The primary purpose of this meeting is to make progress on what will be the successor to the Kyoto Protocol.

The Kyoto Protocol was adopted in 1997, and was the international agreement under which 37 industrialized nations committed to reduce their greenhouse gas emissions to and average value between 2008 and 2012 of 5.2% below 1990 levels. It allowed for many different flexible mechanisms for industrialized countries to achieve these targets such as emissions trading as we see in the EU, or the Clean Development Mechanism (CDM) or Joint Implementation (JI) which allowed them to make greenhouse gas reduction investment in developing countries.

Canada committed to reducing our greenhouse gas emissions to 6% below 1990, although we have failed to live up to that target with our countries emissions instead spiralling to 22% above 1990 levels in 2006.

There were many criticisms of the original Kyoto Protocol, many of which were fully justified. These included:

• Lack of greenhouse gas reduction commitments for developing countries (such as India and China)
• Failure to include emissions from airplanes, ships and deforestation among others
• The ease with which free-riders obtained CDM or JI credits (projects which received funding for reducing greenhouse gas emissions that would have gone ahead without the funding)

However, the criticism of these issues often overshadows the importance of the Kyoto Protocol. It represented the first major international collaborative attempt to reduce global greenhouse gas emissions. The task of solving climate change is a gargantuan one, and one that we will not be able to solve instantaneously. It is going to be a step-by-step process. Kyoto was the first step. Hopefully, this conference in Poland is going to be another step.

In 2012, the Kyoto Protocol comes to an end, and we need another international agreement in place to succeed it. Ideally, we can address many of the problems that Kyoto had, but probably not all of them. In order to have something in place for 2013, the international community will need to have finalized discussions by the end of next year so that individual governments can start planning.

Let’s keep the pressure on our governments to keep working hard towards a solution.

Today’s post is looking at what I am calling ‘Green Obligations’. Instead of applying a cost to negative behaviour, we put a premium, or a requirement, on clean behaviour.

In this context, the term ‘Green Obligation’ refers to a minimum level of a product that must be done in some pre-defined green, and sustainable way. The government specifies a steadily increasing target that industry must reach in order to be allowed to continue to operate without being slapped with a hefty penalty. We’ve got examples of this running already in Canada. In Ontario, fuel suppliers were obligated to supply fuel with a minimum content of 5% ethanol by 2007.

A much bigger scheme operating outside this country would be the Renewables Obligation operating in the UK. Under this program, anyone selling electricity must ensure that a minimum amount of the electricity that they sell comes from renewable sources. Currently, this is set at 9.1%, rising to 15.4% by 2016. Suppliers who fail to meet their obligation must make a penalty payment, that is then shared amongst the suppliers in proportion to the amount of renewable electricity that they generated. This incetivizes generators to meet, and even exceed the obligation level.

Related to a minimum obligation is the idea of a feed-in tariff. Under this system, a supplier is guaranteed a minimum level of payment for producing a product with fewer emissions than the traditional method. This minimum level of payment is set at a level above the normal market price of the product in order to encourage its growth, and offset the cost of the more expensive method of production.

The most well known example of this is in Germany. There, electricity suppliers must purchase renewable energy supplied to the grid by anyone in the country at a fixed price. The rate varies from a low of €0.03/kWh for large scale hydro power, to €0.54/kWh for domestic scale solar power. Each year the minimum amount payable reduces in order to incentivise continued improvement. Some of these rates are substantially above the cost of generating electricity from coal, which makes everyone’s electricity bill slightly more expensive, but that is essential in order to develop these emerging technologies. In 2007, renewables in Germany provided 14.2% of the countries electricity, double what it was in 2002, at an additional cost of about €4bn per year (about $75 per person per year). It’s worth pointing out though that approximately 230,000 people were employed in the renewables sector in 2006 in Germany, and it has become a global leader and exporter of renewable technologies.

There are two major benefits of obligations or feed-in tariffs. The first is that it guarantees suppliers that there will be a defined market or level of financial return for their product. The second is that is forces investment into technologies that might otherwise be ignored, bringing the costs down.

The disadvantage is that by choosing specific technologies, we may not be choosing the most cost effective solution to reduce carbon dioxide emissions. The incentive of a feed-in tariff, or the requirement of an obligation on a less effective technology can lead to under-investment in a more effective parallel technology.

Instead of charging a fixed tax for each tonne of carbon dioxide emitted, the government sets a limit on annual emissions for the country (called the ‘cap’). These limits are then allocated to polluters, giving them a right to emit a certain amount of carbon dioxide for the year. Let’s imagine these allocations as certificates, each one allowing the owner to emit a tonne of carbon dioxide

If the polluter has the right number of certificates to cover the amount of carbon dioxide that he emits during the year, then life is simple. At the end of the year, he submits one certificate to the government for every tonne of carbon dioxide that he emitted.

However, if the polluter doesn’t have enough certificates to cover the amount of carbon dioxide that he emits, then he needs to buy more to ensure that he complies with government regulations.

But where can he buy them? We can’t create new ones, otherwise the number of certificates would be larger than the carbon dioxide we set earlier.

Fortunately, some polluters will have more certificates than they need, and they are free to sell them to the highest bidder (the ‘trade’ part of the system). It works on a very simple supply and demand principle If there are a lot of extra certificates available, then the price of these traded certificates is low. If there aren’t many available, then the price goes up. Each year, the number of certificates are reduced in line with emission targets. Polluters are faced with an ever decreasing supply of certificates, and thus an increasing price of buying the additional ones that they need to continue business as usual.

So how does this result in emissions being cut?

Well, there are many technologies or options available to industry to reduce emissions, from changing energy sources, to increasing efficiency, to capturing and storing the carbon dioxide. Right now, the cost of these carbon reduction technologies is prohibitively expensive, but as the cost of buying all of these additional certificates gets higher and higher, they begin become economically viable.

For example, a power generation company has a coal fired power plant. It’s always been cheap to run, because coal is cheap, and no-one has been charging them for the huge amount of carbon dioxide they emit every year. This is the ‘Business As Usual’ scenario shown in the chart below.

A cap and trade system is put in place, and in the first phase they are only allowed to emit 90% of the carbon dioxide they did in the previous year. It’s a small reduction, and they have two options; continue to operate as normal and and pay the small price associated with buying additional certificates (P1 – Purchase), or to reduce their emissions (P1 – Reduce). At their disposal is a technology known as carbon capture and storage, where the carbon dioxide is capture from the chimney and permanently stored underground. As you can see, at this stage, it is much cheaper for the power station owner to buy certificates, essentially paying someone else to reduce their emissions on his behalf.

Over the next few years, they receive fewer and fewer certificates until one year they are only allowed to emit 75% of the amount of carbon dioxide that they could in the first year. Again, the same two options are available (P2 – Purchase and P2 – Reduce), but the most preferable option has changed. This time, the additional cost of carbon capture and storage is much cheaper than having to buy the additional certificates. The main reason for this is that they have managed to reduce his emissions far below the amount that was required, meaning that they are now able to sell their excess certificates.

At a certain carbon dioxide certificate price, options like these make economic sense. For different technologies, and different industries, it happens at different certificate prices. The beauty of it is that in a highly efficient market such as Canada, the price of a certificate should be more or less equal to the cheapest way possible to meet the annual emission target. If someone can reduce their emissions for less, it is better to pay them to do it rather than waste money doing it yourself. We have incentivized the market to find the cheapest possible solution to climate change.

The overriding advantage of a cap and trade system is that, assuming there is a large enough penalty for breaking the rules, it guarantees emission reductions. The cost of buying an additional certificate will just keep rising until someone cuts their emissions. And since no-one has an unlimited supply of money to spend on certificates, at some point that becomes their only choice. It focuses directly on the problem by setting a maximum amount of carbon dioxide that we want to emit, as opposed to the indirect method of trying to specify an appropriate level of carbon tax to reduce emissions to the required level.

The downside is that it is a very complex system. Because of this it would take a number of years to implement. A large amount of administration would be needed to regulate the trading of these certificates, and because of the complexity associated with buying and selling certificates, it can really only be applied to large industrial emitters which make up only about 50% of Canada’s annual emissions. Also, due to the fact that cost of a certificate is not fixed, there is a certain element of uncertainty about what the price might be in 5 or 10 years time. For large industries, spending large amounts of money on projects that may well be operational for 25-50 years, this uncertainty can be a source of great frustration.

Emissions trading has been proven before, as it has been in use since 1990 in the United States in order to try and reduce sulphur dioxide emissions (responsible for acid raid) by 10 million tonnes from 1980 levels.. The most widely known example of a carbon dioxide cap and trade system is the European Union Emissions Trading Scheme. It has been running since 2005, and has had its fair share of teething problems. In the first phase, far too many certificates were handed out, meaning that virtually no-one needed to buy them, and those that did had an enormous number available to sell. The result was that the cost of a certificate dropped to about $0.01 per tonne of carbon dioxide. Lessons have been learned, and the second phase is proving to be much more successful, with the price currently trading at about $36 per tonne.

Years ago, Arthur Pigou, proposed taxing actions that had a negative effect on society to accurately reflect the cost to society. Cigarette and alcohol taxes are useful examples of ‘Pigovian taxes’, as the base price of these products do not take into account the negative effects of smoking or drinking, which take the form of a lower level of health for the general population and thus increased costs for healthcare.

The rapid rise in man-made carbon dioxide emissions can be can be looked at as a market failure. Unlike, solid waste, or liquid discharges, greenhouse gas emissions in Canada have never had a financial cost associated with them. Disposing of solid waste incurs waste removal and dumping fees, while liquid discharges usually require extensive, anf often expensive, treatment before they can be released. Meanwhile, greenhouse gas emissions have been enjoying a free ride, silenty and steadily increasing the amount of carbon dioxide in our atmosphere. The result of this has been that the cost of an activity (e.g. driving) did not truly reflect the cost to our society. For example, a typical car running for 15,000km a year will emit more than 2 tonnes of carbon dioxide into the air, ultimately causing problems and costs to be incurred by future generations through global warming.

Most economists would argue that if we are going to have any chance of reducing the amount of carbon dioxide that we emit to the atmosphere, then we have to impose some sort of cost on emitting carbon dioxide. A carbon tax is one possible way of doing this.

Polluters of carbon dioxide would see an instant cost associated with their actions. As the tax increases, the cost to the polluter increases to the point where they will save money by investing in carbon reducing technologies. It’s a classic application of the Polluter Pays Principle. Carbon taxes are not a new idea, having been in use in Sweden since 1991. More recently, British Columbia introduced a tax of $10 per tonne of CO2 that became effective on July 1st, 2008. This BC tax will rise at $5 per year until it reaches $30 per tonne in 2012.

The cost of paying these taxes or implementing carbon reduction technologies will ultimately be passed through to the final user; that is average Canadians. Opponents of carbon taxes love to make a lot of noise about how Canadians don’t need to be taxed more, especially through one that would be hidden and disguised in the price we pay for goods and services. And this is true, we don’t. But a carbon tax doesn’t mean we have to be taxed more. We can design it to be revenue neutral.

Governments would have a new source of revenue from carbon dioxide polluters, and could use this extra income to reduce income taxes, as well as those on our investments. We would have more disposable income to spend, which would need to be spent on rising prices associated with the carbon tax, especially on our energy bills. However, we live in a free market and this gives us two unique opportunities.

Firstly, we could change our behaviour, and secondly, we are free to choose who we purchase our goods and services from. Those companies that are more efficient at reducing their carbon emissions will have fewer costs that they need to pass through to the final consumer, and purchasing those products or services over their less efficient competitors will represent a net cost saving to us.

Let’s use driving as an example. We have two driver’s, A and B. Both drivers earn the same amount of money and pay the same amount of tax. Before the introduction of the carbon tax, they both spend $1,000 a year on gas, and buy their gas from the same gas station. A carbon tax is introduced, causing the price of gas to go from $1 a litre to $1.25 a litre at their local pumps. The government gives everybody a $200 tax rebate to cover the cost of this increase.

Driver A doesn’t change his habits. He now spends an extra $250 a year on gas, slightly more than the $200 rebate he was given.

Driver B does change. She bikes to work one day a week, and uses 20% less gas. Because of the price rise, she actually spends the exact same amount on gas as he did before, but has been given $200 by the government to pay for it, which she can now put in the bank. On top of that, Driver B notices that a competing gas supplier has been able to reduce its carbon dioxide emissions more efficiently than his normal one, and that their gas has only gone up to $1.15 a litre. By changing her behaviour and rewarding companies who reduce carbon dioxide emissions effectively, Driver B can save over $300. She is also likely to consider buying a more fuel efficient vehicle when next purchasing one, saving her even more money.

Carbon taxes don’t have to increase the overall tax burden on a country, they just represent a 21st century shift in taxation to punish negative behaviour, and reward positive changes in peoples behaviour. Ensuring revenue neutrality requires that we have independent auditing of the system, a task well suited for the Auditor General.

The advantages of a carbon tax system is that is easy to introduce, and simple to enforce. It can be applied at all levels of our society, from large industrial emitters to individual Canadians. A forward plan for increasing the carbon tax gives individuals and businesses some element of cost certainty, enabling them to take this into account when making longer term purchases (e.g. truck vs. electric car).

The downside is that a carbon tax does not guarantee a reduction in emissions. The polluter still has the right to continue to emit carbon dioxide, albeit at a cost. A carbon tax has no legal requirement to reduce carbon dioxide emissions, only an economic reason to do so.

The ideal result of a carbon tax, is that we reduce the amount of carbon we emit. And if we don’t, then it raises additional revenue for the government to pay the inevitable costs of global warming. Emitting carbon dioxide isn’t free; we just haven’t been paying the bill.