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Emissions trading system

Heartland Conference (New York) - Monday, 9th March 2009

Ladies & Gentlemen: It's great to be here in New York. I often come to America, but it's been decades since I was in this city.

Two points before I start. I'd like to credit a London think-tank, Open Europe, whose work I have used extensively in this presentation. For more detail, visit their web-site at www.openeurope.org.uk/.

Secondly, I think all of us here are climate sceptics. But I will be arguing that even if you accept climate alarmism, the EU's Emissions Trading System (ETS) is a disastrous policy response. It is profoundly wrong even in its own terms.

The EU's Climate and Energy Package calls for 20% of energy to come from renewables by 2020, and the EU defines renewables to exclude nuclear. Most of this will have to come from electricity generation, which means in effect nearly 40%. The EU will also require 10% of transport fuels to be biofuels.

The Package also revises the ETS, or Cap'n'Trade as you know it over here. It lowers emissions limits in Phase 2, and gives more direct control to Brussels. The ETS covers around 40% of EU emissions, and this sector will be reduced by 21%, while member states will be required to reduce the remaining emissions by 10%.

Costs of the programme are estimated at around Euro 73 billion ($100 bn) across the EU, and Pounds 9 bn in the UK ($14 bn). It is estimated that this will add around $300 to the average household electricity bill, and will drive an extra million people in the UK into fuel poverty (where fuel costs exceed 10% of disposable income).

The programme will result in unintended consequences and perverse incentives. It will introduce gross distortions into the energy market.

First of all, bureaucrats will choose the industries to be involved, and the size and cut-off criteria. They will allocate free permits to established energy-intensive businesses. This will create massive barriers to entry in these industries, and will stifle competition and innovation. It will also create a massive opportunity for lobbyists who will seek to establish criteria that favour their own position.

Comparable companies of fairly similar size may find that the slightly larger one is in the scheme, while a similar business next door is not. Grandfather-rights will reward those who have failed to apply energy efficiency measures. Again, if we imagine two similar businesses where the main difference is that one has invested in emissions reduction and the other has not, the investor will be disadvantaged compared to the other. There is talk of basing allocations on industry standards rather than historical emissions, but this again is open to manipulation by lobbyists and interest groups, and will create a vast bureaucracy of analysts to define standards.

In energy intensive industries -- cement is a good example -- the current recession has already left them with spare emissions permits which they may sell in the market as a handy new source of revenue. At the same time, it creates a double temptation for industries to reach informal (if illegal) agreements to cut production, not only to create spare permits to sell, but to maintain market pricing.

The EU has provided for subsidies of particular low-carbon technologies -- for example "renewables" against nuclear, and biofuels, when they should be technology-neutral, so that the market could determine the lowest-cost methods of addressing emissions reductions.

The EU is already foreseeing the need for new "Green import taxes" to cope with what they are calling "carbon leakage" -- the inevitable tendency for energy-intensive industries to move offshore to more friendly jurisdictions, or for imports from third countries to replace EU production. This will challenge the WTO, and create the possibility of new 21st century trade wars. Third countries will certainly retaliate to what they see as protectionist tariffs.

Finally, the EU is internationalising ETS through its "Clean Development Mechanism" (CDM). Run out of emissions permits? You can buy some more from developing countries, against projects that may reduce emissions there! But then we hit the problem of "additionality". The intention is to subsidise third-world projects that would not otherwise have happened. But policing this is next to impossible, and there is already clear evidence of CDM funds sent to projects that would have happened anyway, or worse still to close extremely polluting operations that were built solely to defraud the CDM.

In any case, there is also evidence that EU member-states are planning to buy so many credits under CDM that they will have little or no incentive to reduce emissions in Europe at all.

So let's look at the way that Phase One of ETS worked in practice (2005 -- 2007). It achieved little or nothing in the way of emissions reduction. But it introduced very damaging costs and market distortions. Different member-states applied different approaches to issuing credits. France and Germany were generous, while the UK was parsimonious. So British companies found themselves having to buy permits from the continent. This resulted in transfers of around Pounds 500 million ($700 million) a year from the UK to the continent. Within Britain, it meant transfers of millions of pounds from hospitals, who failed to understand the system and had no lobbyists, to major oil companies who understood the game plan.

There were serious problems with pricing. There is a consensus view (if you accept alarmism) that the social or environmental cost of CO2 emissions is between Euros 20 and 40 a ton. But the price of credits fell close to zero, because of over-allocation. It is currently below Euros 10. Contrast that with the cost of reductions under the EU's Energy Package, estimated at 80 to 100 Euros.

We now have a report from reputable UK consultants suggesting a massive price spike in 2012. They are anticipating economic recovery by then, but they are also concerned about another in-built distortion in the EU's Energy Package. Companies can bring forward allowances within Phase 2 (2008/12), but not from future phases. There will undoubtedly be companies who have drawn down permits from future years, and who become distress purchasers of credits in 2012. The consultants expect the price to spike to Euros 60 per ton. Imagine what that would do to the European economies. We should have a competitive disaster on our hands.

As a Conservative, I am sometimes asked why I oppose ETS. After all, it's a market mechanism, isn't it? Don't Conservatives believe in the market?

Yes, I believe in the market, but this isn't a real market. It's a bureaucratic construct. Real markets deal in commodities with a real, underlying value, unlike emissions permits. Real markets depend on many real players reaching mutual decisions, not on bureaucrats setting, and changing, the rules. There is already talk of governments "intervening" if prices go the wrong way. That's not a market. That's a very complicated tax.

I have written about this before, and Czech President Vaclav Klaus was kind enough to quote my work in his excellent book "Blue Planet in Green Shackles".

Let me offer you a disclaimer. As a Conservative, I hate taxes, and I especially hate new taxes. I would not tax carbon emissions at all. But if -- it's a big IF in this room -- if you want to reduce CO2 emissions, then a straightforward carbon tax would be the way to go. It would be inclusive, bringing in large and small operators. It would be transparent and predictable, facilitating planning for businesses. Above all, it would be non-discriminatory, and would leave the market to gravitate to the most cost-effective approach, going for the low-hanging fruit first. That's economic efficiency.

Let me conclude with an appeal to all of you here today, as Americans. Sadly I don't have a meeting scheduled with President Obama on this trip. But if I had, I'd say to him "Mr, President, Don't do Cap'n'Trade!". There was a famous American journalist who went to the Soviet Union in the 20s, and came back saying famously: "I've seen the future, and it works". He was wrong then, just as the European Commission is wrong now. I've seen the future of Cap'n'Trade, and believe me, it doesn't work.