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After the Glasgow summit: Is cap-and-trade an unproblematic solution?

EU carbon tax – solution or problem?

EU´s carbon pricing mechanism is a proposal to reduce the emission of the EU countries by establishing a marketplace for CO2 emission rights, using pricing mechanism to get the most cost-efficient reduction of these emissions, letting the market do what it does best: allocate the resources to the players with the highest payment propensity. This is why economists are in love with the ETS – companies polluting less than expected can sell their surplus emission quotas and make a profit, at the same time ensuring that pollution has a cost. This has also caused an unexpected lobbying in support of new taxes by the industries of the EU: They are pushing for a taxation on the carbon footprint of imported goods.

So far, the market mechanism has caused a massive increase in the price of emission quotas – following the (hopefully) end of the covid restrictions and the restart of the European economies, the increase has been more than 200%.

Imposing an EU import tax on carbon

The problem for the EU is that too high or too low a tax is both equally undesirable. The worst case would be to taxing to low. This would cause EU industries to face international competition with lower costs, due to the relief from paying for the pollution caused by the production. A probable outcome would be “carbon leakage”, i.e., production of polluting goods being transferred to countries outside the EU, causing increased unemployment and lower economic growth within the EU, without any environmental benefits. The remaining 27 EU countries being anything but homogenous regarding their economies, will most likely experience a situation with governments lobbying in favor of just their domestic industries, demanding exceptions and thus undermine the ETS. With Biden on board in the US, the EU has a transatlantic partner thinking in much the same way. After all, the US had a very successful cap-and-trade regime for SO2- emissions, and in principle, the same system is what is considered applied for CO2- emissions.

China has, at least officially, voiced the same ideas; however, the reality is that the country has increased its CO2- emissions on a scale unknown to any other nation, starting hundreds of new, polluting coal power plants yearly, cementing the country's position as the worlds, by far, largest polluter.

Too high a carbon import tax, while benefiting EU industries, does also have negative side effects by widening the global inequality. Making the EU countries more competitive, it also has the side effect of hitting countries relying more on heavy industries disproportionately harder, these countries frequently being non first world countries. The USA and EU are better positioned to reduce their emissions due to their financial strength as well as enjoying a highly educated workforce. In 2019, the number of jobs in the renewable sector in the USA already outnumbered the jobs in the fossil sector with a ratio of 3:1. The growth pace in the renewable sector is expected to be 11 to 13 times than the national average overall. This transition requires a skilled workforce and R&D resources not available to less developed countries.

Somewhere in-between there is a balanced solution, accommodating the needs of less fortunate countries and at the same time ensuring that more developed countries are charged the appropriate tax to ensure that the polluter pays.

Carbon pricing - causing the power crisis in Europe?

With such a successful model for prizing emissions, why does Europe experience the devastating energy prizes it has seen the last 6 months? To some extent, the success of rolling out wind and solar power plants is key to understanding the exorbitant energy prices in Europe in particular, but also to some extent on a global scale. Combining the massive increase in installed renewable power sources with closing down fossil power plants exposed a overlooked problem in the electricity supply chain: The absence of storage opportunities for wind and solar, replacing the predictability of fossil power plants. When we add that nuclear power is being discontinued in several countries, with Germany expecting to close down its last nuclear facilities next year, removing the only large-scale emission free energy sources to substitute the predictability virtues of coal and gas, Europe has made an energy transition without having all the pieces in place. Focus has been on installing production capacity, leaving the crucial elements of predictability out of the equation.

Why is cap-and-trade a problem?

Simply because it works! The task of such a system is to ensure market clearing for a limited commodity, in this case emission rights. In an energy market where wind and sun have been scarce the last 6 months, and hydro power in Scandinavia has seen lower production forecasts due to lower-than-normal water reservoir levels, the markets do what they are expected to do: Push the price up to a level where an equilibrium is reached. This is true for all markets; oil being the most known worldwide, with a massive volatility and substantial price elasticity, leading to huge price variations even with small, sub 5% adjustments in supply or demand.

The problem is that this also leads to massive increases in the household’s energy bills, having the same effect as a significant tax increase. Using the case of Norway, the new left leaning parliamentary majority is talking about reducing the taxes for incomes under appr. EUR 75.000, while increasing the taxes for those earning more than this threshold. For a family of 4, with an average pretax income of appr. EUR 116.000, the tax reduction is expected to be in the magnitude of EUR 200-300 per year. The same household, living in a single-family home, will experience a EUR 2000+ increase in their energy bill for 2021, dwarfing the potential tax reduction. Such an impact on the family income is only second to interest rates with regard to the financial consequences; and as with interest rates, the households have rather limited influence on these prices. Post covid, the last thing any nation needs is an energy price shock limiting the purchase power of the households and reducing their spending propensity.

What are the solutions?

Storage, storage and storage. To be able to provide an emissions regime ensuring reduced CO2-emission, AND at the same time contribute to keep the energy prices for the household at a palatable level, massive investments in storage and virtual power plants is required within a few years. The installation of new, renewable power plants will continue, driven by the market and political decisions on financing such a development.

Large batteries, once considered to be way to expensive, are already available at prices below the magic USD 100 / kWh storage capacity. Further, the reason nuclear power is losing its attraction is not only disasters like Fukushima, but also because it is massively more expensive than renewable energy. In 2020, solar power was the cheapest energy source. As early as 2014, the think tank Agora concluded that nuclear power was twice as expensive as renewable sources like solar; since then, the cost of nuclear power has risen with double digit percents, whereas the price of solar has continue to drop by 60%. The missing link is, again, to get large scale storage online. The moment such solutions, be it batteries, hydrogen, pressurized air, pumped recharge or swing wheels, are reaching a critical level the only sound advice for investors is to start shorting fossil fuel shares.

Disruptive change - winners and losers.

Finally, it is also worth mentioning that the change to an emission free energy future is also causing opportunity for transfer of power from the large energy mammoths of the past to the consumers.

With the implementation of energy management systems for households, combined with local production (typically solar panels) and storage capacity, each consumer can become a participant in a VPP, or virtual power plant. Once installed, the fuel cost of a solar power installations is limited - as we all know, "Die Sonne schickt keine Rechnung" ("The sun doesn't invoice you"). Using block chain solutions to ensure efficient settlement between the participants, the transaction costs for providing not only energy but also power capacity to the grid will fall significantly, creating new opportunities for millions of households all over Europe.

Such a development will also deliver a more robust energy infrastructure, replacing a limited number of very large, vulnerable single points of production with millions of small and medium sized participants in a large number of VPP´s. Where a hostile cyber attack today can cause havoc by attacking a surprisingly low number of critical objects and thus cause black out in large parts of continental Europe, a distributed future will make an attack with such an effect next to impossible. It would be like trying to knock out the entire internet.

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