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