The dramatic fall in Europe’s carbon price in April led to claims emissions trading had failed as a model for addressing climate change. While the low EU price is problematic for the EU and Australia (by virtue of our linkage with the EU), carbon pricing is still the most efficient tool to address climate change at the scale required.
It may be more productive to discuss what we can learn from the European Union’s experience. What design features should be built into both existing and future emissions trading schemes to safeguard against volatility and ensure that carbon markets reduce emissions and encourage investment in low carbon technologies?
This question is also relevant to other countries that are currently designing national emissions trading schemes, most notably China, Brazil, South Korea and Chile.
Why did the EU’s carbon price crash?
Unlike in Australia, when the EU’s Emission Trading Scheme (ETS) started trading in 2005, most member states had no system in place to measure greenhouse gas emissions from industry.
Industry was left to make their own emissions projections. and allowance allocation was based on these estimates. Perhaps unsurprisingly, this led to a gross over-estimate of emissions by some sectors, notably German utilities. This resulted in the price crashing at the end of Phase 1 (2007).
The European Commission announced a tighter cap for Phases II and III, which increased the EU allowance price to around €30 in 2008.
The recession then took hold in Europe. The fall in industrial activity combined with the success of other emissions reduction policies in the EU, have been the predominant causes of the current oversupply of EU allowances.
The oversupply means prices have fallen sharply over the last year, to a point where they are not driving any abatement in low carbon technologies.
To increase the price of EU allowances, the European Commission tried to address over-supply with a temporary measure known as “back loading”. This proposed that 900 million allowances be withheld from auctioning over the next three years and reintroduced around 2020.
Industry lobbying intensified, the proposal became increasingly politically contentious, and it was defeated by a narrow margin in the EU Parliament last week. The proposal is not necessarily dead, but the Parliament’s vote sent a negative signal that led to prices falling even further, to around €2.
Those in favour of back-loading argued that the EU ETS could not incentivise investment in low carbon technologies while the price was so low. Those against it argued industry should not be hit with further costs at a time when many member states are still in recession. It’s a familiar debate in the climate change policy arena.
The collapse of the EU price is not all bad: it basically means emissions have been cut more efficiently than expected.
Taking decisions away from politicians
The European “back-loading” experience shows decisions about the functioning of carbon markets need to be made outside the political process. The politics of climate change have become more divisive over the last few years, just as the threat to the planet grows.
This is because acting on climate change is still considered to pose a direct threat to mainstream industry’s interests and the status quo. We cannot leave market decisions to the political process if we are to have a chance of addressing climate change.
An independent bank, with the job of regulating the market, should be part of the architecture of any emissions trading scheme. Similarly to the Reserve Bank of Australia, a carbon bank needs the authority to act decisively when required in order for the market to function efficiently.
A carbon bank is critical for two reasons. Unusually, carbon markets are government created; they are artificial markets. When over-supply occurs, it is not naturally addressed by market dynamics; that is, by the low price generating an increase in demand and in turn driving up the price again.
The functioning of a carbon market relies on the quality of the market’s administration.
Further, addressing climate change is too important for each market decision to be subject to lengthy political wrangling. Once a government has decided to establish an emissions trading scheme, the market should be entrusted to a regulator to make the necessary decisions to enable the market to function, such as to regulate over supply.
Over-supply is not necessarily a bad thing, or evidence of failure, in a carbon market. It can mean the market is working better than expected.
The experience in environmental markets to date has been that when a price on pollution is introduced, innovation is unleashed, so emission reductions are consistently underestimated by regulators. Over-supply can also occur because the complementary measures to a carbon price are working effectively; this was certainly a factor Europe.
There are also events, such as recessions, that are unforeseen at the time a cap is set: these also affect carbon markets. The point is, however that there needs to be a mechanism built into a carbon market design at the outset that can address market issues when they occur.
As schemes link up around the world, the focus should shift to the need for a global carbon body will to regulate the global carbon currency, and it could also help countries explore the feasibility of linking with other schemes.
It is important that we remove decisions on market function from the political arena so that we can get on with the task of reducing emissions. If we can do this, we might surprise ourselves and exceed emission reduction targets without even noticing.