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The carbon market, a government failure

2013-06-27

The European Commission, by overloading climate policies, jeopardizes the Emissions Trading Scheme

Power plants are one of the many installations subject to the European Union Emissions Trading Scheme Power plants are one of the many installations subject to the European Union Emissions Trading Scheme

The European Union Emissions Trading Scheme  (EU ETS) is under severe political pressure. During the economic recession, companies participating in the system produced less output and, therefore, emitted less greenhouse gases. The result is that the EU ETS has had an easy time meeting the emission reduction targets. The price for an emission allowance has become so low that it hardly gives companies an incentive to invest in climate-friendly technologies. In mid-2013, allowance prices were below €5 per ton of carbon dioxide, while they reached €25 in late 2008.

“Government failure is the main cause of the problem,” said Edwin Woerdman, associate professor at the University of Groningen, in an interview. His explanation is that “the emission caps are too lax, too many regulatory exceptions have been created for industries and too many policy instruments are interacting at the same time.” The emission market is not to be blamed, because “there is no carbon market failure,” he said. Mr  Woerdman, who is also co-director of the Groningen Center of Energy Law, investigates carbon emissions trading and manages one of the largest research teams in Europe on this topic.

When he spoke of a “government failure,” Mr Woerdman referred to the economic notion of a government that inefficiently allocates goods and resources. A government can distort the market with a tax system, with a subsidy program and with laws and regulations. The market can fail, too. A typical example is a monopoly in the energy industry. Mr Woerdman said the government should have a “very solid argument of a market failure” before intervening in the carbon market.

“A zombification process”

The EU ETS created a financial incentive for energy-intensive companies to reduce the discharge of greenhouse gases in the atmosphere. It caps the quantity of emissions. Companies sell unused emission rights or buy rights they need on the market. The system covers nearly 12 000 installations from energy production, mineral transformation, production and processing of ferrous metals, pulp and paper as well as air transport. “The EU ETS was intended to reach the emission caps at the lowest cost possible,” Mr Woerdman recalled.

The European Commission has, however, added policies that undermine the carbon market. It requires companies to increase the share of renewables and energy efficiency, which has the effect of lowering the emissions and suppressing the carbon price. “It is likely that this ‘zombification process’ will continue,” Mr Woerdman observed. “Policy-makers are considering adding minimum carbon prices, compulsory emission standards or maybe mandatory carbon capture and storage, which makes the emission reduction targets more costly to achieve.”

Some analysts find that the European Commission has allocated too much emission allowances. In 2011, the cumulative surplus was 450 Mt in a total of allowances and credits equal to 2 336 Mt, according to the Community Independent Transaction Log. To create scarcity in the carbon market, the European Commissioner for Climate Action, Connie Hedegaard, proposed to postpone the auctioning of 900 Mt of allowances. The European Parliament voted against this back-loading amendment on 16 April.

The cap, not the price

The emission surplus predominantly originates from the recession of the European economy. While companies released less carbon dioxide and needed fewer allowances, the European Commission increased the supply of allowances and credits from 2 076 Mt in 2008 to 2 336 Mt in 2011, according to the Community Independent Transaction Log. There is a debate about the possibility of “a scheme which fluctuates with economic growth,” Mr Woerdman said. “Fewer allowances in times of economic recession sounds attractive from an environmental perspective. But, at the same time, industries lobby for more allowances in times of economic growth. The implication of this would be that not every unit of emission has a price. This undermines the core idea of internalizing climate damage.”

Mr Woerdman is convinced that the European Commission should decrease the climate policy overload by revising its policies that promote renewable energies, energy efficiency, and carbon capture and storage. “If you want to have cap and trade, then you should keep it real,” he argued. Yet the European carbon market does not “bite enough,” he said. What should be done? Mr Woerdman proposes to lower the emission caps, in such a way that it creates scarcity of emission allowances. He estimates that a reduction of two to three per cent per year would make a beneficial effect. “Do not touch the price,” Mr Woerdman said. “Lower the cap.”

By Jean-François Auger