What's An Emissions Trading Scheme Supposed to Do, and How Can You Tell if it's Working or Not??

You've probably heard all about various emissions trading schemes (ETS) being put in place around the world. Governments and scientists alike hail such schemes as a great way to tackle climate change. But what are they supposed to do and how can you tell if they are working?

Unfortunately, it's very easy to get lost in all of the economic jargon that is bundled up with these trading schemes and if, like me, you don't have a degree in economics then it can all get very confusing. Fortunately, from my point of view, I'm not particularly interested in the way that an ETS actually works. The policy involved and the other economic stuff that makes it all tick is a bit like the inner workings of a wristwatch... as long as the watchmaker knows the details, all I really care about is what it is supposed to do and if it is working or not. But the trick is that you really need to know exactly what something is supposed to do before you can decide whether it is working or not!

So what is an ETS supposed to do? Well in short, it's supposed to put a price on carbon. In doing so, an ETS adds a price representing the environment into the things we buy and use. For example, think of a litre of milk, what prices are involved between it coming out of the cow and ending up in your breakfast cereal? Well, first and foremost, there is the price of breeding the cow, then there are the milking costs, packaging costs, transport costs, storage costs and finally there is a cost of you going down to the supermarket to get it. At no stage does the environment (or anyone representing it) ever stop and say, "Hang on, you've used my land to raise the cow, elements from the earth for milking, packaging, transportation and storage and now you've left me with a heap of byproducts to dispose of, all without ever giving a thought to the impact it may have!".

As the world is coming to realise, the environment spends a lot of time brooding on the amount we take without asking and when it does finally react it doesn't ask us for money. Instead it starts taking away privileges like polar ice caps and consistent weather and plots its revenge through natural disasters. Even worse than that, there is more and more evidence to suggest that the environment is not particularly forgiving in the short term and that the effects of climate change have a certain amount inertia or momentum to them so that even if we start to put things right, we may continue to see the effects for many decades or even centuries afterwards.

But how does this all relate to an ETS? If the environment doesn't ask for money, then what is the point of putting a price on carbon? The answer is simple. While the environment doesn't accept (or respect) concepts like money, humans do. By putting an ETS in place governments are trying to force people to account for the cost to environment in the things they produce and do. Unfortunately, the end consumer tends to bear a large chunk of this cost. While this may seem like a real pain in the short term, it requires slightly longer term thinking to see the real advantages to a strategy like this.

All of this came to mind recently while I was reading (ok I was just skimming through) the International Energy Agency's Energy Technology Perspectives report for 2008 (http://www.iea.org/Textbase/techno/etp/index.asp) the other day and saw this diagram -



The diagram above is referring to some new (clean) technology that is being introduced to the market. Unfortunately, deploying new technology is typically very expensive, but it is assumed that as more units are produced, then unit cost goes down so at some point the cost of the new technology is equivalent to that of the existing (or incumbent) technology. This point is the 'break-even' point. As you can probably work out, the area in the yellow zone is the cost of 'business as usual' for the existing technology. However, because it is new and still requires some acceptance by the market (here they call it 'learning' the technology) there is an overhead of the new, cleaner technology. This is represented by the orange zone.

As is typical of greener technologies, they are cheaper because they are more efficient (and yes I know that is a fairly big generalisation but hear me out), this means that at some stage they will actually reach a break-even point with the existing technology. But imagine if you are a business thinking of investing in this new technology and that the break-even point is 10-15 years in the future. To me, that sounds like a pretty risky alternative... a lot of things can happen in 10-15 years and a lot of money needs to be invested over a long period to make sure it even gets to that point. Well this is where an ETS is really helpful. Because an ETS puts a price on carbon emissions, and if your technology emits less carbon than the existing one, you are at an immediate advantage. Assuming the price of carbon stays relatively constant (and even if it doesn't) then your break even point suddenly becomes a lot closer. In effect you have shifted the goal posts in your favour. This is shown by the BLUE and ACT lines on the diagram, both of which describe a different carbon cost scenario based on IEA modelling.

So at the end of the day, our ETS is making clean technology get to us faster. While it definitely causes some short term pain due to an extra cost on some items, it is worth it for the longer term benefits it brings. For example, imagine if our milk continued to be transported by diesel powered trucks... what happens when oil starts to run out? Diesel prices go up and guess what, so does the price of our milk. But if we pay a little extra for our milk in the short term, more fuel efficient trucks are developed and eventually our milk becomes cheaper.

Just to finish this little post, I'd like to leave you with a thought. Given the current position of the Australian government and its intent to introduce an ETS, is there really any value in giving long term rebates to existing, high carbon emitting industries? In effect removing any competitive advantage that may give newer, cleaner technologies. Given what an ETS is supposed to do, would it then really be working?