Free exchange | Schrödinger’s emissions trading system

Europe’s carbon-trading system is better than thought, and could be better still

Adoption of a price floor and the end of free permit allocations would strengthen the world's biggest carbon pricing system

By Arthur van Benthem, Ralf Martin | University of Pennsylvania, Imperial College London

In December talks in Paris involving more than 200 countries may result in a new agreement aimed at reducing carbon emissions. In the months leading up to the conference, The Economist will be publishing guest columns by experts on the economic issues involved. Here, Arthur van Benthem, of the University of Pennsylvania, and Ralf Martin, of Imperial College London argue that adoption of a price floor and the end of free permit allocations would strengthen the world's biggest carbon pricing system.

THE EU emissions trading scheme, which celebrated its 10th anniversary this year, is Europe’s flagship climate policy. It is often accused of two mutually exclusive sins and not always by different people. Some complain that it is ineffective because carbon prices have been much lower than expected. There is also concern that the ETS threatens competitiveness, which can only be the case if prices are too high. So is the ETS both dead and (too) alive at the same time?

Prices have been low indeed: the EU’s own impact assessment assumes a price of €30. Prices were around that level for only brief periods in 2005, 2006 and 2008. Despite the low prices, the ETS has triggered emission reductions of more than 10% in some participating firms. At the same time, there is little evidence that the ETS has reduced competitiveness.

Low prices are not necessarily a sign that the ETS is working badly. What matters most is the cap—the total allowable amount of emissions. For 2013 the cap was set at 2,084m tonnes of CO2. It has since gone down by 38m tonnes per year. These reductions are scheduled to carry on until 2050, by which time emissions would have to be as low as 33% of the 2013 cap. The European Commission is proposing to tighten that even further to 14%.

These very steep reductions are necessary to effectively mitigate climate change—provided other countries follow suit. A low price could indicate that even steep cuts will be cheap and easy to achieve. But it could also mean that investors are not convinced the ETS will exist until 2050. Since the recession, emissions have been well below the cap. However, as excess permits can be used in the future when caps are tighter, recessions should not depress prices much. Hence, the sharp price drop is a strong indication of lacking investor confidence.

This is a serious problem. The benefit of allowing trade in carbon permits is that market participants can determine who emits what, and when. If the price signal is distorted because of uncertainty over the future of the policy, firms will consume too many permits today. What’s more, there is insufficient incentive to make crucial investments in energy-saving equipment and low-carbon R&D. This could not only considerably raise future costs of meeting the cap, but also become a self-fulfilling prophecy: if meeting the cap becomes too expensive, policymakers may dismantle or weaken the ETS.

To stabilise the price, the EU is “backloading” permit allocations. Some pollution permits scheduled to be issued in, say, 2015 will instead be issued in a later year, say, 2020. This might work if it creates an immediate permit shortage. However, when Europe decided in 2013 to backload some 2014-2016 permits to 2019-2020, the carbon price hardly responded, suggesting the reduction was too weak.

Going forward, the EU proposes a “market stability mechanism”: it will stop issuing permits if there are more than 833m in circulation. It should, however, follow California’s example and specify a floor price: no further permits will be auctioned if the price drops below the floor. Unlike the market stability mechanism, this would actually guarantee that the price stabilises. This leads to higher and less uncertain prices, making clean technologies more attractive to investors.

How high should this floor price be? Conceptually, it would be the price that would have emerged if nobody had questioned the credibility of the future cap. That will be hard to work out. So effectively the price will become a political choice. The EU’s €30 target seems like a natural starting point.

A stabilised price will send the right signal for investments with a short to medium-run payback. It still cannot guarantee investors that the system will be around until 2050. Some of the societally beneficial long-term R&D and infrastructure investments will therefore not be incentivised enough. Direct financing by the EU Commission or member states is probably the most straightforward fix, especially for ramping up clean energy R&D which is growing but still far below early 1980s levels as a share of GDP.

This extra money could be provided by the ETS itself. Many permits are still allocated for free to ensure international competitiveness. But the EU is unnecessarily generous. Ralf Martin and co-authors find that up to €3 billion could be raised annually by better targeting free permit allocation, without having much impact on competitiveness. With this money, the EU could double its spending on renewable energy technology R&D.

By using the proceeds from emissions trading for research on photovoltaics, the ETS could make a more useful contribution to quantum physics than as an aide for Schrödinger’s thought experiments.

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