Responsive cap-and-trade systems and carbon taxes can improve climate change policy by allowing higher greenhouse gas emissions during times of economic expansions and lower emissions during recessions, according to a new report published today (12 December 2014) by the Grantham Research Institute on Climate Change and the Environment at London School of Economics and Political Science.The author of the report, Dr Baran Doda, argues that although it is better to build in responsiveness at the outset, carbon pricing instruments designed with a fixed ‘cap’ or tax rate could be ‘retrofitted’ to respond to economic shocks. When combined with an appropriately selected long-term target, responsive carbon pricing schemes provide better incentives to reduce emissions in times of boom and bust alike.The findings are in line with a recent proposal to establish a market stability reserve for the European Union Emissions Trading System (EU ETS).The report states: “A well-designed system can prevent prices from falling too low during a recession and so maintain the abatement incentive, or from overshooting in a boom and excessively constraining production by regulated firms precisely when they are at their most productive.”
Allowing greater emissions in years of above average economic growth would not affect overall climate change mitigation, since the increase is compensated for in years of below average economic growth.
The report states: “This trade-off is possible over an extended period of business cycles, when there are both booms and recessions, because climate change damages are related to the stock of accumulated emissions in the atmosphere, rather than how much is emitted each year.”
Raising and lowering the ‘cap’ within a cap-and-trade system according to the economic conditions would also reduce volatility in price of carbon.
The report states: “Provided the mechanism implementing responsiveness is well designed, the price of carbon with a responsive policy for an emissions trading system would likely become less volatile relative to its fixed cap counterpart.”
The price of carbon in the EU ETS fell dramatically following the 2008 financial crisis, when the recession reduced demand for emissions permits. The price has since remained low due to a lack of responsiveness in the system, providing little incentive for companies to reduce emissions.
Dr Doda said: “The system was designed with little regard for the potentially disruptive effects of business cycles on prices, especially during downswings in economic activity. So when the price of carbon in the European Union Emissions Trading System plummeted in the recession, regulators were unable to do much. Today the price of carbon remains low and shows no sign of recovering any time soon, severely undermining the effectiveness and credibility of the system.”
The European Union has so far temporarily removed 900 million emissions permits from the ETS – known as backloading – in response to the lower demand, but this action was only taken after more than a year of negotiation among policy-makers and politicians, and arrived several years after the onset of the recession.
New emissions trading systems being set up around the world – such as a new scheme due to be launched in South Korea next year, and pilot schemes in six regions of China – should incorporate lessons learned from the problems experienced by the EU ETS.
The report states: “Building the responsiveness mechanism into the system from the start is preferable to adding it on at a later date. The latter can create uncertainty about the system’s core design features, undermining its credibility and the predictability of outcomes.”
The report on ‘How to price carbon in good times… and bad’ was produced as part of the Grantham Research Institute’s programme on ‘Growth and the economy’, sponsored by the Global Green Growth Institute.
Based in Seoul, GGGI is an intergovernmental organization founded to support and promote a new model of economic growth known as “green growth.” The organization partners with countries to help them build economies that grow strongly and are more efficient and sustainable in the use of natural resources, less carbon intensive, and more resilient to climate change. GGGI’s experts are already working with governments around the world, building their capacity and working collaboratively on green growth policies that can impact the lives of millions.
The Grantham Research Institute on Climate Change and the Environment (http://www.lse.ac.uk/grantham) was launched at the London School of Economics and Political Science in October 2008. It is funded by The Grantham Foundation for the Protection of the Environment (http://www.granthamfoundation.org/).