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«Climate change and carbon markets: a panoramic history Raphael Calel July 2011 Centre for Climate Change Economics and Policy Working Paper No. 62 ...»

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Climate change and carbon markets: a

panoramic history

Raphael Calel

July 2011

Centre for Climate Change Economics and Policy Working

Paper No. 62

Grantham Research Institute on Climate Change and the


Working Paper No. 52

The Centre for Climate Change Economics and Policy (CCCEP) was established

by the University of Leeds and the London School of Economics and Political

Science in 2008 to advance public and private action on climate change through

innovative, rigorous research. The Centre is funded by the UK Economic and Social

Research Council and has five inter-linked research programmes:

1. Developing climate science and economics

2. Climate change governance for a new global deal

3. Adaptation to climate change and human development

4. Governments, markets and climate change mitigation

5. The Munich Re Programme - Evaluating the economics of climate risks and opportunities in the insurance sector More information about the Centre for Climate Change Economics and Policy can be found at: http://www.cccep.ac.uk.

The Grantham Research Institute on Climate Change and the Environment was established by the London School of Economics and Political Science in 2008 to bring together international expertise on economics, finance, geography, the environment, international development and political economy to create a world- leading centre for policy-relevant research and training in climate change and the environment. The Institute is funded by the Grantham Foundation for the Protection

of the Environment, and has five research programmes:

1. Use of climate science in decision-making

2. Mitigation of climate change (including the roles of carbon markets and low- carbon technologies)

3. Impacts of, and adaptation to, climate change, and its effects on development

4. Governance of climate change

5. Management of forests and ecosystems More information about the Grantham Research Institute on Climate Change and the Environment can be found at: http://www.lse.ac.uk/grantham.

This working paper is intended to stimulate discussion within the research community and among users of research, and its content may have been submitted for publication in academic journals. It has been reviewed by at least one internal referee before publication. The views expressed in this paper represent those of the author(s) and do not necessarily represent those of the host institutions or funders.

Climate Change and Carbon Markets: A panoramic history∗ Raphael Calel† Grantham Research Institute on Climate Change and the Environment, London School of Economics and Political Science July 2011 Abstract International carbon markets have grown quickly in recent years, but have also experienced serious problems and faced harsh criticism. This paper looks at the history of climate science, at how the economics of emissions trading developed, and at the formation of international institutions to address climate change. From this historical perspective it appears that climate change was a problem in need of a solution, and that emissions trading was a solution in search of bigger and bigger problems to solve. The political pressure to reach an international climate agreement was building rapidly in the 1990s, and the resulting marriage of climate change and carbon markets occurred before the quality of the match could be adequately assessed.

Many of the problems with international carbon markets can, at a fundamental level, be traced to this imperfect match. This panoramic historical perspective draws attention to the fact that climate change is a very different kind of pollution problem than emissions trading was originally designed to remedy. This helps shed light on recent experiences, and on how international carbon markets must change to provide the benefits they promise.

1 Introduction The Kyoto Protocol created an international market for allowances to emit six greenhouse gases, chiefly carbon dioxide. Today, the world carbon trade includes compliance ∗ I owe thanks Sam Fankhauser, Carmen Marchiori for their comments on earlier drafts. I would also like to acknowledge the financial support of the ESRC and the Jan Wallander and Tom Hedelius Foundation.

† E-mail address for correspondence: r.calel@lse.ac.uk 1 markets in the EU, the US, and New Zealand, representing over 140 billion dollars in traded value and as much as 5 gigatons of emissions per year (Linacre et al., 2011). With talk of enlarging the world carbon trade further, with proposed markets in Australia and Japan, the international market is projected to reach magnitudes of $2-3 trillion by 2020 (Lazarowicz, 2009). Despite doubts surrounding a post-Kyoto international framework, international carbon markets remain a key component of many countries’ carbon policy (see, for instance, European Commission, 2011).

Yet, carbon markets have also suffered from severe growing pains. They have been criticized for not generating real emissions reductions—“hot air” in the Kyoto Protocol and overallocation of allowances in the EU Emissions Trading Scheme (EU ETS) (Reyes, 2011). They have been rebuked for providing financial windfalls to emitters—both with the admittance of HFC-23 projects into the Clean Development Mechanism (Wara, 2007a,b) and the near universal grandfathering of permits in the EU ETS (Elsworth and Worthington, 2010; Elsworth et al., 2011). They have been admonished for lacking even basic safeguards against fraud—examples include the VAT fraud and the recycling of already surrendered emissions allowances. Several national EU ETS registries were recently forced to shut down in response to one instance of theft. The international carbon markets have also been criticised for not providing the incentives for low-carbon innovation proffered by economists and politicians (Schleich and Betz, 2005).

Place this against a backdrop of economic theory emphasizing the static and dynamic efficiency of emissions trading, the lauded success of the US Acid Rain Program in the 1990s, and the acceptance of emissions trading by both business and environmental interest groups. With this background, how can we explain the recent experience with carbon markets? Are they coincidental institutional failures, or are they perhaps symptoms of a more fundamental problem?

This paper pieces together an account of the origins of international carbon markets.

Accounts of the origin of international carbon markets tend to focus either on the history of climate science (Fleming, 1998; Weart, 2003), on how the economics of emissions trading developed (Oates, 2000; Gorman and Solomon, 2002; Vosharp, 2007), or on the formation of international institutions to address climate change (Bolin, 2007). These historical accounts are illuminating and rich in detail, but some important lessons emerge clearly only when looking at the scientific, economic, and political perspectives side-byside (e.g. Hulme, 2009). We do this in sections 2, 3, and 4. In section 5 we examine how these perspectives became integrated and how the international carbon market was created.

A picture emerges of international carbon markets as a hasty marriage of science 2 of climate change and economics of emissions trading, spurred on by political pressure to reach an international climate agreement. This was facilitated and encouraged by a growing scientific and popular understanding of the potential consequences of unchecked greenhouse gas emissions, and a willingness to draw very general lessons from economic arguments. To paraphrase Kingdon (1997), climate change was a problem in search of a solution, emissions trading was a solution in search of a problem, and international negotiations served as the forum in where this problem and this solution eventually came to be united.

We add detail to this sketch in section 6. The resulting picture helps us understand the troubled beginnings of international carbon markets, and suggests how carbon markets must change if they are to have hope of realising the benefits they promise.

2 Scientific origins “Man is both creature and moulder of his environment”; these are the opening words of the Stockholm Declaration (1972). The idea of ‘Man as moulder’ is central to international climate change policy and the creation of the international carbon market. This section tells the story of how we came to understand our ability to influence the climate through our emissions of greenhouse gases.

In 1815, Jean-Pierre Perraudin speculated that large displaced boulders in the Swiss alps might be due to glaciers previously having extended farther into the valleys. 25 years later Louis Agassiz proposed the theory that prehistoric glaciers had moved across the European and North American continents. The idea was considered blasphemous at first, since it contradicted the theory that the biblical flood had displaced the boulders.

However, as evidence of an ice age continued to mount, the scientific community instead became interested in explaining how temperatures could have varied enough to produce such rapid glacial advances and retreats (Riebeek, 2005).

As early as 1681, Edame Mariotte had noted that the sun’s rays appeared to move more easily through glass and other transparent materials than did the rays from a heat lamp. In the 1760s and 1770s, Horace Benedict de Saussure experimented with a solar thermometer designed to capture, magnify, and measure the heat of the sun’s rays (Fleming, 1998). His ‘heliothermometer’ was in a sense an experimental greenhouse, but Saussure did not understand the physical mechanisms that magnified the heliothermometer’s internal temperature. Inspired by Saussure, however, French mathematician and physicist Joseph Fourier began exploring the ‘laws’ governing the transmission of heat through solids and liquids, published in his Th´orie Analytique de la Chaleur in e 3 1822 (Fleming, 1998).

However, Fourier’s equations predicted a temperature far below the Earth’s actual temperature (Weart, 2003). The problem was clear; his theory left out gases. Fourier understood that the atmosphere played an important role in regulating temperatures, famously remarking that... the temperature can be augmented by the interposition of the atmosphere, because heat in the state of light finds less resistance in penetrating the air, than in repassing into the air when converted into non-luminous heat.

— Fourier (1824, p. 13)1 Fourier experimented with the transmission of heat through transparent substances, such as panes of glass, but he was never able to extend his theory to gases.

British scientist John Tyndall had studied the radiative properties of gases early in his career, and returned to these questions once more in 1859, motivated by the mystery of the ice age. He suspected that the recent ice age might have been caused by variations in the atmosphere’s carbon content (Weart, 2003). The scientific consensus of the day was that gases were transparent to thermal radiation, but Tyndall demonstrated experimentally that water vapour, carbon dioxide, ozone, hydrocarbons, and several other gases could absorb heat (Weart, 2003). He thought carbon dioxide and water vapour, absorbing many times more heat than oxygen and nitrogen, were important in explaining the Earth’s temperature. Thanks to Tyndall’s work, American geophysicist William Ferrel had a much better understanding than Fourier of the atmosphere’s heat-trapping properties when, in 1884, he attempted to calculate the Earth’s average temperature.

He came much closer to reality than Fourier had ever managed (Fleming, 1998).

Fourier, Tyndall, and others had relied on experiments to formulate theories that they later tried to apply to phenomena outside of their laboratories. For Swedish electrochemist Svante Arrhenius, however, the starting point was to try to come up with a theory to fit to some poorly understood phenomena—an approach made possible in the climate sciences by the recent expansion of standardised climatological measurement.

In countries around the world, geographical coverage of temperature measurements had been extended in the second half of the 19th century, and the measurement instruments and practices had been gradually standardised. The Prussian Meteorological Institute was founded in 1847, the British Meteorological Society in 1850, the US Weather Bureau in 1870, the Bureau Central M´t´orologique de France in 1877, and other such networks ee 1 The statement was first published in 1824 in French. Quote is taken from the English translation.

4 formed in Italy, Russia, and elsewhere. The International Meteorological Organization (now the World Meteorological Organization) was founded in 1873 (Fleming, 1998).

Combining climatological measurements from a number of sources with well-known physical relationships, Arrhenius (1896) calculated the changes in terrestrial temperatures that would result from variation in the atmospheric concentration of carbon dioxide, taking into account the concurrent changes in humidity. A small initial decrease in temperature would lower the air’s capacity to carry water vapour, which would diminish the atmosphere’s heat-trapping capacity, further diminishing humidity, etc. Taking this positive feedback mechanism into account, Arrhenius found that the temperature in the arctic regions would rise about 8◦ to 9◦ C., if the carbonic acid increased to 2.5 or 3 times its present value. In order to get the temperature of the ice age between the 40th and 50th parallels, the carbonic acid in the air should sink to 0.62–0.55 of its present value (lowering of temperature 4◦ –5◦ ).

— Arrhenius (1896, p. 268) Variations of such magnitude could explain both the warmer Tertiary and the subsequent ice age. Although it was not clear what accounted for such historical fluctuations of carbon dioxide levels, Arrhenius, quoting geologist Arvid H¨gbom at length, favoured o the theory that volcanic eruptions might cause changes in climate. At the time, Arrhenius did not imagine that human activity could noticeably magnify the global greenhouse effect.

Industrial carbon emissions grew rapidly in subsequent years, however, and Arrhenius’ collegue Nils Ekholm soon began arguing that the burning of fossil fuels would “undoubtedly cause a very obvious rise in the mean temperature of the Earth” (Ekholm, 1901, p. 61).2 He believed, though, that the effect would only be felt over millennia.

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