credit for. This is all to say nothing of other unanswered questions about benchmarking. For example, who is the authority in charge of monitoring? If the suppliers decide to meet the targets by cheating and dropping the temperature in buildings below the legally allowed limits, who is to stop them?
These questions all arise even before getting into the question of whether or not the (still mysterious) target is legitimate. For example, if the government is using a statistical method to understand energy efficiency targets that has +/-5% margin of error, and a company, also with an internal margin of error of +/- 5% on its own energy intensity self-reports that it is, say, +/-10% below the cap, then do they get credit for 10% reductions? The gritty details of these schemes are critical in determining whether or not the scheme is actually incentivizing reduced emissions, or just trading hot air. Countries and organizations too often try to get credit for high-level announcements that are often meaningless.
If these questions have answers, then the Chinese government, or the American-operated Tianjin Exchange should should just publish them. Every other emissions trading scheme in the world does, and it is hard to imagine that serious investor or industry participation can take place without intelligible rules of the game.
Ultimately, the Chinese government may not care much about the participation of international investors. It may feel that it can run the scheme with Chinese investors, and claim credit for operating an environmental exchange without ever become more transparent about the exchanges actual achievements.
If the Chinese government expects the world to take its emissions reductions effort seriously, it needs to become more serious and transparent about its emissions information. The Tianjin Climate Exchange is likely just a pilot to understand how trading could be applied in a broader context. But the basic problems illustrated above will increase by orders of magnitude if the government were to attempt to use a similar system to implement a 40% by 2020 economy-wide emissions reductions scheme. If the government showed signs of using best practices from other environmental trading schemes and caps, none of this would be serious cause for concern. But every early indication is that benchmarking real reductions is not a part of the Chinese government’s climate policy.
Carbon Community Piles on the No-Bank-Regulation Bandwagon
Last month U.S. President Barak Obama proposed new regulations to limit the power of banks. One provision, known as ‘the Volcker Rule’, would restrict proprietary trading by commercial banks.
Point Carbon quotes IETA’s David Hunter on the new rules below:
“Banks play an important role in managing carbon risk and promoting technology investments that reduce carbon effectively,” he said.
“I don’t think we want to reduce the potential for banks to help finance our emissions reductions just at a time when we need to ramp up those emission reductions,” Hunter said.
Except that promoting and low-technology investment and proprietary trading in carbon products are not the same thing. You could argue that banks are critical for creating liquidity in the carbon market, the carbon market promotes technology investment though setting a carbon price, and the Volcker Rule restricts bank’s ability to trade in the market, weakens the pricing mechanism, and thereby limits technology investment. This argument is stretching it, particularly given the limitations of Obama’s regulations (discussed below), but for the sake of giving Hunter the benefit of the doubt, you can imagine this logic underlying his thinking. However, there is nothing in the rule that will prevent banks, for example, from giving badly need loans to renewable energy infrastructure projects, or from underwriting the IPOs of cleantech companies. What Hunter doesn’t make clear is why the organizations that perform these types of financial services, and those that make bets and provide liquidity in the carbon market, need to be in the same institution.
IETA has members who will naturally oppose this rule. However, IETA and other financial institutions in the carbon market should be sensitive to the reality that the market is vulnerable to being criticized as being the latest synthetic financial darling of speculators who want to destroy the economy. Given where U.S. public opinion is on carbon markets (tepid), and that carbon markets are young and still largely untested, the burden of proof has always been on the market to show that it has a right to exist. The financial crisis has only increased pressure on carbon markets and carbon products to show that they are worthwhile. To do date, they have not really done this in any significant way, and yet its representatives are already making arguments that show they seem to believe that the goodness of the market is self-evident. Coming out against regulations that are intended to protect–or at least intended to have the appearance of protecting–U.S. consumers at a time when a carbon trading bill has not passed the U.S. Senate, particularly when those regulations actually not particularly harmful to the carbon market, just seems like picking the wrong fight, with the wrong people, at the wrong time.
Point Carbon further reports Soc. Gen’s Emmanuel Fages as saying:
“In times of low activity, price volatility could be amplified if there are fewer counterparties (among which proprietary traders) to accept opposite risk,” Fages said.
Not so much. The restrictions on proprietary trading in the Volker Rule are pretty toothless. For example, if you are not a bank, you can still engage in prop trading. There are plenty of non-bank participants in the carbon market to provide liquidity and accept risk, many that have even cropped up solely for the purpose of participating in the carbon market. A Volker Rule equivalent in Europe would obviously have negative implications for Soc. Gen as far as it’s participation in the carbon market, but it is disingenuous to say that the absence of Soc. Gen would amplify price volatility and have catastrophic consequences for the market as a whole.
Harper’s takes aim at the carbon market, and misses the mark
While the sophistication news coverage of carbon markets has increased steadily over the years, name-calling and reductive syllogisms still abound. Reporters are hungry to say something bad about the carbon market, and hungrier still to conflate the badness of carbon markets with the badness of Wall Street. The line of attack goes like this—Wall Street is bad. The carbon markets are increasingly mediated by Wall Street. Therefore, carbon markets are bad. For examples see here and here.
Mark Schapiro’s cover story in February’s Harper’s is a recent and particularly egregious example. This article starts by chanting through the names of major investment banks involved in the carbon market as though the presence of these names alone proved malfeasance.
From the article:
“Carbon trading is now the fastest-growing market commodities market on earth. Since 2005, when major-greenhouse-gas polluters among the Kyoto signatories were issued caps on their emissions and permitted to buy credits to meet those caps, there have been more than $300 billion worth of carbon transactions. Major financial institutions such as Goldman Sachs, Barclays, and Citibank now host carbon-trading desks in London; traders who once speculated on oil and gas are betting on the most insidious side effects of fossil-fuel based economy.”
However, just mention of the involvement of Wall Street firms and a growing market is not sufficient to prove that there are problems. Moreover, the problems discussed in the article are only for EU-ETS offsets, which are less than 6% of the total market value. Even if one makes the unlikely claim that the purpose of the above paragraph is not to vilify the markets, but merely to provide context for a later discussion, the above article has painted the whole market with the same, broad brush.
Moreover it is difficult, given the title of the article, “Carbon Trading for Dummies: How the Scam Works-Conning the Climate, Inside the carbon-trading shell game” to imagine that the author is not trying to vilify carbon markets simply for being markets.
Indeed, given the title of the article and the opening, I was surprised to read through to the second page and find out that the article had nothing to do with fraud, but with technical difficulties in monitoring and verification. Okay, I understand it is hard to come up with something less sexy-sounding than monitoring and verification to put on the front of a magazine. The chances of getting an average passerby to pick up a magazine stand that promises a scam expose, particularly in a time of abundant financial chicanery, are much greater then the chances of getting someone to buy a magazine that says ‘substantive issues with monitoring and verification.’ But the commonness of Harper’s motives is not an excuse for this misleading and sensational title.
The conflation of fraud with M&V issues is all the more frustrating because monitoring and verification is a complicated and important issue at the core of whether or not the carbon market will ever be able to serve as a means of reducing emissions. If a large enough percentage of total certified reductions are fraudulent, then the system does more environmental harm then good. If the market evolves to the point were a large number of derivatives are being written on fraudulent reductions, then a growing carbon markets will contribute to the risk and instability of an already risky and unstable financial system. So, strong monitoring and verification is the foundation of a good system.
The Harper’s article correctly hits on many of the problems with the system—the technical capacity in validation agencies is weak, their incentives are misaligned with the project developer, spot checks are mostly done at a desk-level vs. project-level, and the system is difficult to administer because of the large number of countries and technologies involved.
In order for carbon markets to have any real impact, or even for there to be an honest conversation about whether or not carbon markets can have real impact, these issues need to be brought into the light. Unfortunately, this seldom occurs. Public discussion and evaluation of these issues with the carbon market is often forgone in favor in favor of reductive, polarized and shrill debate on both sides.
It is important to remember that a market is man-made, and therefore problems in the market are man-made and fixable. The way the article is written, it makes it seems as though the problems are intrinsic to the market itself and could not be reformed or exercised.
“In fact, problems with turning carbon into a commodity begin at the very moment of conception. One-ton of carbon credit is not precisely reproducible like an ounce of gold or twenty-tons of pork bellies; each credit emerges from an entirely different conditions and components, whether the planting of eucalyptus trees, the capture of methane from pigs, and the substitution of wind power for coal. Each represents a promise of potentially varying longevity and effectiveness, to say nothing of trustworthiness. Each involves rewarding a promise that cannot be kept, and whose keeping cannot even be measured reliably. On paper, cap-and-trade is seductively elegant; but in practice, making good of its promises would require an enforcement structure that is hardly less onerous than the obvious (if painful) solution to climate change that cap-and-trade was designed to avoid: that is, a carbon tax.”
I agree with Schapiro in that one ton of carbon is not precisely analogous to one ton of gold. However, the market already recognizes that different types of carbon credits have greater or less value based on a number of factors including their perceived reliability, their perceived environmental and social benefit, and the regime that they are traded in. I happen to feel that the differentiation does not yet go far enough, but the market is as yet not mature. However, in this way carbon is somewhat analogous to oil, which is price depending on viscosity, volatility, toxicity, etc. Of course there are also material differences, but the point is that even more traditional commodities are not uniform in their pricing. But this is the only part of the above paragraph where I can come close to understanding Schapiro’s point.
First of all, a purchased ton of carbon is not a promise. In all cases, a tradable emissions credit represents a ton of carbon dioxide equivalent that has already been permanently reduced. The permanent reduction is a basic criterion that exists in all carbon trading regimes, and the permanence issue is the main reason why, to date, forestry has been kept out of compliance markets. Once a ton of carbon has been permanently reduced, its reduction is just as long-lived as any—i.e., forever. Yes, in order for the market to be effective the participants must know with reasonable certainty that that ton has, in fact, been reduced. However, Schapiro has grossly overstated the problem “each relies on a promise that cannot be kept, and whose keeping cannot be measured reliably” and it is strange that Schapiro would refer to all carbon credits in this way just a sentence behind saying they are not uniform. First, some offsets are difficult to measure reliably, but a great many others are validated through records of physical destruction of greenhouse gasses kept by continuous monitoring systems that are extremely reliable. Further, it is completely possible to have a carbon trading system that does not allow offsets. In this case, verification of reductions and emissions is once again done through continuous monitoring systems on large, point-source facilities. Again, this is very reliable. It maybe worthwhile to discuss which projects are acceptable for offsets, or even for that matter, whether or not offsets can reliably be included in an effective carbon trading system. However this article seems uninterested in that kind of discussion, probably because it’s not sensational, and it’s difficult to get your hands around. Nonetheless, the fact that the first major emissions trading system has allowed the emission of difficult to measure credits does not mean that this is an intrinsic property of all emissions trading systems.
Finally, at the end of the article, the author offers no viable alternative. The strangest component of the paragraph is the claim that, on paper, cap-and-trade is seductively elegant, but that in practice it requires the same regulatory structure as a carbon tax. The usual argument for a tax over cap-and-trade is that the cap-and-trade structure is complicated and a tax is simple. Here, Schapiro seems to assume the opposite. I agree with Schapiro that a tax and cap-and-trade, when put into effect, are equally complicated. However, what I don’t understand is the argument that the complex regulatory structure necessary for cap-and-trade is a bad idea. And if he is too is trying to say that a tax is better (though it is not at all clear to me what he is trying to say), then he appears not to realize that a tax will involve the same monitoring complications? Greenhouse gasses are emitted from almost machine in the economy, and from many life forms and natural formations in the ecosystem. In what dimension of space is coming up with a system that allows for continued economy growth while reducing emissions going to be simple? On what planet will it not have difficulties and pitfalls? If someone comes up with the simple, univariate solution to global warming, I will not be the first to say it is a good idea because too many people will beat me to the punch. But I have confidence that is not going to happen.
Discussion and serious treatment of monitoring and verification, equity, and economic components of solving the climate change problem are incredibly important in order for society to come up with a workable solution. Unfortunately Schapiro, like many other journalists covering the issue, seems to value sensationalism and senseless alarmism over real discussion. It should not be sufficient to say that markets are bad simply because they are markets, or that monitoring is bad simply because it is complicated and prone to error. If, in the future, reporters, market participants, environmentalists, and regulators do not do better it will be a loss for us all.
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