Trading places

Nearly all of the world’s governments have pledged to do their best to secure a deal on cutting greenhouse gas emissions at the UN’s conference on climate change in Copenhagen next week. Whether their words translate into action at the conference remains a matter of fevered speculation, and a deal is far from assured.

But if governments are serious, they must shortly begin implementing a wide range of policies that will ultimately affect every sector of the economy.

The direction was made clear earlier this year in the world’s biggest economy, when Todd Stern, US special envoy for climate change, was given the role of combating global warming. His first message to business was stark, as he set out the policy imperatives of the Obama administration. “High carbon goods will become untenable,” he says. “How good will the business judgment of companies that make high-carbon choices now look in five, 10, 20 years, when it becomes clear that heavily polluting infrastructure has become deadly and must be phased out before the end of its useful life?”

All of the biggest economies have enacted measures aimed at reducing emissions, cutting inefficiencies and diversifying their energy supply. A growing number of smaller economies are also putting in place policies that would cut or curb the growth of their greenhouse gas output. Even if the Copenhagen talks fail, it will be difficult for countries to row back on these commitments, having proclaimed the importance of tackling climate change.

“The trend is clear. We are moving towards a low carbon economy,” says Lord Stern, author of the landmark Stern Review on the Economics of Climate Change. “Investors should be able to see clearly where we are headed.”

In his 2006 report, Lord Stern, a former World Bank chief economist and adviser to the UK government, set out three main methods of legislating for greenhouse gas reduction. These were: carbon trading; taxes on carbon or energy; and regulations to force companies and consumers on to a lower carbon path, such as a minimum efficiency level for vehicles.

Of these policy instruments, carbon trading has attracted the most attention. The reason is simple: it has the best chance of becoming a truly global mechanism for both reducing greenhouse gas emissions at the lowest possible cost, and directing private sector finance to bringing low carbon technology to poor countries.

The first international system of carbon trading was set up under the 1997 Kyoto protocol, whereby rich countries can meet their obligations to reduce emissions by investing in projects such as wind farms or solar power generation in the developing world. This carries the double benefit of being cheaper for the developed world, and bringing low carbon infrastructure to poor regions that could not otherwise afford it.

Last year, the global carbon market was worth more than $125bn, in spite of the financial crisis.

But the carbon markets under Kyoto are in peril. The current “commitment period” of the protocol, under which most developed countries have taken on emissions targets, is scheduled to end in 2012, and as yet there is no framework to replace it. Furthermore, the US has never ratified the Kyoto pact, leaving the world’s biggest economy out of the market.

Governments are set to negotiate a new global framework on climate change at Copenhagen, and that could include a truly global carbon trading system. However, there is so little time left that talks over such finance mechanisms may have to run into next year. The US is also reluctant to submit to an international system, preferring to set up its own system that may connect to other markets in future, so a global carbon trading system may remain out of reach.

In spite of these disadvantages, carbon trading may still represent the best chance the world has of tackling climate change. Alternatives, such as a tax on carbon, are fraught with yet more difficulties.

On the plus side, carbon trading has been embraced by most of the developed world governments, albeit with differing levels of enthusiasm, as a means of bringing down emissions within their own countries. The European Union took an early lead with the start of its emissions trading scheme in 2005. This system covers most of the EU’s heavy industries, such as energy generation, steel, glass and paper, and is to be extended to sectors such as aviation.

Under the scheme, companies are issued with a quota of permits to produce carbon dioxide each year. The number of permits available is gradually ratcheted down, so that companies taking steps to reduce their emissions benefit from being able to sell their spare permits to laggards.

Other countries that have accepted the Kyoto protocol have followed suit with proposals for emissions trading systems of their own, including Japan, Canada and Australia. However, these systems face opposition from some sectors of industry and in some cases have been watered down.

The US is also considering a cap-and-trade system covering at least 85 per cent of emissions from its industry. Though legislation was passed by the House of Representatives by a narrow margin this summer, and has the support of the White House, the bill faces uncertain prospects in the Senate, where it is currently in committee.

Whether carbon trading becomes a truly global system will depend to an enormous extent on whether a cap-and-trade scheme is enacted by the US.

International discussions of a new framework on emissions have fallen under this shadow. Gernot Wagner, economist at the Environmental Defense Fund in the US, is confident that a cap-and-trade system will be passed: “It’s far from inevitable, but all the signs point in the right direction,” he says.

But the bill faces stiff opposition from many sectors of industry and most Republican lawmakers.

Some of the other policy instruments for cutting greenhouse gases are yet more controversial than carbon trading. Carbon taxes already exist in the form of fuel taxes that penalise use. But while these are implicit carbon taxes, getting public agreement for one that is explicit is likely to be difficult: surveys have shown that people are willing to countenance measures to combat climate change, but when asked specifically about taxes, they tend to lose their enthusiasm markedly.

Other instruments are also in use. Many jurisdictions – including China, the US and Europe – impose minimum efficiency requirements on vehicles. Standards to ensure that less energy is wasted from buildings are also common.

Other regulations are being tightened. The EU recently legislated to outlaw incandescent light bulbs, which waste as useless heat more than 95 per cent of the energy they use, in favour of energy-efficient models. Efficiency ratings on energy-using equipment are also made available in Europe, and other parts of the world, by which consumers can judge the value of goods.

Environmental regulation has been tightened more often than loosened in most countries in the past year. A prime example has been the US Environmental Protection Agency’s decision – controversial in some quarters but backed by judicial review – to class carbon dioxide as a pollutant that it can regulate, in the same way as it regulates forms of air and water pollution.

This could open the way to strict controls on greenhouse gas emissions in the US, independently of whether cap-and-trade regulations are passed. It remains to be seen how this power may be used. Other jurisdictions will watch the development with interest.