Tuesday, November 10, 2009

Learning From The EU On Cap-And-Trade

By Amy Harder  

Henry Derwent

President and CEO of the International Emissions Trading Association

While Congress remains in gridlock over the best way to tackle climate change, the European Union is going into its fifth year capping and trading its emissions. Henry Derwent, who helped craft the EU's system and is now president and CEO of the nonprofit International Emissions Trading Association, says the lessons of the EU experience are clear enough that the U.S. should enact a cap-and-trade system of its own.

For instance, he argues, if the federal government doesn't act, both the Environmental Protection Agency and individual states will move forward with regulation. And, that Derwent said, will cause a monstrous headache balancing state and federal authority that's compounded by EPA regulation -- something no one seems to want. "If there is no action in Washington, then it seems probable that you will find essentially a fragmented position across the United States," Derwent told NationalJournal.com recently after a conference his organization hosted in Washington.

Edited excerpts from that interview follow.

NJ: Opponents of a U.S. cap-and-trade system talk about the EU system's initial struggles: It insufficiently reduced greenhouse gases, it conferred windfall profits on firms that got free allowances and it caused volatility in carbon prices. How do you think the U.S. could learn from those problems -- which have largely abated today -- when enacting its own system?

Derwent: The first three years were essentially an experimental system. They were experimental in ways which essentially allowed progress politically on the basis of, if you like, lowest common denominator agreement, rather than trying to get everything absolutely right according to the principles of the commission or any other experts.

Out of that came a number of rather important learnings, which are pretty obvious when you look back at them, but which of course had counterarguments at the time. Probably the most important of which and the simplest of which is that if you have more supply out there than you have demand, then the market is going to do what markets do and say in which case, these things are very cheap....

All the nations of the European Union at the time had their own schedules and their own rules and their own allocation methodologies and their own ideas about when they would issue information....

The important point about Phase II is that at least most of those disadvantages have been got right. And now some of the points you mentioned are really -- it's very, very hard to see the justification for continuing to make those points. Volatility, for example: Look at the actual recorded volatilities of the European Union unit of account. Compare it with even average baskets of stocks or commodities or whatever. It's really very difficult to look among the graphs and identify which is which.

NJ: What are the key lessons the EU learned from its cap-and-trade system that you could give to U.S. lawmakers?

Derwent: Acting as if this was a commodity or a unit of value and behaving in a manner consistent with what we've learned from markets right across the page, whether they're currency or commodity or whatever. Making sure that supply and demand -- the overall aggregate levels are understood sufficiently to be sure that there is likely to be liquidity and there is likely to be a fair balance. And learn that, actually, once you've avoided making those particularly silly mistakes -- with hindsight, anyway -- then actually the system does what it says on the packet, it actually produces emissions reduction.

NJ: Kerry-Boxer includes a soft price collar, and Waxman-Markey did not. Do you think climate change legislation should include a price collar?

Derwent: I think you need to be very, very careful about interfering with markets but still expecting them to produce what markets do. The issue here is about the discovery of the price of carbon. Carbon is a very novel commodity; we don't really know how much it costs to reduce it. We know what various people have done in various places, but the whole point of opening this up to the market is to allow the ingenuity of lots and lots of players to get a hold of this issue and try to find what actually is the most cost-effective way of doing something. So saying "I know actually better than the market where that price is and shouldn't be" is a dangerous thing to get into.

But let's be practical here. Obviously, if the politics is such that people's appetite for risk is bounded, then you're going to have to start talking about trying to knock off at least the extreme points of the spectrum of risk. From that perspective, I think something which is framed more along the lines of a strategic reserve -- something which is actually available to deal with volatility rather than something that simply says, "That is a price beyond which we could not under any circumstances allow this to go" -- is a better approach and more respectful of the principles we've got here.

NJ: Many critics of Waxman-Markey and Kerry-Boxer say that they don't oppose cap-and-trade generally, but the way these specific bills give out the emissions allowances, how they seem to pick winners and losers. Do you think it's possible that these skeptics could ever support cap-and-trade, if crafted differently from these two bills? Is there a way to craft a cap-and-trade system where no industry feels like a winner or a loser?

Derwent: In theory, there is a way of doing that, and that is to for governments to step away from the business of allocation reward protection or whatever, and simply say, "It's open season, we auction everything from day one."

NJ: That was President Obama's initial request.

Derwent: It is obvious that the economic advantages of that are absolutely patent. It is equally obvious that the political issues associated with that are very serious. And at the end of the day, if you want there to be an emissions cap-and-trade scheme, then you have to deal with real-world politics, and you have to deal with the real world of the different abilities of different affected companies to deal at all or to deal quickly with the massive change -- which for some of them is implicit in having to price and accept as a factor of production something that had never been priced before. Over time, everybody, the whole society, can -- indeed, must -- absorb this. But the speeds with which people can do that and the competitive disadvantage that might create is different from one company and one sector to another. So you have to get into this stuff. And it's a political decision, deciding who actually deserves more than the other parts of the economy.

NJ: Some critics concede that implementing a cap-and-trade legislation would be the lesser of two evils -- they don't want the EPA regulating greenhouse gas emissions through the Clean Air Act. What are your thoughts on this?

Derwent: EPA has already had its instructions; it's been made clear that this is a pollutant which falls within the ambit of legislation which binds them to do something already, so it's not surprising to see them moving. That obviously has the benefit of reminding people that there are alternative ways of doing this, and those ways are already in preparation and they may turn out to be much more expensive and much more unpleasant than the cap-and-trade option, which is available right now.

NJ: So you think EPA regulation is the wrong way to go?

Derwent: I think that a solution to greenhouse gas emissions reduction objectives which is a purely regulatory one -- without allowing the possibility of trading on something which, as I said before, is a novel commodity whose price we really don't know -- would be probably the wrong way to go, yes.