The EU Emission Trading Scheme: Band-Aid for a Broken Market

The EU passed a spongy amendment to soak up some surplus carbon permits in their flooded cap-and-trade scheme, but the ‘backloading’ plan only delays emissions until later in the decade

This is the second post in a series about the EU ETS

Economists generally believe that if money incentives for individuals and businesses match benefits and costs for all of society, then goals like protecting the environment will be achieved automatically. For example, a fee representing our electricity’s contribution to the costs of global climate change should make us decrease our power usage, reducing carbon emissions by simply acting in our own interest.1

This theory provides the basic reasoning behind the European Union Emission Trading Scheme (ETS). Europe’s massive cap-and-trade system puts a price on carbon pollution through a complicated permit market rather than a simple fee, but the concept is the same: producers have to pay for their emissions, and this climate-impact charge is then passed on to consumers.

Transaction prices do not normally take climate pollution into account because it is a global environmental cost   it’s spread upon everyone instead of affecting just the buyer and seller of some good whose production or use causes emissions. In general, market mechanisms like emissions trading can safeguard natural resources from overuse and degradation by adding societal costs to prices.

Economists call this ‘internalizing‘ an external cost. And it only works if the price is right.

Market resuscitation

On Monday, December 16 the European Union finalized approval for a measure intended to revive the market for emissions allowances. These freely tradeable allowances act as permits for large industrial facilities like coal-fired power plants or steel mills to spew greenhouse gases into the atmosphere. Companies in the ETS must surrender one allowance for each metric ton of carbon dioxide (CO2) they emit.

The total number of allowances issued sets a ‘cap’ on emissions within the system. According to neoclassical economic theory, ETS members will trade allowances among the group to meet the predetermined cap with the lowest-possible-cost set of emissions reductions.

The carbon trading system needs saving because the right to contribute to global climate change can be purchased quite cheaply allowance prices are far too low to incentivize emissions reductions.

Backloading proposal

The European Union’s rescue plan involves delaying the distribution of 900 million allowances that were set to be available in the next three years. The proposal, called ‘backloading’, transfers those withheld permits to years later in the decade. The aim is to drive up prices in the ETS by increasing scarcity.

Yet news of the withholding measure hardly affected market prices. On Saturday, December 14, Thomson Reuters’ Point Carbon website reported that the price of a permit closed at just €4.80, or $6.60 the exact amount at which they were traded before the plan passed in EU Parliament the week before. For comparison, EU policy makers envisioned permit prices around €25 or €30 when they designed the ETS.

Oversupply of allowances causes low prices in the ETS. A flood of extra permits has inundated the market a few times in the system’s eight-year history, preventing carbon prices from reaching levels that might induce utilities to commit to low-carbon energy generation.

Price collapse I

In the carbon market’s first phase (2005-2007), EU member states allocated too many allowances in response to intense lobbying from ETS emitters and uncertainty about baseline emissions. During this period overall emissions from the trading system increased by nearly 2 percent, yet still fell short of the too-loose cap set by allowance distribution.

Carbon prices fell near zero for all of 2007 because of the over-allocation. Some firms had reduced emissions in anticipation of allowance prices up to €30 the April 2006 peak level but in the end a non-restricting cap hardly disturbed business-as-usual emissions growth.

Supporters of the ETS dismiss the 2007 price crash, calling Phase I a pilot period intended to establish baselines and set up a greenhouse gas market rather than produce significant emission reductions. Unreliable data on past emissions, very small reduction goals, and the intricacy of predicting future emissions made an allowance surplus likely from the beginning, according to a report by MIT economists.

Price collapse II

Oxford economist Dieter Helm uses this graph to show how the ETS' price crashes could be avoided with a set carbon tax. *Data*: Bloomberg. *Graph*: http://www.dieterhelm.co.uk/sites/default/files/Bruegel041012.pdf

Oxford economist Dieter Helm uses this graph to show how the ETS’ price crashes could be avoided with a set carbon tax. Data: Bloomberg. Graph: http://www.dieterhelm.co.uk/sites/default/files/Bruegel041012.pdf

The second phase of the ETS (2008-2012) provided a chance to restore a functioning market and to begin decreasing emissions toward the scheme’s 2020 goal of 21 percent reduction below 2005 levels. These goals complement one another: all else equal, tightening the carbon cap drives up allowance prices.

In 2008, the price rose over €20 per ton CO2, but the schedule for annually decreasing emissions did not anticipate the Great Recession. The global financial crisis led to a decrease in output from energy-intensive sectors, causing emissions from ETS members to fall. Greenhouse gas emissions decreased simply because economic activity slowed; thus firms needed very little abatement to meet the cap.

Carbon prices dropped as diminished demand for allowances made them abundant once again. As Phase II ended in December 2012, permits had been consistently traded at less than €10 for over a year.

Phase III

The beginning of the third phase brought a few small changes to the ETS, including tighter limits on the use of carbon ‘offsets’ and the addition of Croatia to the trading scheme. Yet Phase III brought no immediate market adjustments that might lift the price of emission allowances.

Prior to the recent adoption of the backloading amendment, industrial emitters, the EU Parliament, and national governments had clashed for 16 months over proposals to intervene in the carbon market.

On one side of the debate, environmental activists and economists alike emphasize that the ETS cannot stimulate the climate-saving investment necessary to reduce emissions unless the allowance price includes more of the full cost of atmospheric warming. On the other side, politicians from high-emitting countries like Poland  which burns coal for about 90 percent of its electricity production  side with industry interests, opposing any meddling in the market for fear that a steeper carbon price might hurt fossil fuel-burning sectors of the economy.

Rescue, then reform

The Climate Change Committee will update European Union regulations over carbon-permit auctions in January 2014. The committee, which includes representatives from national governments, will determine details of the backloading measure such as exact dates and amounts of allowances to be withheld.

It may seem that the passage of a rescue plan to alleviate the glut of allowances marks the culmination of this lengthy debate over how   and if   to tweak the EU carbon market. But it is really only a first step; major structural reform will be necessary to salvage the scheme’s status as the centerpiece of Europe’s climate policy.

The long haul

Saving the carbon trading system may require leaving behind the ideal of a ‘free-market’ solution, according to a report from the London School of Economics. Regulating the price or supply of allowances goes against key principles of cap-and-trade, but letting capitalist market incentives drive emission reductions has not worked so far in the ETS.

The European Commission published its first report on the carbon market in November 2012, presenting six possible longer-term structural changes.2 Proposed reform options include strengthening the EU’s greenhouse gas-reduction goal for 2020 from 20 percent to 30 percent below 1990 levels, permanently withdrawing allowances, or expanding the ETS to cover more sectors.

The choices for further altering the ETS will elicit passionate responses from all stakeholders  the drawn-out disagreements over a short-term fix for the carbon market were likely just a prologue to the looming quarrel. The European Commission’s suggestions are a good starting point for discussion; they are strong proposals that can give the scheme the big makeover it needs.

With or without successful revitalization, the system will hobble onward. Dismantling the EU Emission Trading Scheme would prove just as difficult as amending it.


  1. Maybe saying the environment will be protected ‘automatically’ is an oversimplification of economic theory, but assume that (1) we are rational and (2) we know exactly how changing electricity consumption affects our utility bill. We will consume exactly the amount of electric power that equates the marginal costs and benefits of electricity use. If we are charged for the power plant greenhouse gas emissions associated with our electricity use, then buying an energy-efficient furnace or turning off our computers at night might make more sense than without a carbon pricing mechanism. 
  2. Find a link to the state-of-the-ETS report as well as the initial proposal and impact assessment for the backloading amendment  here
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4 thoughts on “The EU Emission Trading Scheme: Band-Aid for a Broken Market

  1. On the sidebar to the right there’s a section “follow your bliss” where you should see either a “Follow” button or a space to enter your email address, depending on whether or not you are signed in to a wordpress account.
    Thanks for the leading question Evan–maybe I need to put it in a more obvious place if I want any subscribers.

    Like

  2. The ETS is gone. Turns out it was one of those mass hallucinations that occur every now and then throughout history…
    Now what, in your opinion, would be the best way to move forward in regards to reducing commercial green house gas emissions. Start a better but similar version of the ETS hallucination? If so what would make it better. More authority, higher emissions pricing, taxing a different aspect of production?
    Or do you believe there is an all together better solution? I would entertain both idealist and realist answers.

    Like

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