Can Markets Stop Climate Change?

“Can we trade our way out of our climate difficulties? Can market mechanisms deal with a problem of such scale and urgency?”

By Renfrey Clarke

from Green Left Weekly (Australia) August 9, 2008

Internationally, as in Australia, governments forced to promise climate change action have generally promoted market-based carbon abatement schemes, mostly of the “cap and trade” variety. But can we trade our way out of our climate difficulties? Can market mechanisms deal with a problem of such scale and urgency?

Perhaps the best place to start is with the things that markets do well. Markets historically have proven very good at mediating exchange in settings where large numbers of sellers, operating on something like an equal basis, need to strike deals with large numbers of buyers. In these circumstances, supply and demand tend to respond quickly to one another, with prices shifting to maintain a rough equilibrium.

Does this have any relevance to a market in carbon emissions? In the federal Labor government’s scheme, about a thousand Australian firms, responsible for about three-quarters of emissions, will be required to square their carbon accounts.

A thousand purchasers of carbon credits might seem like a large number. But in practice, the demand for carbon credits will be concentrated heavily in the hands of a tiny number of large emitters. In theory, these firms could faithfully purchase the credits they need, at a fair price. There are, however, enormous inducements for the big polluters to do otherwise.

For a start, they can put extraordinary pressure on the government to give them credits for nothing. When the European Union (EU) first established its emissions trading system, large numbers of carbon credits were handed out free to established emitters. When the oversupply of credits became obvious, prices collapsed. The right to pollute was now super-cheap, and all incentive to invest in cutting emissions vanished.

In Australia, government advisor Ross Garnaut has argued that coal-fired power generators should have to buy all their credits at auction. But with its Carbon Pollution Reduction Scheme green paper, released in July, the government has dodged this fight. Electricity generators and “trade-exposed” polluters are to receive major assistance, with the latter being given as many as 90% of their permits free. Other sectors such as the liquefied natural gas industry are now wielding the stick, trying to extract pledges of equal treatment.

The big emitters, meanwhile, are world-scale corporations whose size gives them a dominance that no-one enjoys in the classical marketplace of the textbooks. They will face heavy penalties if found to be colluding in order to force down the prices of the credits they need, but such collusion will be extremely hard to prove. In any case, the very largest polluters will be able to influence prices quite independently. The mere planting of a rumour that a big power company is out of the market for a large block of credits will, at times, be enough to send prices tumbling.

Theoretically, monopoly practices and attempts at price manipulation should be less of a problem on the supply side, with large numbers of solar panel installers, forestry operators and small renewable energy companies having carbon credits to sell. But this field, too, has plenty of rotting stumps to tangle the machinery of the market.

For a start, what does a carbon credit represent? Supposedly, it is one tonne of avoided or sequestered emissions of carbon dioxide equivalent. But what if the sequestering is done in a forest, and the forest burns? What if the sharp-minded owner of an old-growth forest decides to cut the old timber and use the land for plantation forestry, which absorbs carbon and earns credits at an accelerated rate?

If markets are to be used to provide incentives for desirable abatement practices, while maintaining due protection for the environment, they have to be accompanied by burdensome regulation. This is because of a fundamental limitation of markets: they fit poorly with non-quantifiable criteria, such as the sustainability of a complex environment, which can be reduced to calculations of economic profit and loss only through bizarre mental contortions, and often in a quite arbitrary manner.

When the generating of carbon credits requires a mountain of regulation, a key theoretical advantage of markets — their relative spontaneity, efficiency, and freedom from bureaucratism — disappears.

This arbitrariness introduces an especially potent danger: corruption. Critiques of the nascent international carbon trading system set up under the Kyoto Protocol include hair-raising accounts of carbon scams in developing countries. The credits claimed as a result have been sold as good coin to emitters in the EU. In Australia, PM Kevin Rudd plans to plug his government’s carbon trading scheme into the world system as the latter assumes a more definitive shape.

The supply side of the carbon credit system, meanwhile, will not be as proof against market-rigging as it might at first seem. In large part, carbon credits will not be bought directly by emitters from the firms that create them. Instead, specialised institutions will buy up credits and resell them. In a letter to the Australian Financial Review, quoted in the July 17 Australian, former AFR editor Vic Carroll warns that financial institutions are “strong supporters of an emissions trading scheme because they [stand] to gain from trading permits and creating complex derivative markets.”

The phrase “complex derivative markets” should ring alarm bells. In a parallel to the Nasdaq and sub-prime mortgage booms, vast quantities of surplus capital that race across the world seeking openings for high-profit speculative investment can be expected to alight in the new carbon credit market. Sharp practitioners will quickly devise ways to push prices in the direction they want. But as with the sub-prime crisis, the derivative markets will in time become so complex that no-one any longer understands just what they are or how they will respond to stimuli. A crash at some point will be a certainty.

No-one else will care much if speculators lose their shirts. But the rationale behind carbon trading is, after all, to tilt the financial playing field so as to encourage investment in green technologies and practices. If the price of carbon credits gyrates wildly — as can be anticipated in a speculative environment — investors will be loath to put large sums into long-term development in areas such as renewable energy infrastructure. A Nasdaq-style crash could render carbon credits near-worthless. Without the protection carbon credits afford, the renewables sector would become uncompetitive, and could expect to be wiped out.

It can, of course, be argued that if one is not too doctrinaire about free markets, regulations can be built into the system to try to rein in its more vicious propensities. Criticising the Rudd government’s ambition to launch its carbon trading scheme in 2010, Matthew Warren noted in the Australian on July 21: “The European Union spent five years just designing its scheme and it’s in the middle of seven years of phased transitions to iron out structural problems. They don’t actually switch to unconditional trading of permits until 2020.”

Since when, however, did humanity have until 2020 to take decisive action against climate change?

When market mechanisms are unsuited in principle to the tasks involved in combating climate change, and when the effect of markets is to introduce high levels of additional risk and delay, why are markets set to become the backbone of world action against global warming?

The belief that market economies work best if left unregulated has a long history in capitalism. Most professional economists remain sceptical of the ideas of the more extreme, “neoliberal” free-marketeers. But the rationale these ideas provide for a general hostility to government regulation means they are popular among corporate executives, especially in times of prosperity. Accordingly, the more literal-minded free-market economists tend to enjoy prestige and influence. And among governments that — like Rudd’s — rule with their ears trained to the sentiment in the corporate boardrooms, the recommendations of neoliberal gurus take on something of the force of holy writ.

If market mechanisms cannot serve as the key tool for stopping global warming, what should be substituted? A carefully devised carbon tax would be useful in many settings. The list of economists who have pointed this out is growing. On July 15, noted US economist Jeffrey Sachs told the ABC’s 7.30 Report that he viewed an emissions tax as a simpler, cheaper alternative to carbon trading.

“It’s much easier,” Sachs said, “simply to tax the few places upstream — the oil, the gas, the coal, that puts on the price on carbon, then works through the economy — rather than a more complicated scheme where you monitor what thousands or even tens of thousands of individual enterprises are doing.”

Taxes, however, are usually unpopular. Price hikes and slumps in the marketplace, by contrast, can be represented as random and impersonal. As Carroll observed in his letter, “Governments prefer to hide behind markets, with all their costly excesses.”

Imposing a carbon tax, of course, is not the same thing as ending emissions; it merely sends a price signal that may be heeded or may not. The need to combat global warming is now so urgent that it requires highly focused action, especially in the case of the really big polluters. Indirect instruments such as taxes are too slow, and their effects too unpredictable and diffuse, for them to be the sole or major tool employed.

The key measures must be of a quite different kind. Public ownership and concerted planning are essential in areas such as electricity generation, metals smelting, transport and vehicle production. Indispensable steps will then become possible whether corporate executives smell profits or not. The bureaucratism, delay and waste implicit in efforts to redirect market impulses using regulations and taxes will be avoided.

None of this is good news for the capitalist system. But then, global warming is not exactly good news either.