The false assumption that markets must be best at cutting carbon

European and UK policy-making has relied too heavily on economic instruments to decarbonise economies and too little on setting standards and well-directed public spending.

All policy-making risks running afoul of the law of unintended consequences. No one intended Europe’s effort to tackle climate change to create a massive transfer of cash from electricity consumers to the profits of power companies. Yet that was exactly what happened in the first phase of the EU emissions trading scheme (EUETS).

Governments gave the companies the required emissions permits for free. They were also massively over-generous in their allocation of permits. Thus, the companies were able to sell those the permits they had received for nothing into the rapidly growing carbon markets without having to make any costly investment in emissions reductions.

Despite this unfortunate experience, the recently announced second phase of the EUETS will largely repeat the mistake. Estimates of the windfall profits this will generate for Europe’s power companies range from €9-15 billion.

Interestingly, this amount would more than pay for the €12 billion that Alstom, the world’s leading manufacturer of coal-fired power plants, estimates it would cost to implement the EU’s proposed but unfunded programme of 12 carbon capture and storage (CCS) demonstrations. CCS is an imperative, not an option, in any successful policy to avoid dangerous climate change.

Europe’s power firms have shown no reluctance at all to accept this public munificence. But this has not led to any enthusiasm to invest in the low-carbon energy technologies that Europe desperately needs.

Indeed, Eon chief executive Johannes Teyssen displayed ingratitude of truly gargantuan proportions recently, when he loudly complained that the Commission’s plans for Phase 3 of the EUETS were too demanding and would chill investment in new generating capacity.

This sorry tale is an empirical warning to those whose ideological or theoretical predilections lead them to believe that markets are always wiser than governments. Current climate policy thinking relies far more than is warranted on the market magic of setting a carbon price.

At best, a carbon price will make a difference at the margins. Price signals are helpful if you are making incremental decisions. However, incremental decisions will not stabilise the climate in the time we have available.

Furthermore, there are many price signals in a market place and not all of them are going in the same direction. The fuel duty escalator illustrates this difficulty perfectly.

You will remember it raised the tax on petrol 6% in real terms each year. But while the tax was going up the real cost of driving fell, and real disposable incomes rose over 40%. Not surprisingly, driving behaviour did not change very much.

It took Ken Livingstone’s introduction of the congestion charge - pricing road space not fuel - to have any significant impact on driving behaviour. In seeking the capital-intensive investments needed to make the transition to a carbon neutral energy system, the price of money may turn out to be a rather more important factor to influence than the price of carbon.

If prices really did work the magic most economists believe in, you would expect that a rise in the price of oil from under $40 a barrel to nearly $100 would have stimulated a huge rush to decarbonise the economy. What it actually stimulated was massive investment in tar sands, converting coal to liquids and in developing environmentally destructive biofuels.

The truth is that markets work much better in economic models than they do in the real world. In the models, investors behave as you assume they will. In the real world, they are much more inventive. Generally, they try hard to find new ways to carry on doing exactly what they were doing before.

Nothing illustrates the incoherence in market-distorted thinking about climate change better than the deep contradiction in this government’s policy. On one hand we are told that we must liberalise energy markets as quickly as possible to drive energy prices down for competitiveness reasons; on the other, that we must drive the price of carbon up aggressively for climate reasons.

Nowhere are we told how the left hand pushing energy prices down at the same time as the right hand is pushing them up leads you to anywhere other than the land of the deeply confused.

The widely held belief that building carbon markets is the best policy for tackling climate change is the triumph - and tragedy - of theory. Of course they have a role to play, but it is much smaller than is believed and much too small to solve the problem.

In practice, three other policy tools are more important and reliable if we are to mobilise the tremendous capacities of the business community in time to make a difference.

The first is to set the right technical standards to drive the technology deployments we need. The European Union has already shown the way by beginning a legislative process that could in time require all fossil-fuelled electricity generation to be carbon neutral.

The second is to structure the regulation of energy markets so as to allow utilities to pass through the additional capital costs of making the low-carbon transition. Since this would mean they were paid by all the utilities’ customers, it would spread the costs so thinly as to make them much more bearable than the oil price rise we have absorbed with little difficulty.

The third is to spend public money on buying the public good of a stable climate by paying to accelerate the rate at which low carbon technologies are deployed, thus driving down their costs more rapidly than markets alone could ever accomplish.

Tom Burke, founding director of E3G, advised three Secretaries of State for the Environment in the 1990s and was Green Alliance’s director from 1982 to 1991

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