Carbon Trading and Pricing Mechanism

Several days ago, US senators Lindsey Graham and Joseph Lieberman outlined U.S. climate-change legislation requiring power companies to buy and sell pollution rights in a carbon market and oil companies to pay fixed fees for emissions. This bill would complement the American Clean Energy and Security Act of 2009 narrowly passed by the House of Representative in June to establish a cap-and-trade program, in which power plants, oil refineries and factories would buy and sell emission rights.

The proposed legislation is estimated to be ready next month. It aims at limiting greenhouse gases by regulating emissions from utilities through a restricted trading system for pollution rights. Some of the trading restrictions would include a maximum and minimum price for carbon dioxide allowances. On the other hand, oil companies would pay a fixed fee for their emissions that is linked to the price that power companies pay for carbon dioxide allowances.

Since 2005, greenhouse gas cap-and-trade systems have been established at local, national and international levels. Regulated polluters will be backed by permits and those who exceed their permits will have the option to reduce their emissions or buy extra permits from participants with surplus allowances. In most markets, two types of permits are exchanged: allowances and credits. While supply of allowances are distributed among selected polluters with various methods, carbon credits most commonly created in unregulated countries where reducing emissions is more economical in the hope to lower the overall cost of pollution reduction. Some unregulated organizations buy carbon credits in voluntary markets in order to offset their pollution or gain the positive reputational exposure.

A continuing debate is the pricing mechanism of carbon credits. Energy use and hence emission levels are predicted to keep rising over time, thus the number of companies needing to buy credits will increase along with prices, encouraging more groups to undertake environmentally friendly activities that create carbon credits to sell. As expected, between 2005 and 2007, the volume of permits traded globally grew nearly tenfold with increased value from $8 Billion to $63 Billion. However, since September 2008 the price of emission permits in the European market had fallen sharply following the economy downturn and casting doubts on the efficiency of carbon trading and pricing.

Triggering a ‘fair’ price for carbon credits requires deep understanding and considerations towards the polluters, types and amounts of pollution and also the adverse effect of pollutions. If the economic supply and demand prevails, the amount that polluters pay to emit should equal the community costs of pollutions to establish the equilibrium price. Yale University economics professor William Nordhaus argues that the price of carbon needs to be high enough to motivate the changes in behavior and changes in economic production systems necessary to effectively limit emissions of greenhouse gases. He suggested, based on the social cost of carbon emissions, that an optimal price of carbon is around $30(US) per ton and will need to increase with inflation. The number is certainly debatable and will fluctuate depending on the global dynamics of technology, politics and economics among all else. The problem remains, how can we correctly quantify our present and future losses due to one ton of CO2 released in the air?

References:

Simon Lomax and Kim Chipman, Senators Outline US Utility Carbon Market for Climate Bill, BusinessWeek Online, March 26, 2010, via http://www.businessweek.com/news/2010-03-26/senators-outline-u-s-utility-carbon-market-for-climate-bill.html

Andre Perold, Forest Reinhardt and Mikell Hyman, The Carbon Market, Harvard Business School, 2009

Forest Reinhardt et al., Global Climate Change and Emissions Trading, Harvard Business School, 2009

Setting a Price for Carbon, www.wikipedia.org, accessed March 28, 2010 via http://en.wikipedia.org/wiki/Carbon_credit#Setting_a_market_price_for_carbon

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