Europe’s carbon trading system needs radical reform, not stop-gap measures

January 7, 2014

–Laurens de Vries is an assistant professor, Joern Richstein is a doctoral candidate, Emile Chappin is an assistant professor, and Gerard Dijkema is an associate professor at Delft University of Technology, the Netherlands. The opinions expressed are their own.–

The European Parliament voted on December 10 to delay sales of around 900 million carbon permits for the EU greenhouse-gas Emission Trading System (EU-ETS). The deferral (or so-called back-loading) may help correct the substantial oversupply of permits which have caused the carbon price to fall below 5 euros, a sixth of the price in 2008.

While back-loading will be welcomed by many governments and by the European Commission, the episode underlines that in its current form, the EU-ETS system is simply not fit-for-purpose. Back-loading is a one-time, ad-hoc fix that does not solve the underlying problem of the unpredictability of carbon prices. If governments give away or sell too many carbon permits, the price falls too low – as now – and there is no incentive for companies to reduce emissions.  If too few carbon permits are sold, the price may become unacceptably high, causing economic hardship.

A solution would be to implement a minimum and maximum price for carbon permits.  Such a price collar would be a far more effective tool for limiting carbon emissions, and would be more beneficial for European companies and consumers too. Polluters would have more certainty about recovering investments in emission reduction while the economy would be insulated against excessive price rises.

To be fair, the EU-ETS is not without success.  It is the world’s largest multi-country, multi-sector trading system. Almost a decade old, it has grown to cover eleven thousand energy-intensive installations in the energy and industrial sectors, which are collectively responsible for close to half of the EU’s greenhouse-gas emissions.

The problem is that the market for carbon pollution contains no properly functioning mechanism to adjust the supply of rights.  Consequently, when demand for electricity declines (as during the economic downturn since 2008) or when significant investment is directed to low-carbon-emitting systems, there is a surplus of emission rights and the price collapses. This uncertainty has proved to be a major deterrent for potential investors in carbon reduction.  Coal-fired power plants, for example, currently provide the cheapest way of generating electricity.

This changes only when the carbon-emissions price is relatively high — between 40 and 60 Euros per ton. Investors need to be fairly sure that the emissions price will remain high enough before pouring money into a scheme that reduces carbon emissions. And this helps explain why the EU-ETS is not producing the incentive for a systematic switch to low-carbon investments that was originally envisaged. By contrast, introducing a minimum price for carbon would send clearer and more predictable signals to investors. It would allow them to invest in new low-emitting technologies without sparking a price plunge.

Conventional wisdom has it that a price collar makes it more difficult to achieve carbon reduction targets, but our research at Delft University shows that this objection is unfounded. A minimum price would invite investment in abatement to take place sooner – because the investment risk is lower – so carbon output would be reduced faster. With lower emissions, companies would pay less for their emissions so, in the long run, electricity prices would remain lower than in a carbon market without a minimum price.

And it is not difficult to determine an effective minimum price.  It can start low, not much above the current market price, and be increased over time. Much more important than the starting level for the minimum price is the certainty that it will not be radically tampered with, and only gradually increase in order to provide maximum security to investors in carbon abatement

Consumers face the opposite risk of carbon prices rising too high.  The resulting high energy prices could frustrate Europe’s patchy economic recovery. A maximum price at the annual auction of carbon allowances could mitigate this risk. Even if more allowances are issued when the price cap is reached, our research shows that this does not need to result in serious deviations from the intended long-run carbon reduction pathway.

Taken overall, at a time of rising energy prices across much of Europe, and when the signs of climate change are becoming more evident by the day, it is becoming ever more urgent to fix the EU-ETS.  And a price collar for carbon offers the single best solution for delivering on the laudable objectivesfor which the system was originally designed.

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