1.9.1 - Economic instruments to cut emissions

Version 3


    Why a carbon economy?


    In the absence of a carbon price, the atmosphere is exposed to the "tragedy of the commons". Since the Industrial Revolution, the development of the world’s economy has rested on free use of the atmosphere capacity to store greenhouse gases. Economic actors considered it an infinite reservoir, capable of absorbing all emissions.

    Setting a carbon price in the economy brings about two types of incentives.

    The first is to rationalize the use of products that emit large quantities of greenhouse gases within the framework of existing technologies: better adjusting heating, adopting slower and smoother driving techniques, reducing congestion by spacing out journeys or car-sharing, etc.

    The second is to accelerate investment in research and development into new low-carbon technologies: developing renewable energies, investing in biofuels, developing electric vehicles, etc.


    Three types of price instruments can be implemented to introduce a carbon price into the economy: taxes, emissions trading and project-based mechanisms.


    1) Carbon taxation


    A carbon tax is a tax that sets a price for CO2 emissions. Its rate, which is expressed in euros per tonne of CO2 emitted, sets the price. A carbon tax adjusts the relative prices of assets or energy sources according to their carbon content. When the fiscal instrument is used, it is the public authority that sets the carbon price, and the effects on emissions will depend on the reactions of the sector players.

    A carbon tax encourages a reduction in the least expensive emissions based on the following mechanism: if an industrialist has to pay a tax of €20 per tonne of CO2 emitted, it is in his interests to carry out all emission-reducing investments costing less than €20 per tonne of CO2 avoided. In this way he economizes on the difference between the tax he would have had to pay without making any investment and the cost of the investment. Compared to the introduction of a norm, a tax therefore means the overall cost of abating emissions is reduced.


    Paying for carbon emissions

    Key point: applying a price of €20 per tonne of CO2 emitted to primary energies would make the barrel of crude oil €8.60 more expensive, i.e. a surcharge of between 5 % and 22 % (for a barrel between €40 and €150). At a price of €20 per tonne of CO2, the average European would have to spend €160 a year if he were to pay all of his direct and indirect CO2 emissions for his energy needs. The same budget for an American would be €400 per year and €80 per year for a Chinese.


    2) Emissions trading schemes or cap-and-trade


    In a greenhouse gas emissions allowance trading system, or “carbon trading”, the public authority fixes a quantitative emission reduction objective and the market then sets the price.

    The global emissions cap guarantees that the environmental objective is met. The authorities set the total volume of emissions authorized by distributing or selling a limited number of allowances (1 allowance = the right to emit 1 tonne of CO2); in this case we refer to regulation by quantities (as opposed to regulation by prices via a tax). The allowances are shared between participants, who can trade these rights among themselves.

    Emissions trading attaches a price to the release of greenhouse gases and enables the environmental objective to be reached at a lower cost. Indeed, to comply with the environmental restriction applied to it, each actor can arbitrate between reducing its emissions and purchasing allowance units on the market. In this way, actors whose marginal costs for emission reduction are the lowest have an incentive to further reduce their emissions so as to sell their excess credits to those with higher costs. This means that emissions are cut where it costs least to do so.


    Illustration: Booklet Challenge Bibendum « more air » p.15


    The United States pioneered the implementation of emission trading, which has proved effective in the fight against acid rain caused by sulfur dioxide (SO2) emissions from power production plants. SO2 emission trading was introduced in 1995 and it has made it possible to reach the initial objective of halving SO2 emissions as compared to their 1980 level (67 % effective reduction) several years ahead of schedule and at less cost.

    The European Union is the first group of countries to have put in place an emissions cap-and-trade system to help reach their objectives under the Kyoto Protocol. The EU Emissions Trading Scheme (ETS) came into effect in January 2005. It covers emissions from 12,000 industrial plants in five large sectors: power and heat generation, refining, cement and glass, paper, iron and steel. Half of the EU’s CO2 emissions are covered, i.e. around 2 billion tonnes of CO2 each year.

    The principle of emissions trading

    Key point: In the absence of emissions trading, compliance with an emissions cap requires each entity to reduce its emissions, whatever the cost may be. Emissions trading gives more flexibility to entities with an emissions cap, each being able to choose to reduce its emissions or to purchase an allowance from an entity that has reduced its emissions. Emissions trading is economically efficient: it minimizes the total cost of hitting the environmental target.


    In 2010, 5.2 billion tonnes of CO2 were traded on the European emissions marketplace, for an average price per unit of around €14 over the year. A little more than a fifth of these transactions were spot deals, while the rest were forward and futures.


    European emissions trading at the heart of worldwide carbon finance


    Illustration: Booklet Challenge Bibendum « More air » p.16

    Key point: the EU ETS represents 82 % of global emission trading; with 14 % of transactions, the Kyoto Protocol’s project-based mechanisms are the second pillar of global carbon finance. These two large markets are directly linked, European manufacturers being at the origin of the great majority of global demand for CDM and JI credits.


    Other countries or regions have developed or are developing similar systems that will enable the geographical scope of economic actors working with a carbon price to be extended in the future: ten Northeastern states and California in the USA, the state of New South Wales in Australia, New Zealand, Japan and soon South Korea. China is also in the process of testing cap-and-trade mechanisms in several provinces. The new carbon economy is made up of all these systems that interact in a complex way and were put in place in the wake of international negotiations under the aegis of the United Nations.


    The price of carbon on the European emissions trading market

    Key point: since its creation, the European Emissions Trading Scheme has functioned in a rational way. The cash price of allowances on the market reflects the balance between supply and immediate demand; it collapsed at the end of phase 1 as the excessive initial allocation led to a surplus of allowances on offer at the end of the phase that could not be used in the following phase. The forward price, which remained stable around €15 from the 2nd quarter 2009, reflects the value attributed by the market to the long-term environmental constraint set by the European union (20 % reduction in emissions by 2020 compared to the 1990 level).


    3)  The Kyoto Protocol Project-Based Mechanisms


    The Kyoto Protocol teamed the introduction of commitments by industrialized countries to cut emissions with “flexibility mechanisms”. The first is the possibility given to states directly to trade rights to emit. It did not lead to the development of significant transactions. However, the two project- based mechanisms introduced by the Protocol, the Clean Development Mechanism (CDM) and Joint Implementation (JI), are the second main pillar of worldwide carbon finance.

    Following the strict rules laid down and monitored by the UNFCCC Secretariat, these two tools fund emission-cutting projects through carbon credits. The mechanism works as follows: to be eligible for the Kyoto Protocol project-based mechanisms, a project must demonstrate that it engenders an "additional" reduction in emissions as compared to a reference scenario, defined as the most prob- able scenario if the project did not exist. Once the project has been approved and implemented, those behind the project receive the number of carbon credits corresponding to emissions cuts brought about by comparison to the reference scenario. These credits are called Certified Emission Reductions (CER) or Emission Reduction units (ERU). They can be sold, either to parties who will be able to use them in order to be in compliance, typically a European manufacturer subject to caps, or for "voluntary compensation".

    In February 2011, 1,150 Kyoto projects were effectively launched worldwide, generating emission cuts of just under 600 million tonnes. It is estimated that around 1 to 1.2 billion tonnes of CO2 will have been cut by the start of 2013 thanks to these mechanisms.


    Taxes or trading schemes, do we have to choose between them?


    Although often opposed, taxes and trading schemes present more similarities than differences. Incentive taxes and negotiable allowances depend on an equivalent price mechanism, in theory, from the point of view of its economic effects: with perfectly informed players, these two instruments enable emission cutting efforts to be made at the lowest cost for the community. If introduced correctly, they can help make substantial savings compared to public actions conducted on the basis of obligatory standards.


    However, the two instruments achieve a balance differently: in the case of a tax, the initial uncertainty relates to the quantities of emission cuts, while in the case of a trading system the uncertainty relates to the price of emission cuts.

    In the real world, the climate policies that are brought in are generally a combination of several instruments. Thus, a growing number of European countries have national carbon taxes co-existing with the European carbon market. Faced with the necessity to take more action to combat the climate change issue, the precaution consists of combining the various instruments as far as possible so as not to neglect any potential source of emission cuts.


    Transport and the carbon economy


    The diffuse nature of transport emissions means that this sector has been excluded from existing and projected emissions trading systems. The main exception to this rule was air transport arriving in and departing from the European Union. Air transport was included in the European system from 2012. With the perspective of greater collaboration between the different modes of transport to cut greenhouse gas emissions the Kyoto Protocol project-based mechanisms could be one way to go.


    In most countries the State has chosen a taxation system.