There are three broad types of policy to address climate change: traditional regulation, innovation policy and carbon pricing. All three are vital.
When investors assess climate policy they look, in turn, for three things – transparency, certainty and longevity.
Subsidizing new technologies, particularly in the early stages, helps reduce costs and makes the learning curve for entrepreneurs less steep. This is the key objective of innovation policy.
Human behavior being what it is, though, businesses and consumers do not always adopt climate-friendly policies, even when it makes economic sense from a societal perspective to do so. Hence, traditional regulation performs its role by phasing out inefficient light bulbs (in the United States, the European Union and Australia among other geographies), by implementing codes for greener and more efficient buildings (as advocated by the C40 Cities Climate Leadership Group, a coalition of the world’s largest cities) and by tightening automobile emissions standards.
At the center of climate policy, however, is the pricing of greenhouse gas emissions, a device to internalize the “externality” that is the cause of global warming. Carbon pricing can be accomplished either through a carbon tax or cap-and-trade.
A number of regions have already announced carbon taxes. A carbon tax establishes a price for carbon, aiming to encourage a set amount of mitigation, or reduction in emissions, when compared to business-as-usual levels. While “guessing” the price of carbon to get to a certain level of mitigation may be suboptimal, proponents of a carbon tax argue that its greater price stability reduces carbon price risk and encourages greater investment in alternative energy.
Cap-and-trade sets a limit on emissions. This is achieved when a central authority creates a limited number of tradable credits, which emitters must hold in sufficient quantity to cover their emissions. Proponents of cap-and-trade, the system that is used in the Emission Trading Scheme (EU-ETS), has been proposed under the American Clean Energy and Security Act of 2009 (Waxman-Markey), and is proposed in Australia and New Zealand, argue it allows carbon reduction to be achieved in the most efficient way possible. This is because cap-and-trade sets a policy-driven cap, motivated by scientific evidence; market mechanisms then allow those with the lowest costs of mitigation to reduce emissions, and to sell excess certificates to emitters with higher marginal costs. The argument against cap-and-trade is that the variability of carbon prices inherent in such a system reduces investor certainty, although that can also be addressed, in part, through minimum price floors and more flexible caps with short-term intervention in the market, potentially by a “carbon central bank.”
There is great flexibility in allocating revenues in either regime. Most carbon tax proposals are presented as “tax neutral”, meaning that other taxes will be reduced to offset the imposition of carbon taxation. So far revenues from the cap-and-trade regime in the EU have been limited, because a relatively low proportion of credits have been auctioned (as opposed to being given away for free). This is set to change in the third phase of the EU-ETS, which begins in 2013.
In systems that auction more of their credits, there may be intense competition for hypothecation – sometimes called earmarking – of the revenues generated. In the American Clean Energy and Security Act of 2009 (Waxman-Markey), for example, local electric distribution companies have successfully lobbied to receive 30 per cent of the permits issued for free. This may lead to windfall profits for these companies, as was the case for many electric utilities in the first phase of the EU-ETS.
Mark Fulton is Global Head of Climate Change Investment Research at DB Climate Change Advisors in New York. Mark Dominik is a Vice President and Senior Research Analyst at DB Climate Change Advisors in London.