The Fallacy of the Carbon Market

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The noise surrounding Copenhagen is deafening. Hidden within the noise and light are several elephant sized questions that everyone seems to be ignoring. Firstly, is carbon pricing really an effective market? Secondly, can a market based solution be found that doesn't involve pricing carbon? My answers to those questions are no and yes respectively.

Carbon trading is unlikely to be a very good market. Not only is it hard to monitor, verify and account; the very difficulties in in monitoring, verification and accounting leave the market wide open to gaming and manipulation. It is quite possible that it will cost more to run a carbon market with less improvement in emmissions than to spend the money on direct measures to improve emissions.

So are there other market-based solutions that are as effective if not more effective than carbon trading? Almost certainly. The whole conversation around climate change has become so tunneled vision on carbon trading that other market based solutions are ignored. Lets step back from the particulars of carbon trading to look at what is being trying to accomplish.

The idea is to use price signals to encourage changes in participant behaviour and resource allocation. In the case of climate change it is to reduce greenhouse gas emissions with the price of carbon as the signalling mechanism. Why carbon price was alighted on one can only speculate(special interest groups such as investment banks looking for the next CDO scam comes to mind and green zealots with a messiah complex) but in reality it can be any pricing (or more than one pricing) signal as long as it accomplishes the goal. All that is required is a pricing signal that change the way energy is generated and used.

A fallacy of the debate is that regulatory regimes are inherently, non-market based. That is untrue. If the regulatory regime specifies the mechanisms of reduction then it isn't market-based. But if the regulatory regime specifies the end goal and then leaves it up to the market to produce the most effective solution, that is a market-based solution. Before rushing to say that isn't true bear in mind that is exactly what the carbon trading market is, a regulatory regime that specifies an end goal and leaves it up to market participants to allocate the resources to produce the reduction desired.

A carbon market is one of many possible markets that will produce the goal of changing the way energy is generated and used. Nor is there anything to say it is the most effective regime and I am coming to the conclusion that a carbon market is probably the worst possible market to achieve this goal. The carbon market strays into specifying the mechanism rather than the goal.

An alternative market would be based on a regime that specifies work per unit energy input requirement, or efficiency. A set time points the efficiency requirement would increase contiuning to drive changes in energy production and consumption.

There are several benefits to this market:

1. it is simpler for people to understand - energy and its use is far more concrete than an invisible gas
2. measuring & accounting for efficiency is far, far easier than measuring & accounting for emissions
3. its harder to outsource consumption and generation in an efficiency focus regime
4. the measure efficiency can be tailored to different industry sectors but still tied back to an overall measure
5. it is harder for free-riders to prosper as each industry has their own targets
6. and doesn't fall afoul of the rather significant problem that the physics of converting to a carbon free economy don't stack up

Technically this type of market is viable but is it politically viable? From my persepctive it is. It is easier to explain to sceptical citizens, targets are based on improvements rather than reductions and allows various players to choose the mechanisms that suit them best. Using efficiency targets becomes globally homogeneous avoiding the brutal and almost politically impossible task assigning blame and reductions according to blame. Nor does it require everyone to sign-up initially. As efficiency is measured at point of consumption, if a large proportion of global consumption uses efficiency targets, suppliers and producers will need to adapt to meet those targets in essence becoming part of the solution should those producers and suppliers wish to trade with that market.

There are other possible market-based solutions as well. We would do ourselves and the world a favour to not tunnel vision on carbon markets but to pick the best market-based solution that produces the desired behaviour of changing energy production and consumption.

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The Sustainable Economy and Economies of Scale

In much of the discussion on sustainable economy has been focused around energy and carbon. One aspect I find missing from the debate is how the wider shift to sustainable development will effect the fundamentals of economic development that have been the guiding forces since the time of the industrial revolution.

One key economic concept is Economies of Scale. Essentially, building lots of things in one place in order to produce each individual thing cheaper. One of the key determinates of economies of scale is transport costs. The shift to sustainable economy is going to bring in what is currently an externality (carbon) to the equation that determines the economies of scale. As carbon is priced into transport (and to the price of energy) building widgets in massive factory in China (for example) and shipping it to the rest of the world is going to loose economy.

The reduction in the economies of scale will see two major effects. The first is a shift to more factories building the same product as opposed to one big factory shipping to the world. These smaller factories will serve a particular region. The size of the region that the factory supplies will be determined by transport costs. The second shift is that many economies will see a broadening of the manufacturing base. There is likely to be a growth in both the number of jobs in manufacturing and also the diversity of manufacturing operations.

Not only will carbon transport costs effect the location of factories but so will access to low carbon energy. In effect, countries with good internal and regional transport links that are not carbon intensive and have ready access to low carbon energy will greatly benefit from the shift to a sustainable economy. Which leads to the conclusion that China is likely to see its global dominance of manufacturing eroded if it is unable to reduce the carbon intensiveness of is energy and transport. It is China's self interest to reduce the carbon intensiveness of its economy now.

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