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What's the worst way to cut CO2 emissions?

Conservative Home - Sunday, 20th July 2008

Put ten economists in a room, and they'll come up with eleven different opinions.  But there's one thing they'll agree on, and that is that taxes (if we must have taxes) should be clear, fair, predictable, easy to understand, cheap to collect, and above all, non-discriminatory. They should not distort markets and economic activity.

The EU takes a different view.  It wants to limit CO2 emissions by creating economic incentives.  But its approaches break all the rules of good and fair taxation.  Their first attempt was the EU Emissions Trading Scheme (ETS).  Phase One was a huge disaster.  It was vastly bureaucratic and expensive to operate.  It created serious distortions between member-states.  And it wholly failed to reduce emissions.  Open Europe has done a couple of excellent reviews of ETS's failure, (Both documents in pdf format).

Phase Two of the ETS started at the beginning of this year, which the EU says will be much better.  But they've been saying that about the CFP for thirty years, so don't hold your breath.

One big problem with ETS is the initial allocation of permits, and "grandfather rights" for existing companies.  These create huge anomalies.  One of the most obvious can be illustrated by this scenario:  Suppose two similar companies sit side-by-side, the only difference is that one invested a large amount of money five years ago on energy efficiency, while the other did not.  If you allocate permits based on recent energy consumption, you are favouring the "bad" company and disadvantaging the "good" company.  One possible solution is the auctioning of permits, but this brings problems of its own.   Another anomaly is the cut-off threshold.  One company may be caught in the scheme, while another slightly smaller escapes.

But a new idea is starting to emerge: Benchmarking.  In simple terms, this means establishing a best-practice norm for emissions per unit of production in different industries.  Then any firm that does better than the norm earns carbon credits, which it can sell to firms doing worse, thus creating incentives for both good and bad firms to improve.  But of course someone has to decide on the norm for each industry.  They need to update the norm every year as standards improve.  They also need to identify those industries which in their nature use a high and irreducible amount of energy (like cement) and make special arrangements, to prevent them re-locating overseas (this is what is known as "carbon leakage" -- the ETS, like so many EU policies, tends to drive production and jobs and investment outside the EU altogether).

Then what do we do about new technologies which are not covered by the existing rules, or hybrid businesses that cover more than one category?

You can start to see the problem.  We'll have a rule-book the size of a telephone directory.  We'll have a vast department of bureaucrats setting levels by industry by year, and checking the performance of each company in the scheme.  Every decision will be challenged by armies of industry lobbyists desperate to set norms and targets that give their own business a competitive advantage.  Emissions costs will be unpredictable and volatile.

And the result will be massive complexity and endemic market distortion.  So what's to be done?  If you really want to reduce emissions (and readers of this blog will know that I am not keen to reduce CO2 emissions, though I am concerned about energy security), the solution is a carbon tax.  As a Jeffersonian in favour of low taxes and limited government, I hate new taxes with a passion.  But a carbon tax would be vastly better than a false and artificial carbon credit market.  It would be simple and predictable.  It would be cheap to collect, with little administration.  It would affect all businesses pro rata to their energy use, with no thresholds and cut-offs.  And above all, it would create no anomalies and distortions.

So will the EU adopt that route?  Will they hell!  The EU generates complexity as a matter of principle.  And emissions benchmarking will do huge damage to the competitiveness of European economies.