June/July 2008 - CER BULLETIN, ISSUE 60

Europe can afford to curb greenhouse gases
by Simon Tilford

In March 2007 the EU pledged to reduce greenhouse gas emissions by at least 20 per cent by 2020, from 1990 levels. But as EU governments and the Commission work on the policies needed to achieve this goal, opposition is mounting, particularly towards the Commission's proposals for reforming the EU's emissions trading scheme (ETS). Such special pleading needs to be treated with a heavy measure of scepticism.

The ETS works by setting a limit on annual emissions of carbon dioxide - the principal greenhouse gas - and then distributing emissions allowances to industry. The objective is to ensure that the prices of goods reflect the environmental costs of their production. For example, a car produced in a low emissions factory would cost less than one built in a high emissions one, because the owner of the latter factory would have to buy more emissions allowances. Consumers would opt for the cheaper car and all factories would have an incentive to lower emissions.

The industries currently included in the EU ETS - iron and steel, cement, glass and ceramics, pulp and paper as well as power generation and oil refineries - cover around half of the EU's emissions of carbon dioxide. The Commission proposes that these sectors should deliver two-thirds of the 20 per cent cut in emissions that the EU is committed to achieving by 2020. It therefore wants to place progressively lower limits on emissions from these industries, guaranteeing high carbon prices and hence strong incentives to reduce emissions.

Industries from cement-makers to paper manufacturers and oil refiners have denounced the proposals. They argue that such unilateral action by the EU will damage Europe's competitiveness while doing nothing for the environment. Industries will simply migrate to locations where energy prices and environmental standards are lower.

It is worth remembering that European countries do all kinds of things that, on the face of it, 'impair' their 'competitiveness'. For example, governments impose extensive pollution standards and rigorous health and safety rules. They also set comprehensive regulations governing working hours and wage rates, as well as all kinds of quality standards for consumers.

Few advocate that Europe's economic prospects would be improved by abolishing such regulations. Far from damaging Europe's competitiveness, most of them probably boost it by forcing firms to use the latest technology, and by encouraging them to use labour efficiently. European economies remain successful despite - or perhaps because of - these policies.

Measures aimed at curbing emissions of greenhouse gases should be seen in the same light. For all but a very small number of highly energy-intensive sectors (aluminium, cement and possibly steel) the price of carbon under the EU ETS will remain small, compared with variations in labour, energy and other input costs between EU and non-EU countries. Moreover, these industries account for a very small share of total economic activity, and the Commission has already raised the prospect of concessions to them, if they are able to prove that having to pay for allowances would force them to move production out of the EU.

In short, the EU can afford to take unilateral action. But it almost certainly will not have to. The so-called Lieberman-Warner bill, which calls for mandatory caps on US emissions and the establishment of a federal ETS, goes before the Senate in June 2008. If it fails to pass then, it will almost certainly gain approval following November's Congressional elections, which are virtually certain to see the Democrats increase their majorities in both houses of Congress.

All three remaining candidates for the US presidency are supporters of the Lieberman- Warner bill. Indeed, John McCain co-authored the McCain-Lieberman bill, a precursor to the bill now before the Senate. He has perhaps done more than any other US politician to advance the cause of climate change legislation in the US.

Europe's ETS could be linked to a federal US system. Such a link would allow companies covered by the EU system to purchase allowances from companies covered by the US programme and viceversa. That would make it cheaper for the ETS to meet its emissions targets and harder for industrial lobbies to argue for special treatment. Plenty of obstacles need to be overcome - not least differences in the stringency of the EU system and the proposed US one - but a link between the two would serve as the foundation of a global carbon market. Joint action by the EU and US would also make is easier to persuade big developing countries such as China and India to curb the growth of their emissions.

Simon Tilford is chief economist at the CER.