Lessons from Europe: Price, Policy, and Market Participants in the EU ETS

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As a European with professional experience in carbon market consulting, I nearly feel obligated to share some of my thoughts on carbon emission trading, especially since California is getting serious with the introduction of its own cap and trade scheme that will most likely take effect next year. Therefore, I will share some experiences and lessons learned from European emission trading in this post, and conclude with some remarks on expectations for California’s cap and trade scheme.

The European Union (EU) has committed to an overall greenhouse gas (GHG) emission reduction target of 20% of 1990 levels by 2020. The commitment would rise to 30% if other industrialized countries agree to do the same. The main market-based instrument to achieve this commitment is the European Union Emission Trading Scheme (EU ETS), introduced in 2005. Large emitters have the option to either reduce emissions internally at the source (for example, by investing in energy efficiency measures), or purchase emission reductions from companies that have undertaken similar activities, if this is a cheaper option. In this way, the market helps discover the most cost-effective emission reductions. This is environmentally acceptable because of the principal nature of global climate change: it doesn’t really matter where GHG reductions take place, as long as fewer emissions enter the atmosphere.

In theory, this sounds very reasonable and somehow efficient (something I can appreciate, as a German). Emission trading is just a tool, a market-based instrument to reach a defined environmental target of emission reductions (the cap). But in practice, you wonder if this really works. Do we achieve actual environmental improvements? Can we rely on trading as an effective way to reduce emission levels?

Since its start, the EU ETS has been proven to be a rather unstable and very complex market. Prices have ranged from more than €30/ton in 2006 to nearly zero in 2007 and 2008. The reasons for the strong price volatility and unstable market conditions have been shifting market regulations, political uncertainty, and insufficient availability of emission data. Nevertheless, market price developments indicated that the market somehow still functioned. It followed the theoretical idea that prices would reflect any over-supply or shortness of the market. And the political goal—the actual emission cap—besides being the major determining factor for the market’s over- or under-supply of credits, it has always been reached. So, yes, the EU ETS emission reduction goals have been achieved.

Today, European Union Allowances can be bought for around €16/ton which is generally considered as being too low to trigger strong carbon emission reductions in Europe. Consequently, one main conclusion could be, the cap is still too loose and not ambitious enough.

The main purpose of emission trading is to create an economic incentive to restructure energy production and shift consumption away from carbon-intensive products. A cap and trade scheme achieves this effect by putting a cost on emissions which means that the products of industries that emit GHG become more expensive and products with low or no associated GHG emissions become relatively cheaper. This is believed to be beneficial for society and the environment since emissions would be reduced, but through the lowest-cost mechanism. Therefore, a cap and trade scheme only works if the cost of carbon is high enough to promote investments into low- and no-carbon technologies. And once again, policy plays the most important role in a carbon market’s price structure.

Leaving aside the significant question marks over whether California’s cap and trade scheme and other proposed measures under AB 32 will work or not, transparency and predictability with regard to policy, regulations, and market information will be the key. It is the market fundamentals underlying the trading scheme that are the issue, and not the market mechanism itself. And in markets created by regulation—as emissions markets are—the problem lies in the target set by the government and how its regulators manage the market’s adherence to that target.

And one last thing I have learned in Europe: we should not expect miracles. It will take time for the market participants, as well as the market regulators, to adjust. Emission trading simply is a kind of compromise about environmental targets and economic principles. And compromises are never easy.