Is this the end of carbon trading, or just a hiccup?

Ratcliffe-on-Soar power station: carbon markets are supposed to be effective, not just hot air. PA/David Davies

Just as scientists almost universally agree greenhouse gases contribute to the planet’s changing climate, economists almost universally agree the problem is made worse because polluters don’t pay for the mess they make.

A carbon tax is one way to force companies to pay for their pollution. A carbon market is another, established by a “cap and trade” system where a limited number of permits (or “allowances”) are sold or given away each year. Every company must surrender one permit for every tonne of carbon produced. The capped limit is lowered over time to reflect the aim of steadily lowering emissions. The resulting carbon price ensures total emissions do not exceed the limit. Market logic suggests that if permits become more scarce relative to demand, then the cost of the permits, the effective “carbon price”, will rise (and vice versa).

Carbon markets have been set up around the world, in Australia and California, Kazakhstan and China. In the UK, companies are covered by the European Union Emissions Trading Scheme (EU ETS). Each system is designed slightly differently, and the resulting carbon prices vary widely. Some policy-makers hope that these systems will one day join to form a global carbon market, so that polluters everywhere pay the same price for their pollution and cannot simply move operations to somewhere cheaper to pollute. But despite a recent agreement on a link between the Australian and EU markets, a global market remains a distant prospect.

A really distant prospect, perhaps, given recent headlines that pronounced the EU ETS dead in the water – carbon prices previously above €30 per tonne (which some economists considered too low) have tumbled to below €5 where they have languished for months. In April the European Parliament considered a plan to increase short-term carbon prices by delaying the issue of 900 million permits; MEPs rejected the move and the EU carbon price fell to €2.7 per tonne.

Dead, or just sleeping?

How has the carbon price fallen so low that it needs “rescuing”? A low carbon price would be a sign of the scheme’s success if it meant companies had developed clean technologies to reduce pollution cheaply over the long-term, lowering demand for permits whose price would fall. Instead, carbon prices are low because the recession has dented economic output, and consequently emissions are lower. Low carbon prices present no incentive for companies to make long-term investments in clean energy, arguably the aim of the EU ETS.

When the carbon price rises or falls to extremes, politicians are tempted to interfere with the supply of permits. This means carbon prices can move significantly depending on political developments, as well as factors such as economic output and the weather (cold weather means more carbon is generated as the heating is turned up).

This has led some economists to argue that carbon taxes are a more suitable tool for a problem like climate change. A stable carbon tax would give companies a predictable incentive to reduce emissions, year after year. It would avoid the wild price swings of a market. True, taxes don’t guarantee that a set limit on emissions will be achieved - carbon markets have been preferred because they provide this guarantee. But the EU ETS only limits emissions for the five to ten years; what really matters is that emissions fall considerably over the next few decades. A tax that was set to increase gradually over time, with the plan for review after ten years, could meet the overall objective of reducing emissions and send a much clearer message.

But supporters argue that carbon markets work well if designed well; they just need some additional features to keep a lid on wild price fluctuations. For instance, prices might be stabilised by transparent rules that define how many permits are released onto the market as carbon prices rise or fall. Fewer permits would be released onto the market when prices are low, and more when prices are high.

The UK has unilaterally implemented something similar, introducing a domestic “carbon price floor” in April. This ensures that most UK companies (there are various exemptions) have to pay a carbon price of at least £16 per tonne this year, rising to £30 by 2020. In an EU-wide market, however, the effect is simply to shift emissions out of Britain and into Europe, possibly driving energy-intensive industries abroad in the process. An EU-wide price floor would sensibly prevent the risk of price crashes, leaving only the problem of price spikes to be addressed.

In the short term, efforts to “save” the EU carbon market continue. German Chancellor Angela Merkel said recently that she favours systematic changes that would solve these problems once and for all, rather than a temporary fix of withholding permits. But her finance minister opposes intervention. The politics are messy, but the stakes are high. If carbon prices do not provide an incentive for companies to move to cleaner production now, the transition will be forced on them later, with greater urgency, and at much greater cost - to us and them.