Written for publication in May 2005.

Like all good theories, the theory of emissions trading is elegant. Governments establish an overall limit of the amount of a pollutant that can be emitted. Enterprises are then allocated permits to emit the pollutant up to that limit – known as the ‘cap’. Companies cannot emit the pollutant unless they have a permit to do so.

Those companies which reduce their pollution below the amount that they have been allocated may sell – ‘trade’ – the unused portion of their permit – called a ‘credit’ – to anyone who has been unable, or prefers not to, keep their pollution within the limits of their permit. In theory, this allows the landscape of opportunity to be explored in order to identify the least cost options for reducing the pollution to the desired level. Hence the common reference to this approach to pollution control as a ‘cap and trade’ system.

So much for the theory. In practise things are more complex. Governments may allocate permits on the basis of present emissions – ‘grandfathering’ or they may sell them to the highest bidder – ‘auctioning’. They can keep back a certain amount of permits to allow for new businesses. They can retire a certain number of permits from time to time in order to improve environmental quality. They can choose whether to allocate permits to every emitter or only to those of a certain size or in certain sectors of the economy.

All of these decisions will have considerable consequences for the economy and will determine the distribution of winners and losers amongst the emitters. They may also affect the environmental effectiveness of the policy. They are therefore highly political.

Since February 16th this year what was once a relatively obscure and rather arcane mechanism for pollution control has become the focus of a vast and growing volume of debate. On that date the Kyoto Protocol came into force. At the heart of the Kyoto Protocol is a global cap and trade system to control the emissions of greenhouse gases, in particular, carbon dioxide.

Underlying the Kyoto Protocol is a seductive rationale. The science of climate change is uncertain as are the costs of reducing greenhouse gas emissions. Furthermore, the issue is a truly global issue that can only be properly solved if everyone joins in. However, because carbon dioxide lingers for a long time in the atmosphere, the rich, industrialised countries are more responsible for its increasing concentration than are the poor, developing countries.

Therefore, the bargain that was struck was that the rich countries would act first by limiting their emissions and when they had done so the developing countries would join in. Hence the division of the signatories into two groups, the so-called Annex 1 countries who would make early commitments, and the Annex 2 countries that would join in later. Much has been subsequently made of the supposed ‘omission’ of the developing countries as a major flaw in the Kyoto Protocol. Actually, all of the industrialised nations, including Australia and the USA agreed to this approach from the beginning.

In order to encourage everyone to join in it was agreed to set the initial cap within relatively easy reach and to proceed in a series of stages, called ‘commitment periods’. This would allow for the cap to be tightened in stages as experience drove down the cost of compliance and as the science became more certain. In order to lower the cost of compliance and pave the way for future participation by the developing countries, three so-called ‘flexibility mechanisms’ were agreed – emissions trading, the Clean Development Mechanism and Joint Implementation.

Under the Protocol, the industrialised countries as a whole have agreed to reduce their greenhouse gas emissions to 5.2% below 1990 levels by the end of the first commitment period which runs from 2008 to 2012.  Each country has negotiated a specific target as their share of the burden of reaching this goal. Those countries that have ratified the Protocol are then entitled to join the international emissions trading system to buy carbon credits to fill any anticipated shortfall in meeting their target.

The theory is that the overall reduction will then be increased step by step until greenhouse gas emissions have been reduced to a level that avoids dangerous anthropogenic climate change – the goal that everyone agreed to when they signed the Framework Convention to which the Kyoto Protocol is an annex. As the permitted level of emissions is reduced the price of credits increases thus encouraging investment in low carbon technologies.

Now come the politics. There are two major practical flaws with this theoretically very elegant approach. First, getting agreement to a relatively small reduction in emissions was extremely difficult and there are still considerable doubts as to whether the industrialised countries will in fact meet their commitments. Furthermore, two major emitters, Australia and the USA, have jumped ship and refused to ratify the Protocol. There is currently no political appetite among the industrialised nations to begin negotiations on a second commitment period which will impose even stricter limits on emissions. Nor is there yet any evidence that the developing countries are willing to meet their side of the original bargain and join in once the rich countries had begun to act.

The second flaw is even more serious. We do not have enough time for the Protocol to work. The future of the climate is determined by two ticking clocks. The first is the rate at which carbon dioxide is accumulating in the atmosphere, currently about 1.8ppm/year. The second is the rate at which the world is building conventional coal fired power stations, currently about 5GW a month.

There is rough agreement around the world that a greater temperature increase than 2.00C by 2100 would be dangerous. One of the messages now emerging from climate scientists is that there is only a low probability of keeping below this temperature increase if the concentration of carbon dioxide in the atmosphere exceeds 400ppm. Today, the concentration is at 379ppm. At 1.8 ppm/year we will pass this threshold in about 12 years. Emissions trading may well be a necessary measure for tackling climate change, but it is a long way from being sufficient.

This makes it vital that the G8 leaders meeting in Gleneagles in July add considerable political momentum to current response to climate change. In particular, we must change the technology trajectory of currently planned investment in 1,400 new coal fired power stations over the next 25 years. If these are built with conventional technology there is no hope of the world maintaining a safe climate.

If they are built with using advanced coal technologies with carbon capture and storage then we still have some prospect of stabilising carbon dioxide concentrations at safe levels. But this will require a willingness to spend public money to change that trajectory. Some 600 of the planned power stations will be built in China. At Gleneagles the EU must give a clear signal that it is willing to work with China to deploy advanced coal technologies rapidly. Trading will not be enough, we must also invest.