One of the most intensively discussed subjects in the economics of climate change is the question of what is the best way of pricing carbon. The most common (and the only one that has been implemented so far) proposal is cap and trade. The idea is simple: constrain the amount of emissions permitted and let market agents decide whether they want to buy permissions or invest in technologies causing less emissions instead.
There are already a few emissions trading (i.e., cap and trade) schemes in some developed countries, but the most significant (because by far the biggest) is the ETS of the European Union. It is controversial but, as Denny Ellerman from the MIT shows, it has been rather successful and provides good examples. Ellerman names three of them that are central:
First, the system works. The ETS has achieved its objective of reducing emissions by the required amount at least cost. Emissions have been reliably estimated to be 3-5% lower in the ETS’s first three years, owing to the carbon price. This is a modest amount, but the initial ambition was also modest. […]
The second lesson is that the side-effects of the ETS are few. The expectations of extremists among advocates and opponents of carbon pricing have been disappointed in equal measure. The former expected transformational technological and social change, while the latter darkly predicted weakened competitiveness and job losses, even recession. […]
The third broad lesson from the ETS is that multinational emissions-trading regimes can be constructed. A little-noted feature of the ETS is that it is more akin to 27 linked national cap-and-trade systems than to one big centrally administered system.
I would add the notion that Clean Development Mechanism, controversial as it is, proved to be able to achieve a real impact and helped to promote technological transfer to the developing world.
Thus, we have a good paradigm to build on. There are two challenges now – one is central for the ETS itself, the other is of global importance.
The first challenge is to include all industry branches in the scheme. Only then it is going to be really effective. The first step is already done (although with delay) – aviation is going to be included by 2012. Furthermore, the scheme has to be more rigorous, e.g. by contracting the amount of permissions traded even faster than it is planned.
The second challenge is to implement a global cap and trade scheme. Or, to use Mr Ellerman’s formulation, a system of interlinked national trade schemes – including industrialized countries as well as the developing world. Actually, this should be the overarching goal of the Cancún Summit.