Emissions Trading: The Good, the Bad, and the Ugly

The green movement has created a plethora of buzzwords. One of the popular phrases is emissions trading. And for good reason. Businesses, traditional and emerging, will soon be affected by this indirect carbon tax depending on where they fall in the supply chain.

One possible regulatory system for limiting future carbon dioxide emissions is a cap-and-trade system. Under this system, permits to produce carbon dioxide emissions are issued by the government and then sold and traded in the marketplace. Total carbon dioxide emissions (represented by the number of permits) are capped, and the market is allowed to set the price of those emissions (as opposed to the carbon tax system where the price is set by law and the market determines the total carbon emissions). The underlying motivation of the system is to achieve desired emissions reductions in the most economically efficient manner possible.

There is a variety of emissions trading proposals that differs in the details and in how draconian the measures are. One of the biggest points of variation is how the allocation of permits is handled. The emissions trading scheme instituted in the European Union allocated permits in most countries by a process called grandfathering. In this scheme, permits were awarded (for free) to existing firms based on the portion of national emissions they had created in the past. Firms could then freely trade the permits they had privately been awarded (through brokers, mind you), or in spot markets, where goods are sold for cash and immediate delivery.

A criticism of this cap-and-trade system has been that it has created huge profits for some firms that have produced the most emissions in the past. These firms have received a large number of permits and have been able to reduce their emissions more cheaply than the cost of permits. This has allowed them to make a large profit off the excess permits they could sell. Other proposals have used an auction scheme of allocation where firms bid on permits to buy them from the government. Under this scheme, the auction price of permits is essentially a tax, with the proceeds going to the government. Some of you may already be raising an important point: How much additional costs (read: overhead) the politicians pile on this tax for their friends and lobbyists affects how well the process works, or does not work.

Of primary concern for business planning is how an emissions trading scheme will affect the price of energy and transportation fuel. Unlike a carbon tax, where determining the cost is relatively straightforward, it is a much more difficult and complicated task to determine the costs imposed by an emissions trading scheme.

The cost of permits, which determines the increase to the cost of energy and transportation, depends on several variables in emissions trading schemes: the number of permits issued, whether the scheme covers one nation or is international, whether the use of carbon sinks (natural systems to soak up and absorb carbon dioxide, such as planting trees) is allowed, or whether a company can pay for carbon offsets in a country not covered by the trading scheme to meet its limitation.

International schemes have the advantage that emission reductions can be made in those countries where they are cheapest, while firms in those countries can sell their permits to firms in other countries where the cost of reducing emissions is higher. Allowing for the purchasing of carbon offsets in countries not covered by the scheme can have the same effect, as will allowing for the use of carbon sinks.

Some proposed schemes, such as one recently proposed in the U.S. Senate, consider a safety valve mechanism. The idea behind this is to make the system a hybrid emissions trading/carbon tax system. Permits are issued to limit total emissions, and these are traded among firms as needed. However, if the price of permits rises above a certain threshold, firms can then buy excess permits from the government at the threshold price. This amounts to an emissions trading system with a price cap. The advantage of this scheme is that it gives policy makers flexibility. They can set the number of permits and the price cap in such a manner as to achieve whatever exact policy they want from a pure carbon tax to a pure emissions trading system, all with a single mechanism.

Depending on the specifics of the trading scheme, and the specific nature of a given firm, emissions trading represents either a potential profit or a potential cost. Under any emissions trading scheme, the costs of energy and transportation will rise, just as it will under a carbon tax scheme. Some firms will be able to cover these costs with profits made from selling excess permits, while others (particularly heavy industry) will be hit with even higher costs. The key is to know where you stand and try to keep your options open as much as possible since it is likely that in the next administration and congress, there will be either a carbon tax or an emissions trading scheme in place.

What all this carbon tax debate is pointing to is the urgency to begin planning NOW for emissions trading inevitability to help protect your business from rising energy and transportation costs.