EU Revision: Carbon Trading
“When we emit greenhouse gases we damage the prospects for others and, unless
appropriate policy is in place, we do not bear the costs of the damage. Markets then fail in the
sense that their main co-ordinating mechanism – prices – give the wrong signals.”
Professor Nick Stern
Carbon trading is an important part of the EU’s environmental targets – the challenge is to
find policies that are EFFECTIVE, EFFICIENT and EQUITABLE.
1. In January 2005 the EU launched the EU Emissions Trading Scheme (EU ETS)
2. EU ETS is a market-based policy to incentivise reduction of C02 ‘greenhouse gas’
emissions in a cost-effective and efficient manner
3. The US acid rain program employed a sulfur emissions cap and trade system and
produced a 50 percent cut in emissions
4. The EU scheme operates through the allocation and trade of CO2 emissions
allowances. It creates a market in the right to emit C02.
5. One allowance represents one tonne of C02 equivalent.
Cap and trade
A cap is set on the emissions – this creates the scarcity required for the market. At the end
of each year businesses inside the scheme are required to ensure they have enough
allowances to account for their installation’s actual emissions. There are heavy fines for
those without such permits.
•
Assets: If a carbon emitting business such as a chemical plant can underuse its initial allowance by better energy efficiency, it can sell its surplus
permits on the market and earn money from doing so
•
Liabilities: If a business is faced by high costs to reduce its emissions, it
must buy extra allowances – carbon allowances therefore add to their costs
Prices and incentives
As the market price of carbon emissions rises, so there is an incentive for businesses to
invest in technologies that are more pollution efficient including carbon sequestration.
The Clean Development Mechanism encourages flows of private sector carbon finance from
richer to poorer countries to help fund investment in cleaner technologies in emerging
markets.
Weaknesses of carbon trading scheme
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The system has suffered from government failure because of the overallocation of carbon quotas and national freedom to allocate carbon permits.
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In recent times, the carbon price has collapsed with the effect of driving up
the demand for coal-fired energy that is a dirtier fuel! (This is an example of
the law of unintended consequences)
•
Uncertainty over the future of the ETS makes it less likely that businesses will
invest in greener technologies
•
Politicians are also unlikely to set the C02 emissions cap low enough to drive
carbon prices to right level especially if they favour their own industries
•
Carbon prices have fallen because of the recession hitting the EU economy.
The recession has caused reductions in output in steel, paper, cement and
glass and a sharp decline in production has led to a sell off of carbon credits
•
That has caused a big drop in the market value of carbon permits from Euro
35 to Euro 9 - there is less incentive for companies to stop polluting and there
are fears for the future of many clean energy projects.
Environmental policies
•Allowances •Quota of C02 emissions
•All EU nations included
•Not all industries involved in Phase 2
Allocate rights
Distribute allowances
•National allocations
•Market auctions of some allowances
•Need for transparency + accuracy of measurement
•Predictability of prices
•Do producers respond
•Personal carbon trading?
Price signals
It is good evaluation to recognize that no single policy on its own will be sufficient to resolve
many of the greatest long-term environmental threats facing the EU and world economy.
Carbon trading is just one of the approaches that the EU has turned to resolve
environmental policies. Others include:
1. Green taxes (e.g. the landfill tax and a tax on plastic bags
introduced in Ireland)
2. Directives on environmental issues including laws on disposal of
household products at end-of-life such as cars and household
appliances
3. Tougher regulations e.g. on c02 emissions per km for all new cars
4. Improving the flow of information to consumers about the carbon
impact (i.e. carbon footprint) of their purchases and use of different
products
5. Promoting renewable energy sources such as wind turbines, solar
and wave power
6. Promoting carbon capture and carbon neutralization schemes
Analysis of how a carbon trading market should operate
Permit Price (Euro per tonne of C02) EU Carbon Trading Market in Theory Supply 2012 Supply 2010 Price 2012 Demand 2012 Price 2010 Demand 2010 Cap 2012 Cap 2010 Quantity of Permits In principle:
The aim of carbon trading is to create a market in pollution permits and put a price on
carbon. In this way, policy can help internalize the environmental costs of firms’ production
and encourage lower carbon emissions as a way of tackling climate change.
In a cap and trade system, the number of available permits declines forcing businesses that
participate to buy the increasingly scarce and more expensive carbon permits to cover their
needs. Effectively the open market is creating a price for carbon (which did not exist before
ETS started). As the price of the permits rises, so the economics of investing in cleaner
technologies and in finding ways of cutting C02 emissions from existing production methods
and processes will change. The hope is that businesses will look for ways of reducing c02
emissions in the most efficient way possible – therefore mitigating the flow of c02 in the leastcost manner.
In practice:
The early years of carbon trading has proved difficult.
•
An over-allocation of permits caused the price to fall and made it uneconomic
to invest in cleaner technologies.
•
There are allegations of government failure arising from the first phase of
emissions trading – including national governments over-estimating the
allowances they needed as a way of favouring strategically important
industries.
•
Allowances were handed out for free rather than being auctioned off. Now
under Phase 2 the UK auctions up to ten per cent of its national allocation
•
The scheme has suffered from imperfect information in assessing how
much carbon is being emitted and it does not yet cover the majority of c02
emissions from the EU economy.
•
The volatility of the carbon price also acts as a barrier towards investment in
renewable energy and low-carbon technologies. Some economists have
called for a minimum price to be applied to the carbon market! Predictability
of prices is important to investment planning.
Prolonged recession and impact on the EU carbon price
Permit Price (Euro per tonne of C02) EU Carbon Trading Market in Theory Supply 2012 Supply 2010 P2012 P2010 Demand 2010 Demand 2012 Cap 2012 Cap 2010 Quantity of Permits This revision note has focused on carbon trading – keep in mind that there are other broad
approaches to cutting emissions:
1. Carbon taxation
2. Investment in carbon capture and storage (CCS): CCS is the secure separation,
transportation and storage of CO2 underground. The EU has already agreed to use
some of the money from future auctions of C02 emission allowances to help fund the
development of 10 to 12 carbon capture pilot plants across the EU.
3. Regulation of both producers and consumers – i.e. regulations enforcing minimum
efficiency standards
4. Having a technology policy to encourage research and development in low carbon
technology
5. Direct funding for poor countries to keep their forests intact and stall the process of
deforestation