Taxation or Regulation to Replace Carbon Emissions Trading?

A recent Financial Times article suggesting that the United Nations Clean Development Mechanism (CDM) for carbon trading is "close to collapse" reminded me of my long-held conviction that carbon trading is not a viable long-term solution for greenhouse gas emissions. The likely alternatives are direct regulation of carbon emissions and taxation. Both of these approaches would be government-led, but it has got me thinking that there should be business opportunities could be if these alternative approaches grow. I would be interested in any views on this.

Although I am not an expert on carbon trading, my conviction that global carbon trading is not viable in the long term feels well-founded. Pollution markets tend to work reasonably well where they operate in a defined geographic area to facilitate administration and limit cheating. Good examples include the original US-Canada markets for emissions of sulfur dioxide and other chemicals to control acid rain, and the market for Packaging Recovery Notes (PRNs) to manage UK compliance with EU packaging recycling legislation. I am heaving involved in the latter as a director of Valpak, the largest trader of PRNs.  It is possible to limit these trading schemes to defined geographic areas because of the relatively local phenomena involved -- acid rain generally results from industrial products relatively near (in the 100s of miles) to where it occurs, and the UK packaging market can be defined by UK border. This is not possible with carbon emissions, which is an inherently global problem.

The European Union Emissions Trading Scheme (EU ETS) is the largest carbon emissions trading scheme, and has suffered from wild fluctuation of prices (which have mostly been too low to discourage carbon emissions) due to over-allocation of emissions permits and other factors.  Aside from the inherent difficulties of getting permit allocations right across the EU, there are problems with cheating (e.g. enterprises that pollute more than allowed), leakage (location of carbon-intensive production outside of regulated geographies), windfall profits for enterprises that can pass through cost of emissions permits that later are less expensive than expected, and even theft (the EU ETS was briefly suspended in early 2011 due to electronic theft of permits valued around €7 m).  The CDM, whose imminent failure is noted at the outset of this blog, has the additional problem of ambiguity / discretion in its projects -- i.e. would the CDM projects that generate credits actually have produced an equivalent quantity of carbon in the absence of the program? The answer seems to be "almost certainly not", which means that the CDM introduces further elements of cheating and leakage into emissions trading.

I do not tend to me a fan of government intervention, but carbon emissions and climate change are problems that appear necessary and indeed urgent to solve, and one which should draw increased attention as the hangover from the global financial crisis further abates. Of the two alternatives to emissions trading mentioned at the outset -- direct regulation and taxation -- my vote for the right way forward is taxation, as it involves less government intervention and greater market discretion on solutions, and is more easily calibrated across borders.

Maury Shenk, Lily Innovation Advisors

Winners and Losers in a Slower Growth World

My favourite Financial Times columnist Martin Wolf asks today "Is unlimited growth a thing of the past?" (registration required to read). As usual, Wolf's observations are grounded in robust economic analysis, focusing on the slowdown in global productivity gains, notwithstanding the "third industrial revolution" associated with information technology. He also addresses the ongoing catch-up by developing countries to developed-country levels of productivity. I couldn't agree more, and have previously written about related issues in my blog "We Will Be Poorer -- Why Should We Care?" As I noted, the growth conundrum also involves issues of the ability of the planet to sustain ongoing growth, including due to issues of food and water sufficiency, security and climate change.

In a slower growth world, there will also be increasing competition among global economic actors, and the relative positioning of the major economies under these conditions is interested. Here are my quick thoughts on winners and losers:

• United States. The US is best-positioned of the major economies. It has a relatively isolated economy, substantial natural resources, and relatively limited dependence on exports (the US is a huge net importer), so has the ability to power ahead alone. Perhaps more important, the US is probably the world's most flexible economy, which explains its leadership in productivity (subject to the threats that Wolf identifies) and positions it well for changing times. For these reasons, I expected the US to emerge as a leader from the global financial crisis of recent years, and initially thought this prediction was wrong. My current conclusion is that the effect has been delayed by Chinese momentum and fiscal and monetary stimulus, as well as the overhang from the very serious effects that the financial crisis had in the country where it originated. All of these delaying effects are now moderating. Of course, the US does still face significant challenges, including its massive public debt, and the inability of Republicans and Democrats to agree on how to deal with it.
• China remains on a path to become the world's largest economy sometime in the coming decades, and its growth will likely continue to be faster than that of the West. But problems are on the horizon, probably more severe than those imagined by most who fear a "hard landing" for China. Reasons include a bubble of investment in property and industrial resources, the effects of slower global growth and increased regional competition on its export-led economy, reduced legitimacy of the Communist Party (reducing in turn its ability to impose policy), and environmental challenges (which should not be underestimated, particularly given their impact on public opinion). Despite these challenges, there are many opportunities for China. Among other things, as I have written recently, China's role as a direct investor in other countries will increase significantly in the coming years.
• Japan. The 20-year economic malaise in Japan shows no sign of abating, and Japan will not in our lifetimes return to the economic stature that it had in the 1980s. However, Japan is in the enviable position of having made most of the adjustments that it needs to make, and of being a highly homogenous, high-income and relatively egalitarian society. These traits will allow Japan to continue to deliver a high standard of living to its population in coming years. Japan is down, but not out.
• Europe is least well-positioned of the major economies. The current Euro crisis will eventually pass or at least moderate significantly, but it is a serious medium-term distraction and a symptom of the challenges of managing an economic bloc that is so culturally diverse. Longer term, Europe will face serious challenges in growing its already high incomes without the flexibility of the US economy. As a result, the overall European project will continue to stall or reverse, and regions within Europe will assume greater importance, with pockets of significant opportunity. For example:
• The United Kingdom, my home country, is facing very serious economic challenges, but is better-positioned than many European countries because of a relatively flexible economy, the strength of its financial sector, and (perhaps) because of what seems a sincere effort by the government to promote entrepreneurial business (leveraging strength in sectors like media and science/technology). The latter effort has contributed to the increasing role for London as the centre of Europe's start-up economy -- but not yet approaching in effectiveness its leading US counterpart Silicon Valley.  
• Many Eastern European countries are also well-positioned, including because of economic flexibility resulting from radical economic re-engineering in the wake of the collapse of the Soviet Union. Russia, now a relatively small player compared to the major economies, also seems to have acceptable options due largely to its natural resources strength.
• Europe has done a relatively poor job of turning its strength in science and technology into successful growth businesses. Many in Europe are working to remedy this situation, and this is a major focus of our business at Lily Innovation Advisors.
• Other Regions. I am less knowledgeable about other smaller but important economic regions, including Latin America, Asia (ex China and Japan), Middle East and North Africa, and sub-Saharan Africa. Many countries in these regions have the potential to maintain growth rates above the global average, because of various factors including relatively small size and/or particular advantages (e.g. low wages, or recent reform after past instability).

Maury Shenk, Lily Innovation Advisors

China Slowdown and Foreign Investment

It is becoming clear that the Chinese economy is experiencing a significant decline in its recent growth rates. Growth in Chinese real GDP has been at least 8%/year since 2000, and at least 9%/year since 2004, peaking at near 12% in 2007. In 2012, growth will almost certainly be below 8%, and possibly below 7%. And the growth trend is downward, including because recent growth has been fueled by uneconomic investment and a property bubble that are producing serious and unsustainable economic imbalances in China. Although growth around 7% sounds healthy from a Western perspective, it is much more dangerous in China where government financing relies heavily on approaches such as taking land from individual owners and reselling it to developers at a significant profit.

These trends are negative for domestic investment flows in China. But the same conclusion does not follow for foreign investment by the Chinese government and private sector in foreign companies. In fact, the opposite is likely to be true, for several reasons.

• First, China will remain a substantial net exporter for the foreseeable future, generating significant funds for investment, and this investment is increasingly likely to flow abroad because of the trends discussed above.  
• Second, in order to transform from a low-cost economy towards an advanced economy, China will increasingly require access to advance, cutting-edge technologies. Notwithstanding perceptions that China tries to steal foreign technologies through industrial espionage, the reality is that Chinese businesses looking for technology will have no choice to significantly increase foreign investments. China does not yet approach the West in successful technology innovation, and is unlikely to catch up soon.  
• Third, Chinese direct investments in Western companies (at least outside natural resources sectors) have so far been relatively moderate (in contrast to the large Chinese investment in US Treasury securities, and similar assets). This is particularly the case in Europe, as illustrated by a recent study "Chinese Overseas Direct Investment in the European Union", published by the Europe China Research and Advice Network. In short, there is almost no way to go but up.

All of these factors suggest to us that there will be a long-term trend of increasing Chinese investment in Western companies, particularly technology companies, notwithstanding the ongoing (and likely increasing) slowdown in Chinese growth.

Of course, there are barriers to growth in Chinese foreign direct investment.  Some governments, notably the United States, have blocked Chinese investments perceived to be in strategic sectors, sometimes with rather weak rationales. In some cases, such actions smack of protectionism, and distrust of a powerful China in a lower-growth world. Differences in negotiating styles, as well as communications challenges, between Chinese and Western companies are also real challenges. But these barriers will not be sufficient to derail the trend, particularly as experience and sophistication of both Chinese investors and their Western partners continues to grow.

Maury Shenk, Lily Innovation Advisors