22 May 2006 - International [Global]
In early May, ITN reported on some potential problems facing the market for tradable permits in carbon emissions in the EU. The basic idea behind tradable permits is that a limit is set on the amount of pollution allowed, in this case of carbon dioxide, that is less than that currently existing. Firms buy these permits, which allow them to pollute up to a certain level. If the firm invests in efficient systems that reduce pollution then they can trade any surplus allowance they have with other firms who may not have been able to meet their targets. The level of the permits will gradually be reduced over time, thus lowering pollution. The market in these permits works, in theory, in the same way as any other market through the principles of supply and demand.
To work over time, the permits must allow for a total carbon emission level that is lower than what would normally have been the case if there were no restrictions and must also provide a challenging target for firms to reach, thus incentivising them to look for more efficient and cost-effective solutions. The scheme in the European Union (EU) is called the European Trading Scheme (ETS). It has come in for some criticism in recent months because of the way that it is operating.
The ETS based the allocation of permits on estimates of carbon emission levels for the year - in this case, 2005. It then released permits to firms at a level below this estimate. Any student of economics and business ought to be able to tell you that an efficient market is only as good as the quality of the information that is available to buyers and sellers. The carbon levels produced by firms fell by 2.5% during 2005 but this posed a problem for the ETS. Its estimate of pollution levels was, it seems, rather generous. In effect, it estimated total pollution levels higher than may have been the case in reality and thus set its target at too high a level, meaning most firms were able to more than meet their targets.
As a result, prices of permits on the markets have fallen - some analysts report the price of carbon credits falling by over 60% over the last month. The UK has been in a slightly different position than some of its European counterparts. The UK claims that it set challenging targets for its firms and as a result failed to meet those targets. The EU has indicated that it will take legal action against the UK for exceeding its quota. The UK counters this by arguing that other countries were far more generous in the limits they set and that revised levels it set in April 2004 are more realistic. The UK felt it should be judged against those levels.
Whatever the arguments, it needs to be stressed that it is clear that there are problems with the market, of course, that the market is very young and that these could be seen as teething problems. The ultimate goal of reducing carbon emissions is the main thing that we should be focusing on rather than short-term problems. Global warming is considered a serious long-term problem and carbon emissions are cited as one of the main culprits. The charity Christian Aid predicts that 185 million people will die as a direct result of global warming in the next 95 years.
To make the market work more effectively, therefore, the quantity and quality of the information available to buyers and sellers and to those who set the limits must be improved. This enables prices in the market to act as appropriate signals and also to ensure that there are sufficient incentives for businesses to change their behaviour and look for more efficient methods of production.
Greater challenges also exist, however. Critics of the global scheme to reduce carbon emissions argue that major polluters like China are not involved in any permit scheme as yet and major micro-polluters like homes and airlines are not included in the scheme. It is one thing, they argue, to have firms like power generators subject to restrictions - however weak they may be - but these represent only a minor proportion of the total carbon polluters.
Listen to the podcast [mp3 1.6 MB]
Using examples, explain the meaning of the terms 'positive' and 'negative' externalities. (6 marks)
Emissions of carbon dioxide are said to give off negative externalities. Explain what these negative externalities might be and whom they might affect. (6 marks)
Externalities arise because of the failure of the price mechanism to send out adequate signals. Explain the meaning of this statement with reference to carbon emissions. (8 marks)
One way of solving the problem of externalities is to 'internalise' the externality. Explain what this means. (8 marks)
Tradable permits rely on efficient and accurate information. Discuss the extent to which the quality and quantity of information is at the heart of the current problems facing the European Trading Scheme (ETS). (12 marks)