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Carbon Policy That Works

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By Sebastian Mallaby
Monday, July 23, 2007

Politicians have stopped denying climate change. Some even want to do something about it. But before reformers propose a grand plan that can't work, they should consider the story of Tecnosol, a small company in Nicaragua.

Half of Nicaragua has no access to electricity. Women and children spend hours collecting firewood; the people suffer respiratory diseases from the wood smoke; they spend what little money they can spare on kerosene. Tecnosol replaces wood and kerosene with solar power; it is partway through an effort to install 25,000 solar units, cutting carbon dioxide emissions by 150,000 tons over the life of the equipment. But the villagers involved in Tecnosol's project are being cheated. They are not getting paid for reducing emissions, even though solar conversions are good for the climate, good for health and good for poverty reduction.

This is more than a little ironic, since the cap-and-trade system developed under the Kyoto Protocol is supposed to promote development.

The system arose out of the tension between economists' belief in the efficiency of trading -- if it costs a producer $15 to cut carbon emissions by a ton, it makes sense for that producer to pay $8 to another producer who can achieve the same reduction for $5 -- and moralists' suspicion that trading lets rich polluters off the hook. The compromise was a "Clean Development Mechanism": Trading would be allowed, but it was supposed to promote development.

The Kyoto system represents the culmination of a huge global diplomatic effort, and the United States was wrong to turn its back on it.

Nevertheless, the system has not lived up to its promise. Nearly all the trading under the Kyoto mechanism involves comparatively rich developing countries such as China and projects that generally don't benefit the poor, such as capturing greenhouse gases created as byproducts in industrial processes. Almost no money goes to the least developed countries or to poor people. The reasons are partly understandable: It's easier to trade bulky industrial offsets than to collect small tokens of progress from dozens of remote villages. But even with that caveat, the Kyoto mechanism works badly.

The mechanism's clunky procedures are supposed to prevent fraud, but in practice they filter out village-based projects while not preventing fraud in big ones. As Stanford's Michael Wara has demonstrated in a devastating paper, the mechanism appears to encourage industrial producers to emit extra greenhouse gases so they can capture them and pocket extra subsidies. Chinese emitters make such extraordinary profits from this system that the government has imposed a 65 percent tax on the windfall. In effect, the green budgets of the rich world subsidize the Chinese government.

A voluntary market has sprung up to compensate for Kyoto's shortcomings. It brings together sellers who want to avoid red tape and purchasers who are free to do so because they come from countries, including the United States, that haven't signed up for the mandatory cap-and-trade regime. The voluntary market has become big business: Last year about $1 billion worth of offsets was traded. So long as this parallel market thrives, someone will figure out a way of selling Nicaraguan carbon offsets to a voluntary purchaser.

There are two snags, however. Inevitably, some voluntary carbon permits have proved fraudulent. They represent carbon reductions that have not actually happened or reductions that have been marketed as offsets to multiple purchasers. As a result, the voluntary market is periodically attacked, and would-be purchasers shy away. Voluntary purchasers buy carbon offsets to be pure. Impure scams defeat their objective.

The boosters of the unofficial market are regrouping. Last month an international coalition of banks promulgated new voluntary standards that would prevent scams while avoiding the red tape of the Kyoto system. But even if the banks can restore confidence to voluntary buyers, a second worry looms. If U.S. lawmakers mandate cap-and-trade, many of today's leading voluntary buyers will be forced into the compulsory part of the carbon market. Companies such as DuPont, American Electric Power and BP have bought peace from environmental critics by offsetting their expansion plans. In the future, they may have to buy offsets that are sanctioned by the government -- which could exclude village-based projects.

Hence the warning to Congress. It would be great if carbon policy could get out of its timid rut: energy bills that raise fuel-efficiency standards, subsidize windmills and so on. It would be great if Congress could get serious about reducing emissions across the whole economy, either by taxing carbon or by capping it. But if Congress creates a mandatory cap-and-trade system that mimics Kyoto's clunkiness, it will funnel billions to Chinese industrialists, creating perverse incentives for greater emissions. And Nicaraguan villagers will be cheated.

smallaby@cfr.org


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