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Reducing CO2 Emission by 25% is Feasible (Part 2)

“International Cap and Trade is the Key”

Risaburo Nezu
Executive Fellow, Economic Research Center

February 26, 2010 (Friday)

All developed countries introduce emission trading

Emission trading is called “cap and trade.” Under this system, CO2 emitters either receive a quota or purchase emission credit in advance, and are allowed to emit within these parameters. Surpluses can be sold on the market; shortages can be covered by buying extra credit. Conservative use therefore translates into money, creating an incentive for energy-saving. Meanwhile, energy inefficient companies will shoulder higher costs and will be forced out of the market. If adopted throughout a country, this scheme would create an even playing field as all parties could purchase emission credits through the market for the same price. The price of emission credit is the marginal cost of reducing one unit of emission in the country concerned. Buying and selling will stabilize the price of credits regardless of differences among industries or companies, and will minimize total reduction costs. Reducing the total amount of emission credits issued will provide a reliable measure to combat global warming—such is the theoretical basis behind emission credits.

Though cap and trade remains an unfamiliar concept in Japan, such trading schemes began appearing in the EU in 2005. The US succeeded in reducing lead and sulfur dioxide in the atmosphere by adopting this method in the 1990s. Though the Bush Administration derailed plans for cap and trade by withdrawing from the Kyoto Protocol, the Obama Administration is keeping its campaign promise and currently has a cap and trade bill on the table in Congress. California and 22 other US states are set to implement cap and trade; Canada and Australia are also expected to pass bills in the near future. Discussion seems imminent in Japan, where the Democratic Party of Japan’s manifesto states it will “establish an effective domestic emission trading market from the cap and trade system.” In sum, cap and trade is already underway or expected in the near future in all developed countries. What is important for Japan is that the cap and trade markets in these countries are integrated so that companies can freely buy and sell emission credits across borders. This would allow Japanese companies to obtain credits at the same price as other companies in developed countries and avoid being put at a competitive disadvantage.

Overwhelmingly cheap emission credits from overseas

The dominant view among the industrial community is that Japan has already spent vast sums of money improving energy efficiency and it is therefore unfair to demand reductions at the same level as countries with no such history. Criticism of the government’s 25% reduction target also remains strong among these circles. Such criticism, however, should be accompanied by aggressive support for international emission trading. Quickly establishing cap and trade in Japan and linking it with markets in other countries would allow free trading of emission credits across borders, and would set a consistent emission credit price. Japan would benefit the most in this scenario. This is because countries with poor energy-saving records have room to improve energy efficiency at a low cost, so instead of exhausting credits they would be better off reducing emissions cheaply and selling the surplus credits at a high international price. Japan could purchase credits at a price far below the cost of reducing domestic emissions, creating a mutually-beneficial situation. An international cap and trade market has already been proposed by the EU as well as several states and provinces in the US and Canada. The EU has called for a study of an OECD-wide cap and trade system by 2015. The bill under deliberation in the US, however, is only for domestic trading and denies entry of overseas businesses. This is likely because allowing such entry would drive up emission credit prices and put US businesses at a disadvantage.

Dramatic decrease in Japan’s marginal reduction costs

We now look at this from a numerical perspective. Fujitsu Research Institute calculates that efforts by Japan to reduce 25% by itself would cost US$270 per ton of CO2. Like further wringing an already dry cloth, this is unfair. The Research Institute for Innovative Technology for the Earth (RITE) calculates the cost at US$476 per ton based on different assumptions. Meanwhile, 30% reduction would cost the EU $135 and the US $60 per ton, far cheaper levels than in Japan. This is the basis for cries of unfairness. However, linking these cap and trade markets and allowing Japanese companies to buy credit from the US market would establish an equilibrium price somewhere in the middle. Considering Japan emits only 4% of total global emissions, the equilibrium price should settle much closer to levels in the EU and US, likely in the $100-$150 range. Japan’s industrial community should have no complaints if Japanese companies could obtain emission credits under the same conditions as overseas companies. Of course, the price would drop further if developing countries participated: a private think tank and international institution calculated the price in this scenario at $10-$20.

This means that Japan’s so-called “real reductions” would be significantly less than 25%. We calculate Japan’s domestic reductions at around 4% under a global cap and trade scheme. Agreement was reached (including the industrial community) on “8% real reduction” under former Prime Minister Aso, but the actual percentage will likely be lower. Of course emission credits must be purchased from overseas, but the cost would be extremely cheap at about 120 billion yen per year. Government experts are analyzing how much to reduce domestically and how much to rely on buying from overseas, but this has little meaning. The Japanese government should leave this to the market and show that it is uninvolved. This would not only reassure other countries, but also prevent the Japanese government from making statements that would affect the market such as how much it will buy from overseas.

Outflow of national wealth is a mistaken theory

The reality is Japan’s industrial community opposes cap and trade. Its first argument is that payment to other countries to obtain emission credits is a loss of national wealth. This uniquely Japanese viewpoint likely stems from a resistance to paying for something that cannot be seen, and reflects a shallow understanding of the essence of the environmental problem. The environment has become a precious resource and it goes without saying that a cost should be paid to use it, the same as paying to buy crude oil and grains from overseas. In reality, no one believes that Japan can achieve 25% reduction through domestic measures; the industrial community likely understands that buying emission credits is unavoidable. Persistently opposing cap and trade on ideological grounds is therefore meaningless. Of course, there is nothing requiring Japan to buy from abroad if it isn’t comfortable doing so.

Japan’s industrial community’s aversion to the market mechanism

The second argument follows that cap and trade will be exposed to speculative price swings and money games, and will simply be taken advantage of by US and European hedge funds. Some go as far to claim it is a conspiracy of western financial capital. This is also a uniquely Japanese notion. In reality, companies operate under a system where most raw materials such as crude oil, grain, and nonferrous metals are traded on the market with daily price fluctuations. There is no reason to fix the price of emission credits in an age when even currency exchange rates fluctuate daily. Existing European markets see daily price changes, but the range of fluctuation is 15-30 euros per ton, comparable to swings in crude oil prices. Yet, you don’t hear complaints that such swings make it difficult to conduct crude oil business, or that speculative money has reaped huge profits. If it were that easy, Japan should take advantage of emission trading markets in Asia.

As a former head of the steel division at METI, I understand well the industrial community’s emotional resistance to cap and trade. Executives of steel and power companies have an inherent aversion to the market mechanism, thinking that “steel and electricity must be provided stably over the long-term as foundations of the economy, and cannot be left to unstable markets.” In fact, a custom for leading sellers and buyers to meet once a year to negotiate the yearly price of coal, iron-ore, and other raw materials is maintained to this day. Even regarding products, major users such as automobile and shipbuilding companies set prices through similar processes. Many top executives at electricity and steel companies have risen to power through this kind of negotiation. The pervading opinion in these circles is that pricing of such important goods cannot be left to the market.

Yet, times are changing. Suppliers of steel raw materials in Australia and Brazil have begun to assert that the market should decide pricing, not secretive negotiation between top suppliers and users. Moreover, it is clear that China will replace Japan as the pricing authority in the future; the curtain is falling on the era of Japanese domination in the global raw materials market. The general perception regarding cap and trade should also begin to change.

Will technological innovation be delayed?

The third argument is that cap and trade will slow technological innovation, an assertion that is half correct. Emission trading and environmental tax promote energy-saving and new energy development by placing costs on emission, and in doing so encourage technological innovation in these fields. By focusing on reducing emission as cheaply as possible, however, these systems render extravagantly expensive technology irrelevant. Japan gives little thought to the economics of developing technologies related to energy, a tendency that is incompatible with cap and trade frameworks. Citing high costs as a reason for opposing the 25% reduction goal cite is therefore inconsistent.

“Carbon leakage” concerns

The fourth and most compelling argument against cap and trade is that it will create an uneven playing field with companies from China and other emerging countries especially in steel and other energy-intensive industries. China is now the greatest steel producer in the world and is followed by countries such as India and Brazil. These countries will likely not participate in international frameworks because of their status as developing countries. With no chance to compete, companies in developed countries will be forced to move factories to unregulated emerging countries and slash thousands if not tens of thousands of jobs. And the sources of CO2 emission are simply transferred with no signs of real global reduction. This problem is known as “carbon leakage.” In light of this problem, until now the EU has allocated free emission credits to energy-intensive industries based on past performance. The plan is to gradually increase the auction ratio until all credits are auctioned in 2027, representing a complete transfer to the market mechanism. However, for some time free credits will be allocated to the steel industry only as an unavoidable measure to ensure a level global playing field. US Congress is currently deliberating a bill that would temporarily allocate free emission credits to electricity and steel industries and eventually shift to an auction system. Switching to an auction system would place the financial burden of buying emission credits on the industrial community, putting it at a competitive disadvantage with burden-free industries in developing countries.

A level playing field is essential

This represents a serious problem for steel, cement, paper pulp, and other energy-intensive industries facing international competition. Production of 1 ton of steel currently emits 1.5 tons of CO2, so a credit price of US$50 (the current price on the European market is 13 euros) would raise the cost to about 7,000 yen. The current price of common steel is around 70,000 yen; this translates into a 10% disparity with countries without cap and trade or environmental tax measures.

The exact impact of this 10% difference is unclear, but it can be expected to be severe as steel is a basic materials industry in which differentiation is difficult. Company efforts alone would be insufficient to overcome this problem; enterprises would be forced to transfer factories to countries with lax environmental regulations, leading to unemployment and other serious issues. The Corus Group, a British steel company, recently closed its factory and moved to India. It laid off employees and also tried to sell the free emission credits it had received for a profit, inciting opposition to cap and trade on the grounds of potential for abuse.

To address these problems, developed countries should cooperate and introduce a tax framework for adjusting for the difference in imports from countries without appropriate global warming countermeasures. The bill currently on the table in the US Congress includes such a provision. The EU will likely jump on board if the response is concerted among developed countries; the WTO must first review such a framework, but theoretically it should find no problems.