Monday, 22 April 2013

The EU ETS, Backloading and the End of the Carbon Markets

According to the news reports, the carbon markets are in trouble.  Prices on the world's largest market, the EU Emissions Trading Scheme (ETS) are at an all-time low.  Generic compliance-grade offsets from the United Nations Clean Development Mechanism trade for pennies.  And the European Parliament just voted on April 16th to reject a move called "backloading" that would have helped to prop up carbon prices.  Investment banks are closing their carbon trading desks, and clean energy project developers are looking at other revenue streams beyond carbon to support their activities.

What went wrong? And does this spell the end of the carbon markets?

The first thing to note about the carbon markets is that they are an artificial construct.  Climate change is a problem mainly because governments, companies, and households normally are unaware of the cost their own environmental pollution.  Carbon dioxide is colourless, and odourless, and the warming effects of greenhouse gas emissions can take fifty years or more to become evident.  Absent many direct feedback mechanisms, few organisations would put a price on their emissions without government intervention.

Building on the experience of air pollution emissions trading in the US, governments around the world have begun setting up greenhouse gas emissions cap-and-trade schemes.  Regulators create carbon markets by setting an overall cap on emissions (thus stimulating demand) and by setting rules on how emissions allowances and carbon offset credits can be used (thus creating a regulated source of supply). This basic approach has been the same whether the carbon markets are set up in California, Australia, China, New Zealand or the European Union. Remember, emissions anywhere contribute to climate change everywhere, and a reduction anywhere has the same general climate change benefit.

In the EU, regulators established an overall emissions cap and then set companies free to meet that cap in the most cost-effective manner, so long as they followed the rules.  The goal was to fulfil the European Union's greenhouse gas reduction targets under the Kyoto Protocol at the lowest overall impact to the economy.  The EU ETS is a price discovery mechanism that allows firms covered under the cap to determine who can reduce emissions most easily.  Those firms that can cost-effectively meet and exceed their reduction targets can sell any savings below their cap on the market.  Firms that for whatever reason are unable to meet their targets must buy excess permits from their more carbon-efficient counterparts, purchase certain allowable types of international offsets (which represent certified reductions in developing economies' GHG emissions), or else pay a hefty fine.

And it worked! While early predictions were that the marginal cost of emission reductions under the ETS would be at least €25 during the current compliance period, prices are instead hovering just above €3. Put another way, companies in the European Union have been able to  meet their GHG emission targets during this period at minimal overall cost to the economy. Cutting carbon has been cheaper and easier than we ever thought possible.  That's the good news story.

The bad news is that this low price has done little to spur low-carbon investment.  €3/tonne is equivalent to barely half a Euro cent or 0.4 pence per kWh on household and business electricity tariffs.  When buying pollution permits becomes the cheapest option for meeting regulatory targets, few firms will spend the money to improve energy efficiency or switch from coal to natural gas and renewables. Such a state of affairs is particularly troubling for investments in energy infrastructure.  A company that builds a coal fired power plant instead of a series of wind farms is locking in 30-50 years of carbon-intensive energy production.  What we need, then, is a carbon price that is high enough to provide incentives for green investment, but not so high that it creates economic hardship.

So how did this happen? What went wrong?

Put simply, regulators did not anticipate the recession of the past five years. The emission targets set in 2007 assumed that economic growth - and GHG emissions - would continue to rise each year in the absence of the Emissions Trading Scheme.  In the real world, the housing market collapsed, companies shed employees and closed offices, and output from the emissions-intensive steel and cement industries collapsed.

The result was like asking an Olympic sprinter to run 100 meters in 20 seconds - it was far too easy.  Those challenging emission reduction targets suddenly became achievable with little or no effort, which meant that few companies needed to buy excess permits and many had surplus allowances for sale.  Supply and demand - when sellers outnumber buyers, expect the price to fall.

What's the solution? If achieving a higher carbon price is the goal, regulators can either boost demand for emission reduction credits or restrict supply.  Increasing demand is best accomplished by setting even stricter carbon targets.  If a firm can easily achieve a 1.4% annual reduction, regulators could set a 2% or even 3% reduction instead.  This approach has the added benefit of accelerating emissions reductions in the near term - when we most need them - while providing greater incentives for long term investment.

For various reasons EU regulators decided that boosting demand was a political impossibility in the near term and that a better short term fix was to focus on supply.  The preferred tool, "backloading", restricted the number of allowances members states could sell into the current depressed market.  This would create a modest shortfall, forcing firms to use up some of their excess allowances.  Member states would sell those "backloaded" allowances several years from now when, presumably, the economy had improved and increased corporate GHG emissions would better soak up some of the supply without depressing prices.

Notice that the backloading proposal did not propose to change the EU's overall emissions reduction ambition.  It merely shifted in time the overally supply balance of emission allowances.  Even this move, however, creates winners and losers and EU parliamentarians argued bitterly on behalf of their respective constituencies' short-term interests. Some even argued that the EU Parliament should not meddle in the market - ignoring the fact that the EU ETS is itself a creation of the EU Parliament.

In the end, the backloading proposal was rejected. With no prospects for increasing near term demand for carbon credits or decreasing supply, prices on the EU ETS have continued to slide. [Update 24April - prices have recovered slightly on news that the backloading proposal may be reintroduced this summer.]

The important point here is that the current problems with the EU ETS are not due to the carbon markets.  They are working exactly as they were designed, finding the lowest-cost emissions that can meet government targets.  The problems facing the EU ETS are political.  The market has shown that it can meet current targets much more cheaply than envisioned.  Just imagine what could be achieved with a cap that drove the carbon price to €25-€30, a price that was politically palatable just a few years ago.  But the European Parliament has not set a more ambitious target.

Imagine how many investment decisions might be swayed with the slightly higher carbon price that would come from backloading.  But the backloading vote failed.  The decisions about more ambitious emission reduction targets, backloading and other approaches are being made not by carbon traders but by country governments and EU parliamentarians.

The lessons for other governments that are contemplating or implementing market based emission reduction schemes are clear:
  1. Do not abandon carbon trading - it  gives companies the flexibility to meet emission reduction targets at least cost, and often cheaper than you can imagine.
  2. Don't be afraid to set ambitious targets.
  3. Remember that the carbon market is a regulatory construct.  Companies crave certainty and do not want rules to change too often, but success fighting climate change requires regulators to leave enough flexibility to respond to unforeseen events.
As I've noted previously, fixing the compliance carbon market in the EU will require inspired political leadership. Citizens are calling for urgent action on climate change.  The carbon market has the tools to deliver this action.  What is needed now is the political will.