Some time back I had a discussion with a scientist who was a lead author on the latest report of the Intergovernmental Panel on Climate Change. Given his senior position in the IPCC I was amazed to find that he had a remarkably inaccurate view of how renewable energy (specifically bio-energy) would work in a carbon emissions market.

The problem was that he believed that an energy supplier who relies on fossil fuels would (and should) pay an amount (based on carbon emission savings per unit of energy produced) to an energy supplier who uses renewable fuels, such as bioenergy from agroforestry.

That is not the way that markets for emission permits actually work, and it is not the way they should work either.

If the market is working well, net emitters of carbon should pay an amount equal to the marginal environmental cost of that carbon times the amount emitted. Let’s assume that the cap on carbon emissions has been set at the “right” level, meaning that the market price of carbon emission permits would equal the marginal environmental cost of carbon emissions.

Now here is a stylised example to show how an emissions permit market would work. Suppose the price of carbon emission permits is $50 per tonne. There are two emitters, named Fossil and Forest.

At time = T₀ Forest grows some trees and instantly sequesters a tonne of carbon.

At time = T₁ (one year later), Forest chops down the trees, burns them to generate energy, and emits a tonne of carbon.

Also at time = T₁, Fossil generates some energy using fossil fuels and emits a tonne of carbon.

In an ideal market for carbon emission permits:

• Forest sells a permit at T₀, and gains $50.
• Forest has to buy a permit at T₁, at a cost of $50.
• At T₁, Forest would receive interest from its bank on the $50 that has been sitting there since T0. If interest rate is 5%, Forest gets $2.50.
• At T₁, Fossil has to buy a permit, at a cost of $50.

The net outcome of all this is that at T₁, Forest has gained $2.50, and Fossil has lost $50 (not counting any other costs or income). Thus, Fossil has been appropriately penalised for the carbon it has emitted, and Forest has been appropriately rewarded for the carbon that it briefly sequestered. Any other cross payments will mess this up. If one tonne of emissions was moved from the non-renewable to the renewable energy producer, the net gain would be $52.50.

(Note that the annual benefits to Forest equal the interest rate times the carbon price times the amount that remains sequestered during that year. If the carbon is sequestered for longer, the annual benefit remains the same. This relates to another misconception I’ve encountered among some people who promote sequestration, that the annual benefit per tonne of sequestration is the carbon price.)

Now consider what would happen if there was a cross payment (of $50 per tonne of carbon emitted) from the non-renewable energy producer to the renewable energy producer.

(a) If the cross payment occurs in addition to the above system, then we would end up with Fossil paying $100 for a tonne of emissions and Forest receiving $52.50. This is much too large a penalty to Fossil and too large a benefit to Forest. If one tonne of emissions is moved from the non-renewable to the renewable energy producer, the disparity is $152.50, which is about three times too big. It favours renewable energy relative to fossil fuel energy by too much. We would end up paying more than it was worth to cut carbon emissions.

(b) Maybe a cross payment could happen instead of the above. The result would be Fossil paying $50 and Forest receiving $50. This time the difference in net receipts is $100, which is almost double the correct amount for one tonne of carbon.

My scientist protagonist thought that the cross payment should be calculated on the basis of emissions per unit of energy produced. Notice, however, that in my explanation above, I did not talk about the quantities of energy produced by either Fossil or Forest, as they are completely irrelevant to the carbon market. Of course the amounts of energy generated per tonne of carbon are important to Fossil and Forest, but they are not relevant to the market for carbon emission. The overall relative attractiveness of fossil fuel energy versus renewable energy is a combination of the energy economics and the carbon economics.

All the above discussion is based on an ideal market for emission permits. In reality, the rules and regulations that are put into place may make it difficult, impossible or expensive for it to actually work this way. For example, the system may exclude sequestered carbon, or require it to be sequestered permanently, rather than temporarily as in the above example. In principle there is nothing wrong with allowing and rewarding temporary sequestration using the approach described above, but some people seem to think that if it’s not permanent, it’s not real. This is bad logic. On the other hand I suppose there may be better arguments around the transaction costs of rapidly turning over permits from brief sequestration. In any case, it doesn’t alter the conclusion that cross payments in the example above would be illogical and inefficient.

Unfortunately, despite a long discussion, I wasn’t able to convince the scientist that his view was in error, and when I followed up with a detailed explanation by email, he didn’t reply! Oh well. One can only try.

David Pannell, The University of Western Australia