Why the key to carbon trading is to keep it simple

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The genius of the market system is that it responds flexibly, if imperfectly, to a future that will not have been predicted. But when it is created through political action, rather than emerging spontaneously, business will seek to influence its design for commercial advantage.

Share prices of European electricity producers were weak in the last week of April, after a sharp fall in the market price of tradeable carbon emission permits. The market had it right. The smaller the penalty for climate change, the lower the profits of the companies responsible for it.

Regulation that works with market forces rather than against them is a good idea but difficult to implement. When the British electricity industry was privatised, the plan was to create a market that reproduced the efficient system through which the publicly owned Central Electricity Generating Board had ensured that electricity was always supplied from the lowest cost power stations. In practice, it was not possible to do this.

The first problem was the lawyers, whose instinct is to write rules to cover every possible contingency. But no one can anticipate every possible contingency. Some economists believe in, and lawyers aspire to, a world in which contracts and property rights are completely specified. But business must face imperfect information today and inescapable uncertainty tomorrow. The genius of the market system is that it responds flexibly, if imperfectly, to a future that will not have been predicted. That is why clear and transparent regulation is hard to achieve in a market economy.

The second problem was the lobbyists. When a market is created through political action, rather than emerging spontaneously from the needs of buyers and sellers, business will seek to influence market design for commercial advantage.

The third problem was people with good ideas. Every simple concept can be improved, every new idea can be elaborated. But those who would kill several birds with one stone generally end up missing all of them. The electricity trading system put in place at privatisation proved too clever by half and was scrapped in favour of a less efficient but simpler regime in which people could buy and sell electricity like any other commodity.

As with electricity, so with the closely related market in carbon emissions. The sensible concept is that some business and industrial sectors will find it easy to achieve lower carbon, others will not. If those that can make above average reductions are able to sell permits to those that struggled to reach that target, the overall result will be greater effect at lower cost.

But lawyers were needed to give effect to this broad principle with audited and enforceable rules. Lobbyists followed. Investment banks salivate at the prospect of new speculative markets. So instead of a simple mechanism for transferring credits between businesses, we have an online, real-time market in which the price of carbon fluctuates wildly to the benefit of day traders and the detriment of long-run guidance on investment. Industrial companies need only use the words “productivity” and “competitiveness” for politicians to fish in the pockets of consumers and taxpayers. Europe must use less carbon, but not at the expense of business. Carbon taxes feed through into electricity prices but permits are handed out to electricity generators. That explains those share price movements. The higher the carbon price, the larger these effects will be.

After the lawyers and the lobbyists come the well meaning: naive academics – for whom the good must always be sacrificed to the possibility of the best – and social engineers, determined that their particular concern should be reflected in every policy. Would it not be a good idea if businesses that are environmentally unfriendly in Europe could gain credit for being environmentally friendly in developing countries? It would. But not if it got in the way of stimulating them to be more environmentally friendly in Europe. As, of course, it did.

These general problems are found whenever attempts are made to build economic policy on economic theory. They bedevil auction design, competition policy and market- oriented reforms in the public sector. The mantra of the government economist must be to keep it simple. If you cannot explain in two or three sentences exactly why and how a new economic policy will work, you can be confident it will have unintended consequences. As it has with the carbon emissions trading scheme.

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