How good climate policy goes awry

THERE's good news and bad news in humanity's struggle against climate change. What's good is that we have an excellent instrument against global warming that we can extend and improve: a market-friendly carbon price. What's bad is that we seem bent on gumming it up with other policies that are faddish but misguided, and amount to a new form of central planning.

Let's start with the good news. The price of carbon allowances being traded in the European Union's emissions trading system (ETS), which is by far the world's largest, has been soaring and now hovers around 50 euros ($61) per metric tonne of carbon-dioxide equivalent. The reason is high demand from industrial polluters as well as hedge funds and banks that speculate in these permits.

This carbon price must eventually go much higher yet. And it will, as regulators gradually reduce the overall quantity of emissions allowed, thus making the permits scarcer and dearer. That's how cap-and-trade works. After years of an allowance glut, we're now finally approaching prices that give polluters the right incentives to cut down on emissions by investing in green technologies.

Better yet, the EU, as part of its quest to become carbon neutral by 2050, will expand this emissions trading system. Right now, sectors such as power utilities or steelmakers are included but suppliers of energy to heat buildings or move cars aren't. In all, the ETS currently covers industries accounting for only 45 per cent of the bloc's emissions. The goal should be 100 per cent, and I'm optimistic that we'll reach it.

Even better, Europe's ETS is now inspiring emulators all over the world. China, the world's biggest polluter, launched its emissions trading system in February. It's half-baked and needs to be tweaked, but Beijing is going in the right direction. South Korea already has a cap-and-trade system. Indonesia, Vietnam, Thailand, the Philippines and Japan are getting ready to launch theirs.

The ultimate goal is establishing a global carbon price. One way to achieve that is to link cap-and-trade systems, such as the EU's and the UK's. And to encourage the slouches (Australia, say) to participate, we should form international "carbon clubs," as I've previously argued. Countries with an emissions price in their domestic markets would trade freely with one another; all others would pay a carbon surcharge when exporting to the clubs.

It's hard to overstate the virtues of using a simple price mechanism to send signals that percolate through entire economies, in all their unfathomable complexity. The efficiency comes through decentralisation: It's not politicians and regulators (that is, central planners) allocating resources. Instead, it's producers, consumers and investors who are freely deciding how to adjust to the carbon price.

In a well-functioning market, if the price of carbon rises at the front end of an activity, its cost will also go up at the other end, and people will do less of it. If you make producers of kerosene pay more for its carbon content, airfare gets more expensive, causing people to fly less and operators to explore greener hydrogen fuels.

The tradability of emission permits also means that pollution will be reduced fastest wherever it's easiest and cheapest to do so. Imagine two emitters: Company A sees a way to adopt a greener technology this year, but B needs more time. A can sell its unneeded permits to B, thus profiting from its investment immediately.

Now for the bad news. For a price signal to work, markets must work freely. And yet, governments keep interfering, thereby distorting the incentives to all actors in the economy. Unwittingly, they end up neutering the price mechanism.

Clemens Fuest of the Ifo Institute, a think tank in Munich, gives the example of rent controls. A rising carbon price should make house owners invest in better insulation or modern heating systems. But in rented apartments, it's the landlords who'd put up the capital and tenants who'd benefit from lower heating costs. If rent controls prevent the landlords from recouping their outlays, the investments therefore won't happen. Governments can still help tenants — or other groups of people who'd suffer disproportionately from carbon adjustment, such as those with long commutes. But they should do it in ways that don't compromise the market mechanism — ideally, by directly and transparently paying people cash.

Increasingly, policymakers are also making another mistake: They're imposing direct limits or prohibitions — banning a type of engine, for example, or slapping an emissions cap on a specific fleet of taxis, ships or airplanes. In effect, this amounts to central planners allocating resources again, as opposed to market participants.

The worst market to distort is the one for capital. If the carbon price is allowed to work, investors will fund those technologies that cut emissions and shun those that don't. But governments and central banks increasingly appear not to trust that process.

The EU, for example, is now erecting a complex and bureaucratic "taxonomy" to decide which activities to call green. Companies snagging these labels could then issue bonds that central bankers give their special blessing. Banks could be allowed to set less capital against loans deemed "green."

This is a great way, first, to seed the next financial crisis; second, to distort the allocation of capital so that the carbon price no longer works; and third, to make every lobbyist's dream come true, as flacks and schmoozers descend on places like Brussels to wangle their spot in the taxonomy. As the 20th century showed, central planning doesn't work. By contrast, markets usually do work. And when they don't, it's government's job to correct these "market failures" and "externalities," among which our destruction of the atmosphere is the most monstrous. The way to do that is with a global and rising carbon price — one that's allowed to do its work. (Bloomberg)