carbon or harm? the price of the risk of anthropogenic global warming

8/14/2019 Carbon or Harm? The price of the risk of anthropogenic global warming

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Carbon or harm? The price of the risk of anthropogenic global warming

Bruno Prior, Summerleaze Ltd

Summary:

The causes, consequences, mechanisms and extent of anthropogenic global warming(AGW) are uncertain, as is the optimum balance of mitigation and adaptation in re-

sponse. That balance is achieved where the marginal costs of (a) mitigation, (b) adapt-ation and (c) inaction are equal. Discovery in an appropriately-structured market is a

better way than calculation to establish prices and volumes of complex, diffuse, uncer-tain and evolving risks. Popular mechanisms (e.g. cap-and-trade or carbon tax) pro-

duce distorted outcomes by fixing in advance those things (volume or price) which the

market exists to establish.

This paper argues that the market should not host trades in a notional commodity (aquantum of reduction in output of CO2 from certain sources), but rather in the risks

associated with AGW. The cost of factors that affect these risks is the cost of liabilityfor future damage attributable to AGW. The present cost of future liability is the costof insuring with substantial counter-parties against that liability. A mechanism is pro-

posed to match the emission of a volume of greenhouse gases (GHGs) with the liabil-ity for a proportionate share of any consequential damage. The mechanism establishes

the annual volume of permissible emissions (net of absorption) that participants in the

market judge to represent the balance of risk (cost of liability) and reward (sale ofemissions permits). National governments are responsible for accounting for the per-

mits for the annual net emissions within their boundaries. They have significant influ-ence over the permitted level of emissions, and their means of achieving the necessary

balance of emissions and permits is not constrained. The market is open to private aswell as public participants. Liability is depreciated over time in parallel with the ab-sorption of the GHGs. An approach is suggested for quantifying the costs for which

those who hold the liability are responsible. Brief consideration is given to some risksand weaknesses of the proposal, and to aspects needing further investigation.

Pros (++) and Cons (--):

Structurally, the proposal offers mostly advantages over currently-favoured mechan-

isms. Price and volume will react quickly and strongly to changes in understanding

and conditions (++). Both adaptation and mitigation are incentivized without prefer-ence (++). Carbon sinks are valued proportionately, providing incentives to preserve

and enhance them (++). Centuries of experience in managing risks in efficient insur-ance-markets are leveraged (++). Each nation has greater autonomy to decide how to

respond to the market signals (++). The value of low emissions and high absorption in

many undeveloped countries is recognized, helping them to develop but to do so effi-ciently (++). Commercial organizations (e.g. insurers) as well as governments have in-

centives to support research (++). Researchers' focus and emphasis should move fromthe worst case to the most likely case (++). An incentive is created for those holding

liabilities to reduce them by funding adaptation measures (++), but no suggestion is

provided for how such investments would avoid free-rider problems (--). Certain typesof emissions (e.g. some methane) may be hard to accommodate (--).

Politically, the proposal has strengths and weaknesses. It requires a complete rupture

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with the current approach embodied in the Kyoto Protocol. Politicians may wish toavoid starting again (--), and a change will be opposed by the many vested interests

that have been created by the mechanisms established in the wake of Kyoto (--). On

the other hand, the failings of the Kyoto approach are inherent in the concept and can-not be removed by refining the implementation. A clean break and fresh start based on

a concept that more accurately reflects the reality of AGW may be the only way toachieve broader agreement and realistic action (++). The proposal should be more at-

tractive than Kyoto to undeveloped nations, who should be able to use it as a source of

revenue and spur to outside investment (++), developing nations, whose demands thatrich nations be responsible for their legacy are taken into account (++), and heavy

emitters in the developed world,who can more easily strike a balance between thecosts and benefits of various measures than under a Kyoto-style mechanism (++).

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1. Facing the risk

There is a risk, the scale of which is subject to uncertainty and differences of opinion,

that human emissions of greenhouse gases are changing the climate in ways that may

have consequences (positive and negative) of uncertain magnitude at unknown dates

in the future.

This effect occurs at a global scale, but there is a disparity between nations (and indi-viduals) in their contribution to the emissions, their vulnerability to the risk and their

perception of its probability and severity. Any solution will require broad internationalagreement. To have a chance of gaining broad support, that agreement will have to in-

corporate flexibility to allow different governments to deal with the problem in their

own ways, whilst providing assurance that the burden is not being exaggerated or un-derstated, and is being shared as fairly as possible. It will not be possible to provide

that flexibility and assurance unless the solution takes account of the differences inperception.

Whether based on cap-and-trade, carbon-tax, regulation or technology, mostmechanisms proposed for tackling the threat of anthropogenic global warming (AGW)

rely on the arbitrary selection by central agencies of an optimum profile of emissions,and/or price of carbon, and/or shares of the burden. They confront very great diffi-

culties of coordination and trust (the prisoner's dilemma writ large) between nations,

as may be expected of political solutions not rooted in sound economics (i.e. trying tooverride rather than harnessing people's interests and subjective impressions). This pa-

per presents an alternative.

As many national governments are determined to retain control of the methods used to

respond to this risk within their national boundaries, markets are likely to remain themost acceptable and practical means of achieving international coordination.

However, the market structures deployed so far require a significant surrender of thisindependence, rely on the decision of central-coordinating agencies about the op-

timum profile, and second-guessing of and political unanimity on the appropriate shar-

ing of that profile between nations and between solutions. These features inhibit theemergence of rational price signals; effective markets need the freedom to discover

exactly those things that are being pre-judged in the EU-ETS and other such schemes.

The problem is that people have been trying to create the wrong types of market. This

is not a commodity market it is a risk market.

The external cost of carbon-emissions is equal to the share of those emissions in thecost of any ensuing damage, or in the cost of preventing that damage (whichever is

lower). The net present value of that external cost is equal to the price required tomake sufficient provision for the liability for the risk of that damage or the responsib-

ility for its prevention. Carbon does not have an innate value or cost of its own that is

separate from the consequences of its release into the atmosphere. Its cost is that re-quired to persuade someone of sufficient financial standing to underwrite that risk. 1

The underwriters themselves will use a variety of methods and perspectives to estim-ate their liabilities and risks. The diversity of the market will provide a more balanced

1 More precisely, it should be the net cost, balancing the costs against the benefits of greenhouse-gas

emissions, but if those who may benefit can take part in the insurance market, they can price thatbenefit into their offerings.

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and responsive price than the calculations of one central agency. The objective shouldbe to create a market that provides this insurance and charges its cost proportionately

to those whose actions contribute, positively or negatively, to the risk.

2. A suggested approach to a new market for global-warming risks

The following suggestion for the outline structure of an international mechanism to

trade the risks of global warming focuses initially on carbon dioxide as a prime ex-ample, but it should be remembered that other significant greenhouse-gases (other

than water-vapour) should be incorporated within the mechanism on an equivalent

basis (see Section 5 below). The basic elements of the market would be as follows:

i. A process is agreed internationally for assessing national, annual, net emissions ofeach greenhouse gas for each country. It will take account of sources of carbon di-

oxide (e.g. the combustion of fossil-fuels and biomass, composting etc.), methane

(e.g. coal-mines, landfills, farms etc), nitrogen oxide (e.g. vehicles and other com-bustion plant) and other significant greenhouse gases, and of biological, chemical

and mechanical carbon-sinks (e.g. forests, seas, or carbon-entombment). These as-sessments are already, by and large, being carried out for the purpose of under-

standing the processes that affect our climate.

ii. National governments agree that they will present excess-emission credits (see be-

low) annually in proportion to their net emissions.

iii. An international agency offers, on an annual basis, paired excess-emission credits

and excess-emission liabilities. These are a pair of certificates, denominated in acertain mass of carbon dioxide (say 10 ktC [thousand tonnes of carbon]). The

credits can be used, ultimately, by national governments to satisfy their obligation

from the previous paragraph. The liabilities denote the acceptance by their pos-sessor of their obligation to pay towards the cost of repairing the damage from any

climate-change impact, above a baseline level of severity and incidence (see Sec-tion 6 below), in proportion to their share of total issued outstanding liabilities.

iv. The paired certificates are neither bought nor sold nor limited on first offering. A

bidding period for initial issuance of that year's certificates (the initial market) is

defined, during which eligible organizations (public and commercial) declare whatvolume of credit/liability pairs they would like to take. All declarations are visible

to all other participants in the process, and can be adjusted until the close of thebidding period, at which point the organizations are bound to take the number of

credit/liability pairs in their closing bid.

v. The total number of excess-emission credits taken by all parties represents the total

volume of net emissions that can be emitted globally that year. The total numberof excess-emission liabilities represents the combined responsibility for the costs

of any above-baseline climate impacts attributable to that year's global net emis-

sions.2 Participants in the initial market will want to ensure that the potential costof the liabilities (established either directly by actuarial calculation, or indirectly

by laying off the risk to commercial underwriters) is less than the value of the

2 Climate impacts will be attributable to the emissions from more than one year. We cover below how

this should be taken into account, and the question of the baseline. For the sake of simplicity, wewill continue to deal with a single year for the timebeing.

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credits to the operators of the various processes that cause emissions (the pol-luters).

There is much more detail to be considered, but it should already be possible to dis-cern the fundamental strengths and weaknesses. Relative to existing mechanisms, it

can be seen that this basic structure more effectively:

a) Discovers the economically-efficient level of total carbon-emissions;

b) Takes account of differences in national perspectives and circumstances to achieve

their most efficient distribution; and

c) Makes provision for those who may be affected by the consequences of the emis-

sions.

This approach is more economically-efficient because it allows costs and benefits ofmitigation, and adaptation to be weighed against each other. The marginal value of ad-

ditional credits falls as the total number of credits issued increases, particularly as thevolume approaches, first, the level at which demand could be reduced by easy (i.e.cheap) carbon-savings, and even more strongly as the level approaches the level of

current emissions. The marginal cost of additional liabilities does not fall as strongly,and may hold steady or increase, as the total number of liabilities issued increases, be-

cause subjective judgements of the risk will take account of the possibility of non-lin-

ear aspects of the effects of GHGs on climate-change (tipping points, feedbackloops, etc) as well as the simple cumulative effect on the probability of impact from

increased volumes of emissions. The market should gravitate towards the point atwhich the total number of credit/liability pairs results in a balance between the value

of credits and the cost of the liabilities. This point, by definition, represents the level

of emissions at which the carbon-cost of adaptation balances against the carbon-costof mitigation. The mechanism thereby establishes the most economically-efficient

level of emissions, without resort to central calculations.

3. Internalizing the international mechanism within national boundaries

Nations may choose their own ways of internalizing this mechanism to their own eco-

nomies. No agreement is required on a unified international mechanism for carbon-

trading, taxation or any other approach, beyond the establishment of volumes of al-lowable emissions in the initial market. The options include:

i. The simplest approach, which will be adopted by more centrally-planned econom-ies, will be for governments to estimate their potential net emissions and bid for

the necessary number of liability/credit pairs to match those emissions. They willretain the liabilities within government, and pass on the costs of providing for that

liability in whatever way they see fit (these may simply be socialized in the mostsocialist of economies).

ii. Mixed-economy governments may take a similar initial approach to the first op-tion, but might alternatively choose to lay off the liabilities and/or sell the credits.

The laying off of the liabilities would establish the cost that should be recoveredfrom those whose processes contribute to the net emissions. The selling of credits

could be used to pass on that cost to polluters. Such governments may also chooseto take a minimum baseline of credit/liability pairs and rely on traders to take the

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marginal, uncertain volumes, buying back (at necessarily elevated cost) whatevervolume is needed to balance the books at the end of the year.

iii. Market-economy governments may choose to delegate responsibility to pollutersand traders from the start. A government could place an obligation on the polluters

to surrender credits in proportion to their emissions. Larger polluters may chooseto bid directly for credit/liability pairs in the initial market, while financial institu-

tions will also bid for volumes to sell to larger and smaller polluters who are un-

willing or unable to trade directly.

Whichever approach were used to internalize the international mechanism, govern-ments would have complete freedom to determine the methods they would use to en-

sure that they achieve the necessary level of net emissions.

Those governments that are more sanguine about future risks and costs may choose

not to apply tight constraints to their emissions, on the basis that they take a largershare of the future liability. Their subjective judgement will be that their more cau-

tious rivals have imposed unnecessary costs on their economies, and should therefore

feel that they have achieved a good deal from the process.

Those governments that are more worried about future risks may reduce their expos-ure by taking fewer credits and liabilities, but will then be obliged to find ways to re-

duce their emissions to match. Their subjective judgement will be that their more

sceptical rivals have taken on an unwise share of the future costs, and should thereforefeel that they have achieved a good deal from the process.

It is possible that governments of more sanguine countries may choose to buy

credit/liability pairs beyond their requirements, planning to re-sell some of the credits

to less sanguine governments, on the basis that the former place a lower value on theliabilities than the latter, and can therefore profit to both parties' advantage from

selling on the credits while retaining the liabilities. This offers real potential for redu-

cing the tensions between governments with different perspectives on AGW.

Governments of poorer nations exposed to risks of damage from climate changewould have, for the first time, a mechanism by which they could recoup costs result-

ing from climate-change. They should feel pleased not only that this marks a signific-

ant improvement on their current position, but also that the associated increase in cer-tainty about the future will allow greater confidence in investment to develop their

economies. They would have an incentive to develop in a way that minimizes the in-creases in their carbon-emissions, so as to retain their position as beneficiaries of this

mechanism. And they would have an indication from the market of the real cost ofcarbon, and therefore of which low-carbon investments are genuinely worthwhile, andwhich are merely vanity projects that are inappropriate to developing nations.

Given the difficulty of predicting precisely the number of credits required each year,

national governments will be likely to find themselves with a surplus or a shortfall ofcredits at year-ends. The first recourse will be for those with a surplus to trade with

those with a shortfall. But there are still likely to be imbalances at a global scale.

If there is an overall shortfall, those who cannot submit sufficient credits will be ob-

liged to accept additional liability certificates in proportion to double their shortfall.This would provide the incentive for people to make an honest attempt to estimate

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their emissions rather than leaving it to year-end to correct retrospectively an im-portant constraint if the initial market is to provide a reasonably accurate guide to per-

ceptions of risk and cost attributable to carbon emissions. This also places a cap on the

tradeable value of surplus credits if those possessing surplus credits try to charge theequivalent of more than double the cost of the associated liability, those with a short-

fall will choose instead to take the extra liability.

If there is an overall surplus, those with excess credits should be able to bank them for

use or trading in the following year.

4. Accounting for national and international carbon-absorption

One of the objectives of basing the mechanism around net rather than gross emissionsis to put a real value on carbon-sinks and thereby to provide proportionate incentives

for their protection (in the case of natural sinks) or development (in the case of man-made sinks). Many sinks (such as forests and those that rely on absorption of GHGs in

coastal waters) lie within national boundaries. It is desirable to attribute the capacities

of these sinks to the countries within which they are located, so that their national gov-ernments have an incentive to put an appropriate value on them in whatever mechan-

ism they use to internalize the carbon market. Thus the owners and occupiers of thesinks will, in turn, have an incentive to preserve and enhance them, to balance the in-

centives associated with other possible actions, for example to replace forest with an

activity (such as farming) that provides a return.

Some carbon-absorption, however, occurs in international waters. At present, it is es-

timated that the ocean (including national and international waters) absorbs around 2GtC (billion tonnes of carbon) annually. At this rate, the ocean is acidifying, and not

all that absorption can be attributed to international waters, but it might be reasonable

to allocate (say) 1.2 GtC as the volume of carbon that can be absorbed sustainably byinternational waters. This represents approximately 0.2 tC per person. For political

reasons, and in the absence of a more rational alternative, it is suggested that shares of

this international absorption-capacity be allocated to each nation in proportion to theirpopulation. If so, a country with a population of 60 million people would have scope

to emit 12 MtC (million tonnes of carbon) without its net emissions exceeding zero,even before taking into account any national carbon-sinks.

Allocation in this way means that the poorest nations will not need to take on anycredit/liability pairs, and indeed will be able to trade the difference between their al-

lowable emissions and their actual emissions with any net emitters. This effect will be

enhanced by the fact that many of the poorer countries enjoy a good share of the land-based carbon-sinks (typically forests), which will further increase the volume of un-

used emissions-credits that they can trade.

5. Temporal aggregation and depreciation

Let us now return to a complication that was postponed earlier. One cannot isolate theimpact of carbon-emissions in a particular year any damage that results from global

warming will be the result of emissions over many years. Liability therefore needs to

be allocated to holders of liability certificates related to emissions in all relevant pre-ceding years.

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Emissions do not remain in the atmosphere for ever. They are gradually reabsorbed. 3

One can say, in effect, that the contribution of a tonne of carbon in Year 2 is less than

it is in Year 1 after emission. The liability certificates should indicate the absorption

rate that was applicable in the year of emission for the gas in question. As each year'sliability certificates are added to those of the previous years, the total share of liability

is spread thinner, and the share attributable to the earlier certificates is reduced in ac-cordance with their absorption rate.

An example may make this easier to understand. Let us say that only three organiza-tions (A, B and C) are taking credit/liability pairs, and that we are only dealing with

carbon dioxide, which has (for the sake of argument) a linear absorption rate of 1 percent/year (i.e. a lifespan of 100 years). In Year 1, Organization A takes 1,000 MtC, B

takes 1,500 MtC and C takes 2,500 MtC. Their shares of the liability, if it were isol-

ated to that year would be 20, 30 and 50 per cent respectively. In Year 2, A takes1,000 MtC again, but B and C each take 2,000 MtC. Their shares from the liability

from that year would be 20, 40 and 40 per cent respectively, but we must also take

into account the remaining liability attributable to emissions in Year 1. These havebeen absorbed a little, so their contribution to the combined liability for both years is

now 4,950 MtC.

Liability will be shared in proportion to the total combined liability of 9,950 MtC(4,950 MtC for Year 1 and 5,000 MtC for Year 2). Organization A's liability at this

point is 990 MtC from Year 1 and 1,000 MtC from Year 2, or 20 per cent (exactly) of

the 9,950 MtC. B's liability is 1,485 MtC from Year 1 and 2,000 MtC from Year 2, orjust over 35 per cent. C's liability is 2,475 MtC from Year 1 and 2,000 MtC from Year

2, or just under 45%.

Year 1 A B C Total

Emissions (MtC) 1,000 1,500 2,500 5,000

Share (per cent) 20 30 50 100

Year 2

Emissions (MtC) 1,000 2,000 2,000 5,000

Y1 emissions depreciated 990 1,485 2,475 4,950

Remaining emissions (Y1 + Y2) 1,990 3,485 4,475 9,950

Share (per cent) 20 35.03 44.97 100

The organizations can adjust their share of the liability by reducing or increasing theshares that they take in each year, and if they stop taking credit/liability pairs, their li-

ability will degrade to nothing over time. But they will retain some share of the liabil-ity for as long as the emissions for which they were responsible are retained in the at-

mosphere.

An under-appreciated but important component of AGW theory is that different

greenhouse gases have different average lifespans of retention in the atmosphere.When we quote a Global Warming Potential (relative to carbon dioxide) of 23 for

3 Or, more precisely, a certain volume of each greenhouse gas can be absorbed each year, so this rate

of absorption is spread over all emissions to give a notional absorption rate. This rate may changewith changes to the ability of the Earth to absorb a particular gas.

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methane, that is an arbitrary figure taken over a 100-year time horizon. In fact, meth-ane's instantaneous contribution to radiative forcing is approximately 100 times

greater than that of carbon dioxide, but because it is reabsorbed much more quickly,

some adjustment has to be made to allow for this factor. This adjustment distortspolicy. If one considers that methane emissions today have a much stronger impact on

warming in the near future than is usually imagined, the obvious reaction, particularlyif one were worried about tipping points, would be to target methane emissions more

strongly than we have done until now on the basis of the false generalization that its

impact is only 23 times that of carbon dioxide. If, on the other hand, one felt that dis-aster was relatively distant, one would place a relatively low cost on methane emis-

sions, because their impact would have dissipated before their effect was felt.

The proposed mechanism can take account of this reality, and therefore direct efforts

in the most beneficial directions, in a way that other mechanisms cannot. The credit/li-ability pairs will be for specific gases. The credit will entitle the emission of a specific

volume of a specific gas. The liability will attribute responsibility in proportion to the

carbon-equivalence of the credited volume of the specified gas, but will have an asso-ciated absorption rate (similar to a rate of depreciation) that is applicable to the gas in

question. In the case of methane, if it were linear (for the sake of simplicity), it wouldbe around 8 per cent of the original carbon-equivalence each year, as methane's aver-

age lifespan in the atmosphere is only around 12 years. In the case of nitrous oxide,whose average lifespan is around 120 years, the absorption rate would be less than 1

per cent of the original carbon-equivalence each year. Those who would rather take a

large share of short-term risk but limit their exposure to long-term risk will prefer totake certificate-pairs for methane than those for carbon dioxide or nitrous oxide.

Those who would rather spread their risk thinner over a longer period of time willprefer to take pairs for carbon-dioxide or nitrous-oxide than for methane. These pref-

erences will be affected by developments in the understanding of the severity and im-minence of the threat. The mechanism would provide the right incentives for people torespond in rational ways to the latest science.

This effect can also be used to reduce one of the significant tensions in international

negotiations. The developing nations point out that the vast majority of anthropogenic

greenhouse gases currently resident in the atmosphere are attributable to the de-veloped nations, and that they therefore ought to take the lion's share of responsibility

at this stage. The developed nations point out that, if growth continues on its currentpattern, the emissions from the developing nations look likely to dwarf their own

emissions, and that placing all the onus on the developed nations will not only place

an unbearable economic strain on their economies, but will be wholly ineffective ifsome constraint is not also placed on emissions from the developing nations. Both

sides are right, but the necessity under current mechanisms to agree a hard cap andhard shares of allocations within that cap, makes it difficult to find an acceptable com-

promise.

Under the proposed system, all governments would be expected to take responsibility

for their historical net emissions of the various greenhouse gases going back howeverfar is relevant for the gas in question (e.g. 12 years for methane, 120 for nitrous

oxide). A cut-off at (say) 1900 might be agreed as a date before which (a) estimates

may not be reliable, and (b) the current impact is likely to be de minimis. Given the

depreciation in impact caused by the absorption-rates, the most recent emissions will

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be proportionately more significant than earlier emissions. If major impacts are felt inthe near future, the developed world will have to pick up most of the bill for the costs

of those impacts. But for impacts further into the future, which are likely to be the li-

on's share of impacts, liability will be spread increasingly closely in proportion to cur-rent emissions. This should satisfy the developing nations' demands that developed

nations take responsibility for their historical emissions, without saddling developednations with a disproportionate share of the burden going forward, and providing

strong incentives for both developed and developing nations to develop their econom-

ies as efficiently and cleanly as possible.

6. Estimating liabilities

And so to the most difficult and contentious part of the proposal: the liability. It is all

very well to say that liability should be shared in proportion to emissions, but liabilityfor what? Which impacts ought to be covered, and how should the cost of the liability

be calculated? Ignoring for the moment the possibility that rising temperatures may

not be caused primarily by human activity (we return to this issue below), some im-pacts, such as flooding due to rising sea-levels, are obviously a consequence of global

warming and therefore their costs should fall on those holding the liability. But othersare less certain: inland flooding or drought may be caused by bad development, irre-

sponsible agricultural practices or even simple economic collapse, as well as by atmo-spheric conditions. Even where atmospheric conditions contribute, the effects can of-

ten be mitigated by sensible provision (e.g. flood defences, stores of food and water).

People and governments should not be absolved from responsibility to make what pro-visions they can, nor should they be insulated from the costs of failing to do so.

Then there is the common case where people have ignored risks and exacerbated the

consequences of disaster. If (for sake of example) more frequent and severe hurricaneswere a consequence of global warming, should those carrying the liability have toshoulder the full cost of damage to the ever-more-expensive properties that sprout up

irrationally along the USA's South-East seaboard? Clearly not. If you are foolishenough to build or purchase a property in a known hurricane-zone, you should

shoulder the cost of insuring the predictable damage.

Let us start by returning to that particularly awkward consideration that rising tem-

peratures may yet turn out to be caused more by natural causes (e.g. solar activity)than by human activities. Mechanisms that cap emissions and value only carbon-re-

ductions would have been spectacularly pointless and wasteful in those circumstances.

And yet, action might still be required, because the consequences of rising temperat-ures might still need to be considered.

If warming were caused by solar activity rather than by anthropogenic carbon-emis-sions, it would not reduce the risk that large parts of Bangladesh might be flooded.4

Simple humanity would require that we still, in those circumstances, place a value ondefending against the consequences of the warming. If severe flooding of a country

like Bangladesh were to occur due to rising sea-levels, the international community

would be called on to assist. The obligation to assist might reasonably be apportionedrelative to economic capacity. The historic level of carbon-emissions would be a reas-

4 It has a better chance, as solar activity is likely to be cyclical, but we have seen big as well as small

swings in climate before, sufficient to have substantial impacts on sea-levels, so a change ofparadigm with regard to global warming would not rule out the possibility of significant flood-risk.

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onable guide to each country's economic capacity and therefore its moral obligationregardless of causation of the damage.

It may be no bad thing to develop a mechanism that determines in advance where thecost of such damage would fall, and apportions it roughly in proportion to economic

capability, even if there is dispute about the cause and therefore responsibility for thatdamage. It is justifiable, on this basis, to include within the liability covered by this

mechanism the responsibility for those extraordinary impacts predicted by AGW the-

ory, regardless of whether the connection is perfectly proven. The underwriting of theliability under this mechanism becomes an underwriting of the cost of certain major

disasters regardless of cause.

So which impacts might we include on that basis? Some are not controversial, in the

sense that they are definitely a consequence of warming, whatever the causes of thatwarming, e.g.

Flooding due to rising sea-levels.

Consequences of changes to precipitation outside the normal range of variation

(e.g. dryer summers, wetter winters in temperate latitudes).

Falling river-flows due to the disappearance of glaciers (and associated con-

sequences, e.g. crop-failure and drying of vegetation leading to fires).

Erosion and other damage due to loss of permafrost (e.g. large chunks of some

mountains are collapsing as ice melts, which may cause damage in some situ-ations).

Habitat destruction and loss of livelihood in those places and for those activitiesdependent on winter snow.

Other potential impacts are more controversial, for example the potential reduction inthe flow of the North-Atlantic conveyor, and the consequent changes to climates onboth sides of the North Atlantic, or the incidence and severity of hurricanes. A com-

mission should be established to assess which risks are credible (not their likelihood

and probable scale), and for each risk, to establish a historical baseline and range ofnormal variance. Being based on possibility not probability, and historical not projec-

ted data, this should allow very much less scope for the imposition of subjectivejudgements than within the IPCC/Kyoto mechanisms.

For each of these impacts, the commission would establish a historical baseline, howthat baseline has moved over time, and a range of normal variance around that travel-

ling baseline. For example, if increased incidence or severity of hurricanes were acredible risk, the commission would establish the average incidence of hurricanes

(how many and of what grade) in (say) 1900 in each area that is exposed to hurricane-

risk, the annual variance of this incidence and severity, and how that average and vari-ance had changed over time since 1900. Liability under this scheme would not apply

to damage to properties from hurricanes that were within the historic range of variancefor the period when the property was built. Such damage would be the domain of

private household insurance. But where repeated damage occurs due to a hurricane

season that has more hurricanes of a particular grade than would fall within the normalrange of variance for the construction-date, the liability for the costs of damage from

any hurricanes that exceed the norm will fall on those holding the liability certificates,in proportion to their share of the liability in the year in which the damage occurs.

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To allow for establishment of a meaningful range of variance, this baseline and vari-ance will have to be calculated over reasonable intervals. Given the climate cycles that

are known to occur due to solar activity, intervals of less than 15 years are probably

not practical, while intervals of 50 years or more might smooth-out the twentieth-cen-tury climate changes to too great a degree to give a meaningful figure. 20-year periods

might be a reasonable compromise. If so, the initial baseline and variance would beestablished on the basis of historical patterns between 1900 and 1920, and updated fig-

ures would be calculated for the periods 1920-40, 1940-60 and so on. Liability for

damage attributable to events outside the 1900-20 range of variance would be incurredon those properties built before 1920. If the upper-bound of the range of variance had

increased during the 1920-40 period, those properties built after 1920 would not becovered for damage from some events for which properties built before then were

covered. This would leave everyone covered for damage due to events that were not

predictable at the time the property was built, but responsible for their own cover forany events that were predictable at the time the property was built.

With baselines and variances established, an international agency (perhaps the same asthe issuing agency) could be made responsible for receiving, verifying, and arranging

for the assessment of claims for damage from events outside the relevant variances.Verification would consist of confirming that the events were outside the normal

bounds, as claimed. Assessment would consist of costing the damage that is covered,once liability had been established. The latter could be subcontracted to assessors on

the usual basis. Once assessments had been received, the agency would be responsible

for notifying all holders of liability-certificates of the share of the underwriting-costthat was required from them, and for disbursing those funds.

To avoid thousands of small claims being handled directly by the central agency, the

agency should only accept claims from licensed intermediary organizations, whowould compile claims from an event and submit the aggregated claim to the agency.The intermediaries would pay a substantial agreed sum to the agency for the license to

be able to act in this capacity, to provide a significant source of funding for theagency's operations, and to ensure that only substantial organizations can act in this

way.

In many cases, the intermediaries might be government agencies, but there should be

scope for commercial bodies also to act in this capacity. The intermediaries may befunded from taxation (e.g. if state-run bodies) or from fees charged to those placing

claims. The presence of commercial as well as state-run intermediaries will be import-

ant to minimize abuse of the system by third-world governments, some of whom maybe tempted to submit claims on behalf of their people to the agency, but fail to fully

disburse the sums received. It should be a condition of participation in the scheme thatgovernments permit their people freely to choose through whom to submit their

claims. The license of any state-run intermediary should be revoked if clear evidence

is presented that the government in question is not allowing a free choice in this way.The license of any intermediary should be revoked if clear evidence is presented that

they have failed to disburse the money properly.

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7. Minimizing the risk of default

Of course, failures can be accidental as well as deliberate. The greatest risk of acci-

dental destabilisation of the mechanism is the threat that some organizations may take

on liability and then be unable or unwilling to cover the costs. As an initial precaution,

there ought to be a liquidity requirement for participants in the market only thosewho can show that they have sufficient financial standing should be able to take on li-abilities, in proportion to their standing (this should apply to governments as well as

businesses).

Nevertheless, circumstances can change between the time that liabilities are accepted

and the time when the costs are incurred. The sanction that should be applied in order

to minimize default is that failure to pay out the amount assessed by the agency shouldresult in the exclusion of that organization (government or business) from further par-

ticipation until the amounts owing have been paid. For the poor governments who aremost likely to default, this is potentially very serious. Such governments are likely to

be responsible for nations who are most exposed to the risks, and are also likely tohave low emissions. They would be beneficiaries from trading credits as well as fromthe underwriting of the risk of harm. To be excluded from the trading and insurance

benefits would probably be more expensive than the money saved by defaulting.

Commercial organizations would have the same reasons not to default as they do in

current insurance markets their business is in providing cover, so to default is effect-ively to go out of business. If this were not felt to be sufficient security, one can con-

ceive of a system where the credit/liability pairs have unique IDs, through which theliability associated with a credit can be traced to the government that surrendered the

credit. That government could be made the insurer of last resort if the holder of the li-

ability certificate defaults.

The most serious threat would be default by a rich government, which had taken on asignificant share of the liability. Ultimately, one cannot guarantee, without recourse to

force, that any independent government will honour treaty obligations. But if this

mechanism allows developed- and developing-economy governments the greatestfreedom to marry their own interests with the collective interests of global economic

growth, environmental stability and social responsibility, those governments wouldhave an interest in maintaining the credibility of the mechanism. The alternative

would be a return to the policy nationalism that is increasingly popular nowadays.

That nationalism tends towards economic isolationism, and towards economic, envir-

onmental and social degradation through the diminution of the social cooperation thatis key to all improvements in human welfare.

There are no guarantees. But the combination of self-interest in maintaining the integ-

rity of the mechanism, and the diffuse nature of the cover (so the default of one under-writer should have only a marginal impact on the cost to others) should minimize the

risk of default. And to the extent that the risk of default remains, those taking on theliabilities will have to price in their assessment of the risk that their share of the over-

all liabilities may be greater than expected. This will make the availability of credits

marginally tighter than it would be if there were no risk of default. That is an appro-priate risk for the market to take into account.

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8. What next?

This is only a rough outline of an idea. There are doubtless many problems and omis-

sions. For example:

i. Will national governments accept responsibility for their net emissions, when in

certain cases, their emissions may be the product of feedback mechanisms exacer-bated by general warming? For instance, release of methane from thawing of the

Russian tundra, or drying of the Amazon rainforest converting it from a carbon-

sink to a carbon-source.

ii. What do we do about international emissions, such as release of methyl hydrates

from the ocean floor?

iii. Perhaps the most significant incomplete aspect is the question of how we encour-

age investment in adaptation measures. There is a collective-action problem asthings stand with this proposal. There is a general incentive to minimize exposure

to risk, but any liability-holder investing, for instance, in a sea-wall incurs the fullcost but shares the benefit with all other liability-holders.

But at least this proposal confronts these issues and provides a framework withinwhich they can be considered. Existing mechanisms do not and cannot take account of

these and many other of the aspects that this proposal has already taken into account.

It is, unlike existing carbon markets, a reasonable representation of economic reality.To take a couple of reductio ad absurdam demonstrations, if it turned out that human

activity had very little impact on climate, this mechanism could bed down as a way ofinsuring against certain extreme weather events, whereas existing mechanisms would

have been not just pointless but wasteful and counterproductive. If, on the other hand,

the most extreme predictions look likely to happen, the apparent risk will make gov-ernments and institutions so reluctant to take on liability that it will put a stronger

break on emissions than a marginally-reducing cap.

Much more work is required on this proposal. Details need exploring. Gaps needfilling in. Problems like those above need resolving. But the first step might be to de-

velop a model that allows the basic system to be tested and scenarios to be run. How

will people, placed in the roles of national governments or financial institutions parti-cipating in this market, respond to internal (market) and external (scientific and envir-

onmental) information? And how will the market respond to them? It needs a modelthat allows scenarios and behaviours to be tested in the manner of, in effect, a multi-

player game.

But in the meantime, it is to be hoped that this paper has demonstrated, if nothing else,that it is possible to conceive of superior alternatives to the cap-and-trade approach.

We should not proceed, in our discussions on future global-warming mechanisms bey-

ond 2012 (the date of the expiry of the Kyoto Treaty and the end of Phase 2 of theEU-ETS), on the assumption that the best or only practical option is to continue with

the existing, broken approach. We can and should do better if we put our minds to it.

14


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NOTE TO EDITORS:

Word count: Summary: 324 Pros and cons: 342 Text: 6528

The original draft of this paper included two NASA images that helped to illustrate

some of the basic concepts regarding carbon flows, but for which reproduction rightshave not been obtained. It also included, for reference, at Annex A a table, based on

UN figures, of annual carbon emissions per capita from each country. And it waspaired with another paper that explained why cap-and-trade is as flawed an approach

as is assumed (but not explained) in this paper, which could be included as an Annex

B. That paper preceded this one (indeed, was the spur to it), and is therefore a little outof date now, though the arguments have not changed. It is also more polemical, as it

was prepared to challenge the electricity industry's unthinking allegiance to cap-and-trade.

I have included them below for use at your discretion. It may be assumed that yourreadership is sufficiently familiar with the data and arguments that they do not need

including. The papers were originally prepared for internal distribution amongst our

industry to a less educated audience. On the other hand, it could be argued that oneshould never take a reader's background knowledge for granted, and that inclusion of

this material at least saves the reader the bother of having to do their own research.The inclusion of Annex B would take the word count to over 11,000 words.

15


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Images originally included in Section 4:

16

Figure 1: The Carbon Cycle, from NASA's Earth Observatory Library:

http://earthobservatory.nasa.gov/Library/CarbonCycle/


17/28

17

Figure 2: 2002 Net Primary Productivity, the annual rate of carbon absorption, from NASA's Earth

Observatory Library (http://earthobservatory.nasa.gov/Newsroom/NPP/npp.html)


18/28

Annex A: Annual carbon emissions per capita (2003)

Source: United Nations Millennium Development Goals Indicators(http://mdgs.un.org/unsd/mdg/Data.aspx)

18

Country Country Country Country Country

33.08 2.37 1.12 0.38 0.1

17.21 2.37 1.12 0.38 0.1

United Arab Emir. 9.16 2.35 1.09 0.35 0.1

8.48 2.26 1.06 0.35 0.09

8.45 2.24 1.06 0.35 0.09

6.82 2.15 1.01 0.33 0.08

6.19 2.13 1.01 0.32 0.07

6.08 2.13 0.98 0.32 0.07

6.03 2.13 0.95 0.31 0.07

6 2.1 0.95 0.31 0.075.4 2.07 0.93 0.28 0.06

4.91 1.99 0.93 0.27 0.06

4.88 1.94 0.9 0.27 0.06

4.36 1.91 0.87 0.26 0.05

4.12 1.88 0.87 0.26 0.05

3.87 1.8 0.85 0.26 0.05

3.71 1.75 0.85 0.25 0.05

3.55 1.75 0.82 0.25 0.05

3.55 1.69 St Kitts & Nevis 0.82 0.25 0.05

3.55 1.69 0.79 0.25 0.05

3.52 1.64 0.76 0.24 0.04

3.46 1.61 0.74 0.24 0.04

3.35 1.55 0.74 0.24 0.04

3.11 1.53 0.71 0.24 0.04

3.08 1.53 0.68 0.2 0.03

3.08 1.53 0.68 0.22 0.03

2.95 1.53 0.63 0.2 0.03

2.92 1.53 0.63 0.2 0.03

2.89 1.53 0.6 0.2 0.02

2.81 1.5 0.6 0.2 0.02

2.81 1.47 0.57 0.19 0.02

2.75 1.45 0.57 0.17 0.02

2.73 Rep. Macedonia 1.42 0.55 0.16 0.02

2.7 1.39 0.55 0.15 0.02

2.67 1.39 0.52 0.14 0.02

2.65 1.36 0.49 0.13 0.01

2.62 1.34 0.49 0.12 0.01

2.56 1.31 0.46 0.12 0.01

tC per

capita

tC per

capita

tC per

capita

tC per

capita

tC per

capita

United States

Virgin Islands Netherlands Macau MaldivesRepublic of

the Congo

Qatar Greece Jamaica Indonesia Ghana

Austria Mexico Fiji

Equatorial

Guinea

Kuwait Belgium Guadeloupe Uruguay Cte d'Ivoire

Bahrain New Caledonia Thailand Colombia Kiribati

Guam Poland Lithuania Morocco Cape Verde

Netherlnds

Antilles Bermuda Chile India Kenya

Aruba Slovenia

British Virgin

Islands Namibia Sudan

Trinidad &

Tobago South Africa North Korea Armenia Benin

Luxembourg Italy Azerbaijan Tonga BangladeshUnited States Iceland Martinique Kyrgyzstan Cameroon

Australia Spain Argentina El Salvador Laos

CanadaCayman

Islands Runion Albania Haiti

Montserrat Slovakia Jordan Peru Timor-Leste

Falkland Islands Seychelles China Philippines Gambia

Faroe Islands Ukraine Mongolia Honduras Zambia

Estonia Belarus Turkey Vietnam Myanmar

Saudi Arabia Malaysia Belize Swaziland Bhutan

Gibraltar France Gabon Guinea-Bissau

Finland Malta Latvia Bolivia Eritrea

Oman Bahamas FrenchPolynesia Zimbabwe Guinea

Brunei Sweden Iraq Guatemala Liberia

Palau Hungary Syria Yemen Madagascar

Czech Republic Portugal Mauritius Mauritania Sierra Leone

Singapore French Guiana

om n can

Republic Samoa Comoros

St Pierre &

Miquelon Switzerland Saint Helena Georgia Nepal

Nauru Iran Cuba Pakistan Tanzania

Kazakhstan Venezuela Botswana Western Sahara Ethiopia

Israel Bulgaria Guyana Nicaragua Niger

Ireland Hong Kong Grenada Tajikistan Burkina Faso

Russia Lebanon Tunisia Paraguay Mozambique

Denmark Croatia Saint Lucia

So Tom &

Prncipe Malawi

Greenland Egypt Angola Rwanda

Norway Algeria Niue Puerto Rico

Central

African

Republic

Germany Suriname Panama Sri Lanka Uganda

Japan

Antigua and

Barbuda Ecuador Djibouti Mali

Republic of

Korea

Bosnia and

Herzegovina DominicaPapua New

Guinea Cambodia

United Kingdom Uzbekistan Moldova Vanuatu Burundi


19/28

Annex B: Why cap-and-trade is the wrong approach

There is strong support in certain circles for relying on the European Union Emissions

Trading Scheme (EU-ETS) to internalise the social cost of carbon. It is often acknow-ledged that the scheme has not so far worked, but argued that it can be broadened and

strengthened to make it work. There are many reasons to think that this is a mistake.

1. The reasons why Phase 1 failed have not gone away

The UK Manifesto on EU-ETS (DEFRA, 2007) argued that what was mainly needed

to make the mechanism work was increased clarity and transparency. It was clarity

that caused the market to collapse. For as long as it was not clear that every countrybar the UK had not been honest in their Phase 1 allocations, the market was able to ex-

ist in a fool's paradise that yielded prices of 15-30/tonne (forward prices for Phase 2currently exist in a similar fool's paradise). As soon as the mendacity of most

European governments became clear, the market collapsed to less than 1/tonne.5

Honesty and selflessness are needed more than clarity. Yet the National AllocationPlans (NAPs) for Phase 2 submitted in November 2006 demonstrated that Europeanpartners intend to continue to game the process. The Association of Electricity Pro-

ducer's (AEP's) European representative reported shortly after the NAPs had been sub-

mitted that a senior DG Tren official noted that only the UK appeared to have takenthe process seriously and there were considerable problems of over-allocation. If the

NAPs were approved as submitted, the cap for 2008-12 would be 10% higher than thelevel of emissions in 2005.

The Commission has responded by reducing the allowed emissions of most countries,but the reductions that will be achieved, even if all countries accept the revised allow-

ances and go on to achieve their targets, are pitiful a saving of 43 million from overtwo billion tonnes (see table below). In other words, the EU-ETS (which covers al-

most half of all greenhouse-gas emissions in the region) will, by 2012, be responsible

for at best a reduction of 2% relative to 2005 levels if all countries comply fully. Thatis a lot of bureaucracy and interference in the market for very little carbon benefit. In

practice, given the history of Phase 1 and the cynical attitude demonstrated by the sub-mitted NAPs, compromise, gaming and non-compliance is likely to result in emissions

exceeding those of 2005.

No wonder Europe's emissions are not on track to meet its modest Kyoto obligations;

and, in fact, are being reduced less effectively than in the USA, which was widely cas-

tigated for rejecting the cap-and-trade approach, though their reasons have been borneout by experience.6 The EU-ETS is failing to deliver sufficient savings from the sec-

5 Presenting evidence to the House of Commons Environmental Audit Committee in November 2006,

representatives of the Environment Agency observed that, to that point, they were not aware of any

documented cases where a particular business has reduced its emissions because it has been in the

scheme, that where businesses had made preparatory investments to save carbon, that has actu-ally almost stopped because there is little incentive to burn fuels other than coal, and, in fact, that

it is not clear whether we are really seeing any environmental benefits just yet. They concludedthat Phase 1 had to be written-off as experimental, and that it was possible that the same would hap-

pen to Phase 2.http://www.publications.parliament.uk/pa/cm200607/cmselect/cmenvaud/70/6112103.htm

6 Lawrence Summers, We need to bring climate idealism down to earth, Financial Times (FT),April 30 2007, http://blogs.ft.com/wolfforum/2007/04/we_need_to_brin.html

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tors and countries covered by it to make their contribution to a target which, ifachieved, might reduce temperatures in 2050 by 0.06C.

2. A rational basis for allocating emissions-rights?

France obtains a little under one-third of its energy from nuclear power, but is this anyreason why France should be entitled to emit less than forty percent of Germany'sper-

capita entitlement? If there is a carbon-benefit to nuclear power, should France not be

entitled to that benefit? Germany produces more goods for export than most Europeancountries. To what extent should Germany's entitlement be increased to take account

of this?

Latvia is one of the greenest countries in Europe. It produces more of its energy from

renewable sources than most other nations, resulting in the lowest carbon emissionsper capita in the EU. However, most of this is in the form of biomass for heating and

therefore falls outside the sectors covered by the EU-ETS. Should Latvia be punishedfor achieving its carbon-savings in this way, by being allocated just over half the per-

capita entitlement of Lithuania, and less than one-sixth of the per-capita entitlement

of Estonia? On the other hand, Estonia has been more successful than its neighboursin growing its economy. To what extent should it therefore be allowed to emit more

than those neighbours?

The following table shows how the EU-ETS allocations (in million tonnes of CO 2equivalent) from the Phase 2 NAPs, as applied for and approved (i.e. heavily modi-fied) by the Commission, compare with actual performance.

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There is (presumably) method to these allocations, but not logic. This is a central-

planner's fantasy, and a libertarian's nightmare.

3. The EU-ETS fails to deliver long-term price signals

It is future certainty that the UK Manifesto on EU-ETS has in mind when calling for

greater clarity. It is optimistic to imagine that a reliable, efficient and long-term mar-

ket will result from a system that relies on 27 democracies to set themselves targets,and to self-administer honestly and carefully a scheme that requires them to inflict

pain on their own economies while trusting that their neighbours will be equally rigor-ous. Is there anything in the history of the EU to suggest that such selflessness will be

ubiquitous and sustained? Even if present governments commit to future reductions

beyond the usual 5-10-year timescale, how will they bind their successors underdemocratic systems? If a means could be found to bind them, how will future recidiv-

ist governments be prevented from fudging a system that depends on all participantsacting in good faith?

There are, in any case, practical obstacles to fixing a scheme beyond 2012. The EU-ETS is an offshoot of the Kyoto process, and integrates with other Kyoto mechanisms,

such as the Clean Development Mechanism (CDM) and Joint Implementation (JI).

The Kyoto Treaty covers the period to 2012. Beyond that, it is not clear what globalmechanisms will be available for the EU-ETS to link to. As Certified Emission Reduc-

21

Population

Per capita

Austria 33 33.4 32.8 30.7 8,361,000 3.95 3.99 3.92 3.67 66.78% 38.54% 253.35%

Belgium 62.1 55.58 63.3 58.5 10,392,226 5.98 5.35 6.09 5.63 102.37% 59.08% 388.42%

Bulgaria 40.6 67.6 42.3 7,323,000 5.54 9.23 5.78 105.05% 60.62% 398.57%Cyprus 5.7 5.1 7.12 5.48 855,000 6.67 5.96 8.33 6.41 116.56% 67.27% 442.25%

Czech Rep. 97.6 82.5 101.9 86.8 10,228,744 9.54 8.07 9.96 8.49 154.32% 89.06% 585.53%

Denmark 33.5 26.5 24.5 24.5 5,550,000 6.04 4.77 4.41 4.41 80.28% 46.33% 304.59%

Estonia 19 12.62 24.38 12.72 1,335,000 14.23 9.45 18.26 9.53 173.28% 100.00% 657.44%

Finland 45.5 33.1 39.6 37.6 5,310,000 8.57 6.23 7.46 7.08 128.78% 74.32% 488.59%

France 156.5 131.3 132.8 132.8 63,713,926 2.46 2.06 2.08 2.08 37.91% 21.88% 143.82%

Hungary 31.3 26 30.7 26.9 9,956,108 3.14 2.61 3.08 2.70 49.14% 28.36% 186.43%

Germany 499 474 482 453.1 82,400,996 6.06 5.75 5.85 5.50 100.00% 57.71% 379.41%

Greece 74.4 71.3 75.5 69.1 10,706,290 6.95 6.66 7.05 6.45 117.38% 67.74% 445.34%

Ireland 22.3 22.4 22.6 21.15 4,234,925 5.27 5.29 5.34 4.99 90.82% 52.42% 344.60%

Italy 223.1 225.5 209 195.8 58,147,733 3.84 3.88 3.59 3.37 61.24% 35.34% 232.34%

Latvia 4.6 2.9 7.7 3.3 2,277,000 2.02 1.27 3.38 1.45 26.36% 15.21% 100.00%

Lithuania 12.3 6.6 16.6 8.8 3,390,000 3.63 1.95 4.90 2.60 47.21% 27.24% 179.12%

Luxembourg 3.4 2.6 3.95 2.7 467,000 7.28 5.57 8.46 5.78 105.14% 60.68% 398.93%

Malta 2.9 1.98 2.96 2.1 407,000 7.13 4.86 7.27 5.16 93.83% 54.15% 356.02%

Netherlands 95.3 80.35 90.4 85.8 16,570,613 5.75 4.85 5.46 5.18 94.16% 54.34% 357.27%

Poland 239.1 203.1 284.6 208.5 38,518,241 6.21 5.27 7.39 5.41 98.44% 56.81% 373.50%

Portugal 38.9 36.4 35.9 34.8 10,643,000 3.65 3.42 3.37 3.27 59.46% 34.32% 225.61%

Romania 70.8 95.7 75.9 22,276,000 3.18 4.30 3.41 61.96% 35.76% 235.10%

Slovakia 30.5 25.2 41.3 30.9 5,390,000 5.66 4.68 7.66 5.73 104.26% 60.17% 395.57%

Slovenia 8.8 8.7 8.3 8.3 2,020,000 4.36 4.31 4.11 4.11 74.72% 43.12% 283.51%

Spain 174.4 182.9 152.7 152.3 40,448,191 4.31 4.52 3.78 3.77 68.48% 39.52% 259.81%

Sweden 22.9 19.3 25.2 22.8 9,150,000 2.50 2.11 2.75 2.49 45.32% 26.15% 171.93%

UK 245.3 242.4 246.2 246.2 60,776,238 4.04 3.99 4.05 4.05 73.67% 42.52% 279.51%

Total 2,181 2,123 2,325 2,080 490,848,231 4.44 4.33 4.74 4.24 77.06% 44.47% 292.37%

Member State

1stperiod

cap

2005verified

emissions

Proposed Phase2 cap

AllowedPhase 2

cap

1stperiod

cap

2005emissions

per capita

ProposedPhase 2(P2) cap

ApprovedP2 cap

P2 caprelative toGermany

P2 caprelative toEstonia

P2 caprelative

to Latvia


22/28

tion (CER) Certificates from CDM/JI represent a safety-valve for the EU-ETS (a wayof balancing the carbon books at low cost), the uncertainty about their prospects bey-

ond 2012 will make forecasting the EU-ETS market after that date very difficult, even

if market-players are confident about the long-term reliability of the internal Europeanmechanism.

Markets will emerge where rational values can be derived. The absence of long-term

prices is a sign that future uncertainty is sufficient to make prediction foolhardy. It is

typical hubris of politicians to imagine that they can reduce this uncertainty by declar-ing their intentions for a time when they will almost certainly not be in power, and for

a market over which they have only partial control. It is likely that not even increasedfederalism would be sufficient to deliver greater certainty, and only a Napoleonic

solution would suffice.

4. Penalising Europe and offshoring our carbon

Even if the EU-ETS could be made to work efficiently, fairly and on a long-term

basis, it would disadvantage European nations for as long as other nations did not im-

pose similar costs of carbon on themselves. Some argue for a 'Son of Kyoto' to resolvethis problem, by extending emissions targets to rapidly-developing countries, and

bringing America back into the process. Others suggest that the weakness can be re-duced by negotiating the interoperability of EU-ETS with other emissions trading

schemes springing up around the world in New Zealand, Australia, Japan, Canada and

various US states, aiming perhaps for a single global cap-and-trade carbon market.This is not just optimistic, but positively panglossian.

a) Even as the White House finally agreed (31 May 2007) to commit to action on cli-

mate change, it ruled out carbon trading as the way to cut emissions.7

b) The Lieberman-McCain Climate Stewardship Bill of 2003, which would have im-plemented a cap-and-trade mechanism, was voted down by the Senate. It has been

amended and reintroduced in 2007, but the constraints have been loosened, to theextent that McCain acknowledges that significant reductions in greenhouse

gases - well beyond those required by this bill - are feasible over the next 15-20

years using technologies available today.8 The EU-ETS demonstrated the fail-ings of cap-and-trade schemes with easily-achievable caps. Any attempt to integ-

rate the EU-ETS with American cap-and-trade schemes with loose caps will resultin Europe paying America for notional savings, while America's carbon emissions

remain well above Europe's. Similar effects could be expected for Australian and

Canadian trading schemes.

c) India has recently reiterated its refusal to consider a cap on its greenhouse-gas

emissions,9let alone agreeing to enter a trading mechanism, other than taking in-

cidental gains from the largely spurious Clean Development Mechanism (CDM)of the Kyoto Treaty (see below).

7 Financial Times (FT), June 1, frontpage: Bush in U-turn on global warming,

http://www.ft.com/cms/s/32856c56-0f84-11dc-a66f-000b5df10621.html

8 http://mccain.senate.gov/press_office/view_article.cfm?id=803

9 Daily Telegraph (DT), May 30, India to shun G8 demands on gas emissions, http://www.tele-graph.co.uk/earth/main.jhtml?xml=/earth/2007/05/30/eagas30.xml

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d) China and several other major developing nations are said to share India's view.10

e) Russia and much of the old Soviet Bloc are still mainly interested in selling hotair the source of many Joint Implementation (JI) carbon credits. Hot air is the

notion that, because emissions in Soviet Bloc countries collapsed along with theireconomies, they should be entitled to count the reduction as a contribution towards

tackling climate change. The per-capita CO2 emissions of Russia are higher than

those of every country in the EU listed above, except Estonia, the Czech Republic,

Luxembourg, Finland and (just) Ireland, i.e. than 95% of Europe (by GDP or pop-ulation). If measured relative to GDP, Russia and its satellites are the dirtiest ma-

jor nations on earth (closely followed by China and India). Thanks to strongly-

subsidised energy-pricing, many of the developing nations remain some of themost energy-profligate. Subsidising their continued inefficiency, by paying them

for improvements that were in any case inevitable once economic reality bit andthey stopped producing for production's sake and started producing in order to

meet market demand, is our money for their old rope.

f) A significant proportion of carbon credits from projects developed under the CDMare bogus. The FTidentified in February 2007 that billions of dollars are being

wasted in the international carbon trading system as a result of a loophole in the

Kyoto protocol....by exploiting the regulations in the protocol surrounding a potentgreenhouse gas, HFC-23.11The Guardian reports a litany of problems, including

that a senior figure estimates there may be faults with up to 20% of the [CDM]carbon credits, that another one of the CDM's experts calculates that as many as

one third of the projects registered in India....do not produce any additional cut in

greenhouse gases and were wrongly approved, that Ernst & Young were compli-cit in some of the fraudulent auditing reports, and that 53% of existing CERs come

from six projects to reduce HFCs from refrigerant-manufacture.12 Not surprisingly,

given the low cost of these spurious savings, in a recent survey of companies in-volved in the EU-ETS, most were planning to buy these bogus credits rather than

reduce their own emissions.13

There is no merit in cooperating for cooperation's sake. If the cooperation is with

countries whose mechanisms are less rigorous than the EU-ETS, inter-mechanismtrading will simply result in transfer of funds and activities from Europe to countries

that take a more relaxed view of their environmental obligations, without a propor-

tionate environmental benefit. We will be suckers in a rigged global market for hot air.

10 DT, June 1, Leave global warming to market forces,http://www.telegraph.co.uk/opinion/main.jhtml?xml=/opinion/2007/06/01/dl0101.xml

11 FT, Feb 8, Billions lost in Kyoto carbon trade loophole, http://search.ft.com/iab?id=070208000416

12 The Guardian, June 2, Abuse and incompetence in fight against global warming (http://environ-ment.guardian.co.uk/climatechange/story/0,,2093835,00.html) and Truth about Kyoto: huge

profits, little carbon saved(http://environment.guardian.co.uk/climatechange/story/0,,2093815,00.html)

13 The Economist, May 31, Trading thin air, http://www.economist.com/surveys/displaystory.cfm?story_id=9217960

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5. Market distortion and perverse incentives

The allocation of emissions rights to existing players rewards dirty incumbents anddisadvantages their cleaner or newer competitors. For instance, the Irish cement-pro-

ducer Ecocem pioneered the use of blast-furnace slag in its production process. Their

emissions were reduced to one-sixteenth that of their competitors too low to qualifyfor the allocation of permits. Their competitors, on the other hand, did qualify for per-

mits, and could profit from them by introducing the techniques that Ecocem had pion-eered, putting Ecocem at a competitive disadvantage.14

This perverse incentive, to avoid unnecessary reductions in emissions to ensure max-

imum future allocations, can be avoided by auctioning rather than allocating the car-bon-credits. However, the companies currently receiving free allocations have so far

fought a successful campaign to hang on to their advantage. If it is not politically pos-

sible to move to full auctioning of credits, the EU-ETS will continue to embed themarket power of incumbents (who, perhaps not coincidentally, are notably enthusi-

astic about the mechanism). The role of government should be to prevent incumbents

from erecting barriers to entry, not to institute those barriers for them.

6. Preferential pricing of some sources of greenhouse gases

The EU-ETS applies only to a subset of greenhouse-gas emissions and cannot practic-

ally be extended to cover all emissions. Below the size of installation currently

covered, the transaction costs of this bureaucratic system exceed the benefits of its ex-tension. This means, at best, that alternative mechanisms are required to price carbon

from smaller installations, and in reality, that improvements in areas that cannot prac-tically be covered by cap-and-trade are encouraged (ineffectively) by means of cajol-

ing, grants and regulation, rather than pricing. The result is differential pricing of

identical goods (greenhouse-gas emissions), and a skewed market that encourages fa-voured solutions rather than the most efficient means of delivering carbon-reductions.

Most European countries with low levels of emissions, such as Latvia, Lithuania,

Denmark, Austria and Sweden, have high levels of renewable heating (e.g. wood-firedboilers, ground-source heat-pumps etc). Typical green-heat installations are too small

to integrate into the EU-ETS. Reliance on the EU-ETS for large installations and ahodge-podge of dirigiste interventions at the lower end of the market explains why the

UK has so far failed to make any meaningful progress on renewable heat, despite the

fact that the sector offers more efficient and significant savings than the electricity andtransport sectors that have received most of the attention.15

Burning biomass to produce electricity is strongly encouraged under the RenewablesObligation. Burning biomass to produce heat receives very little encouragement. Asmost of our heat is produced using gas-boilers, and (conversely) twice as much of our

gas is used for heat as electricity, increased use of renewable heat would have a biggerimpact on our gas-import dependency than efforts to further diversify our electricity

supply, which is already relatively diversified. In what way does it meet our carbon

14 Submission of Ecocem Ireland Limited to the Environmental Protection Agency in respect of DraftNAP 2,

http://www.epa.ie/downloads/pubs/air/etu/nap2firstpublicconsultationsubmissionsreceived/epa_nap2_submission_ecocem_ireland_limited_2_of_3.pdf

15 I must declare an interest since writing this paper, my company has invested in a green-heat busi-ness.

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and energy-security objectives to encourage production of electricity from biomass at30% efficiency and of heat from gas at 90% efficiency, rather than heat from biomass

at 90% efficiency and electricity from gas at 60% efficiency?

Our incentives are irrational, and they are largely so because there is not a single car-bon-price applying equally to large and small installations and to the fuelling of elec-

tricity, heat and transport. The European idolization of the cap-and-trade approach is abarrier to more rational carbon-pricing.

7. Wrong in principle as well as practice

Cap-and-trade mechanisms would be the wrong approach, even if they could bebroadened to cover, with tight, fair, and strongly-enforced caps, all sources of emis-

sions from all locations. They inevitably provide distorted price signals, regardless ofthe details of implementation.

(a) Cap-and-trade produces an irrational, discontinuous demand curve

For most goods, price falls gradually as supply increases. There is no reason to thinkthat prices for carbon-savings should not behave like this, at least up to the pointwhere atmospheric emissions stabilise at an acceptable level. The caps in cap-and-

trade systems are always set at a level very much above the stable level, close to cur-rent emissions-levels, in order to avoid so-called deadweight costs (a misapplication

of this term). Consequently, the demand curve looks more like the following:

The consequence of this irrational demand curve is severe. While emissions are above

stable levels, each extra tonne of carbon saved is almost as useful as the previous sav-

ing. Yet under a cap-and-trade scheme with a cap set close to current emissions-levels,it does not take very much to save sufficient carbon that the value of additional sav-ings falls to close to zero in the market, even though the utility of those savings is not

very different to the utility of the high-priced savings. It is difficult to predict, in a

market with hundreds of players making thousands of investments, the exact point atwhich one approaches the cliff-edge. Businesses are strongly disincentivised from

investing in all but the very cheapest carbon savings if they fear that the market isclose to the level of the cap. As the cap is deliberately set to be close to the current

level of emissions, this is a real fear in most circumstances.

It is not an accident of current implementations that cap-and-trade has failed to in-

centivise significant investment in its own market, and has instead relied on cheap

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(largely artificial) carbon-savings from outside the market. It is fundamental to theconcept. It is not obvious what would justify the design of a market in such a way that

the marginal value collapses when supply reaches the level of an arbitrary cap that

bears no relation to the stable emissions-level.

(b) Cap-and-trade focuses on gross emissions

The carbon-cycle is very much larger than that part which is amenable to control bycap-and-trade. Failure to incorporate all sources of emissions and all means of absorp-

tion distorts choices.

The classic example is forests. Existing forests absorb carbon each year. Conversely,

destruction of existing forests releases stores of carbon into the atmosphere. Given thecomplex contribution of existing forests to ecosystems, rainfall patterns, soil-based

carbon etc, preserving those forests is at least as important as planting new forests. Yet

our carbon markets only value the planting of new forests. The result is small planta-tions sprouting up to offset the carbon emissions from our various activities, while

swathes of existing forest are cut down for lack of a value for their preservation. Thecarbon contribution of the new plantations is over-valued, counting (in a mark-to-mar-

ket exercise that would have embarrassed even Enron) all absorption for the notional

100-year life of the trees during year one, whilst the carbon contribution of existingforests is under-valued.

What matters is not a nation's gross emissions from combustion of fossil fuels, but its

net carbon emissions taking into account all sources of emissions (including agricul-

tural emissions, deforestation, etc) and all absorption in that year by carbon-sinkswithin the nation's boundaries (arguably, this should include oceanic absorption within

national waters as well as forests and mechanical/chemical sequestration). Taking net

rather than gross emissions as the basis for trading would result in a very different pic-ture, significantly reducing the contribution of some supposedly polluting nations like

America, Canada and Russia, and significantly increasing others' shares. The formerare aware of this, which is one reason why they have refused (and will probably con-

tinue to refuse) to sign up to a system where they are held to account for their grossemissions. The latter are equally unlikely to accept allocation on the basis of net emis-

sions. Yet without this modification, prices are likely to remain seriously distorted, so

that we carry on cutting down our forests while investing heavily in symbolic butwasteful gestures like photovoltaic energy.

(c) Cap-and-trade applies a positive price to non-carbon, not a negative cost to

carbon

The assumption is that one is simply the inverse of the other, but this is incorrect.

There are indeed carbon-positive and carbon-negative activities. But activitiesthat do not emit carbon are not carbon-negative, they are at the zero point of the scalethat runs from carbon-negative to carbon-positive. Carbon-neutral the zero-carbon

option is worth less than the carbon-negative option. In fact, carbon-neutrality reallyhas no positive value its value is in the avoidance of the carbon-positive cost. Re-

newable energy is carbon-neutral, not carbon-negative, yet we treat it as though it hasactually reduced our carbon emissions. Renewable energy should not receive a value

for carbon-reduction, but should be attributed a value for avoidance of the cost of car-

bon-emission.

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This may sound esoteric, but it has very practical impacts. Currently, by treating theinstallation of renewable-energy projects as effectively carbon-negative, we use them

to offset the costs of our continued emissions. But if we do not reduce those emis-

sions, there is no amount of renewable-energy that will reduce the environmental im-pact. It is possible to envisage, in a reductio ad absurdam, a scenario where we have

installed so much renewable energy that the whole world is notionally carbon-neutralaccording to cap-and-trade accounting, and yet our carbon emissions remain as high

as they ever were. This situation requires (besides massive engineering and expense)

only that we increase our total consumption of energy in proportion to the increasingrenewables contribution. That is precisely what is happening (and more) in many of

the countries that are selling us the notional carbon-savings from CDM renewable-energy projects.

There is no easy solution to this in a cap-and-trade approach. One has to attribute anotional carbon-saving to renewable-energy projects if they are to be able to trade on

the market. And yet that carbon-saving is fictional, and provides excessive encourage-

ment to engineering solutions relative to behavioural changes and protection/encour-agement of carbon-sinks. Very often, the latter choices, requiring very little invest-

ment, will be the cheaper options, and will have additional benefits for the environ-ment, and security of supply. But engineering solutions have been, and will continue

to be, the preferred solutions of cap-and-trade market participants.

(d) Cap-and-trade assumes that there is any rationale for an arbitrary cap

Efforts to calculate these caps have been based on scientists' judgments about what

level of emissions will be acceptable, how we should get there, and how the pain ofgetting there should be divvied up. We have already considered the impracticability of

developing a rational basis for allocation of the emissions allowances within an over-all cap. But what about that cap itself?

It is often assumed that this is just a question of science what is the level of emis-sions that presents an acceptable level of risk? But risk is subjective and uncertain.

Avoidance of risk carries costs, as does incurring that risk. It is a question of choice

and subjective judgment. Where we face many alternatives and circumstances, uncer-tainty, risk, and subjective choices generally, the market is a more effective tool than

is central calculation.

This is about the balance between adaptation and mitigation. When we set a cap, sci-

entists have decided for us what that balance should be. Reducing emissions to thelevel of that cap will carry a cost. Some of that cost could have been spent instead on

measures to reduce the risk of damage from any global-warming impacts, or indeed

simply on investment to improve the current quality-of-life of those who are subject tothe risk. The balance between investing in adaptation and mitigation should not be de-

cided for us by scientists, but discovered in markets that establish people's preferencesand perceptions of the balance of risks.

Conclusion

There is no way of adapting cap-and-trade mechanisms to satisfy these objections. We

should carry through with Phase 2 of the EU-ETS, because the market has a reason-

able expectation that it will be fulfilled. But we should agree now to put it out of its

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misery after that, and to use the period before 2012 to negotiate an alternative systemto replace Kyoto one that provides a more rational price, reflecting all sources and

sinks, and taking account of adaptation as well as mitigation, and that is agreeable to

all nations, or at least all major emitters. There are alternatives, if people are preparedto open their minds.

carbon or harm? the price of the risk of anthropogenic global warming

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