Cutting Carbon: Is Europe's Emissions Trading System Broken?

By Joel Stonington

Emitting CO2 into the atmosphere is dirt cheap in Europe these days. At just 8 euros per ton, the low price is undermining the European Union's effort to establish an effective cap and trade system. Implementing necessary fixes to the system, however, won't be easy in the face of industry opposition.

The European Union's CO2 emissions trading system needs to be fixed. Zoom
DPA

The European Union's CO2 emissions trading system needs to be fixed.

Europe's carbon market is in deep trouble and it's not just environmentalists sounding the alarm. Back in April, the CEO of Shell said that the European Union's system for trading allowances for the emission of greenhouse gases was "in danger." But that's about as direct as anyone will get in this world of bureaucratese. Most simply talk of "price weakness" (meaning that emission credits are absurdly cheap), a desire for "long-term policy certainty" (the system needs a fix!), and the need to "restore confidence" (and the fix has to come fast!).

The simple fact is that the most important tool in Europe's fight against climate change needs a major fix. When it was introduced in 2005, the idea was to make pollution expensive. And in the summer of 2008, the price for emitting a ton of carbon peaked at a price of around €30. But the global financial crisis and ensuing economic downturn in Europe have taken their toll. Prices are currently hovering around €8 euros per ton of carbon emissions, hardly the disincentive policy makers had hoped for.

"The emissions trading system is not very credible," said Jo Leinen, a Social Democratic member of European Parliament from Germany, in a recent phone interview. "It doesn't look like it has credibility in the near future. So we need to give it back its real function to be an incentive for low carbon investment and low carbon technology."

The regime, known as the Emissions Trading System (ETS), is now entering a third phase intended to begin the process of reducing the number of credits available, thus forcing prices up and pollution down. It will also dramatically increase the number of credits that are auctioned off rather than handed out. But its problems this year are more obvious than ever. Far too many carbon credits were given out in the beginning of the program and companies produced less in the downturn, resulting in a huge surplus of credits. Current prices for emissions certificates hardly act as a disincentive to continue emitting CO2.

Looking at Fixes for the ETS

The European Commission is aware of the problem. In a draft report leaked to the press earlier this week, the Commission lays out proposals for both short- and long-term fixes to the ETS. And time, it would appear, is of the essence. "The options for structural measures outlined in the report should be discussed and explored without delay," the report reads according to Bloomberg.

Neither fix, however, will be easy and even proposals for short-term repairs are controversial. It remains to be seen whether there is enough political will to address the issue as the EU continues to muddle through the euro crisis. Yet failure to act would render meaningless the single most important governmental tool for reducing the emissions that cause climate change.

According to a Climate Action Commission report released on Wednesday, the EU remains on track to achieve its goal of 20 percent lower emissions by 2020 relative to 1990. Some point to the reductions as a success for the ETS, such as a recent study by the Environmental Defense Fund, while others suggest reductions so far are due to governmental policies in addition to the economic downturn. Indeed, success for the program can thus far mostly be measured in the fact that it exists at all.

But the ETS blueprint calls for the third phase, which will run from 2013 to 2020, to be much more rigorous, making it more expensive for major emitters and generating large amounts of revenue for member countries through the increased auctioning of credits.

Yet the huge surplus of credits handed out early in the program has largely undermined the teeth that the launch of the third phase was supposed to show. The proposed solution for the short-term is to take some credits out of the system early in the third phase of the program and put them back in at the end. The idea has been called back-loading.

'No Brainer'

European Climate Action Commissioner Connie Hedegaard called this "an administrative thing" in a recent phone interview, though it's more controversial than that, with some opponents calling the plan a form of market manipulation.

According to Mark Lewis, a carbon market analyst at Deutsche Bank, the market is betting that back-loading will happen, with the only question being how many credits should be taken out. Without the back-loading plan looming, Lewis estimates that emissions allowances today would be worth just two or three euros. "The only value that these allowances have at the moment," said Lewis, "is the value of the political option."

Hedegaard laid out a plan in July containing models for withholding 400 million, 900 million or 1.2 billion carbon credits from planned auctions during the next three years. The price on Friday for an EU carbon permit on the ICE Futures Europe exchange is €7.94 euros per metric ton. A report from Deutsche Bank suggests the price would stay steady or drop if only 400 million are taken out and rise to around €15 per ton within 18 months if 900 million or 1.2 billion were initially removed.

"On backloading, this is a no brainer," Hedegaard said. "This is an overflooded market. Would it be wise to continue to overflood it?"

Various players in the carbon market have proposed that up to a full year's worth of carbon credits -- in 2011, 2.08 billion allowances were issued -- be removed for later back-loading. With phase three, credit auctions were supposed to provide member countries with money for investing in low-carbon initiatives. But revenue from the scheme is less than half of what was projected just a few years ago.

It isn't difficult to find the culprit. When the system was designed, it used contemporary models predicting economic growth. But 2008 radically changed the outlook in Europe and the surplus of carbon credits has been building ever since.

'A Very Expensive Route'

As it currently stands, The European Commission does not expect the surplus to disappear organically by 2020. A commission draft document recently predicted that 1.5 billion surplus allowances will still be on the books at the end of the third phase. The draft report leaked earlier this week raised that estimate to 2 billion, according to Reuters.

"Having a low carbon price isn't a reflection of cheap decarbonization," said David Hone, Senior Climate Change Advisor at Shell, in a recent phone interview. "It probably means you've gone down a very expensive route and haven't allowed the ETS to do what it was set up to do, which is to find the lowest cost route to tackle the emissions problem."

Simply temporarily removing allowances from the system, though, may not be enough. The recently leaked draft document proposing fixes to the ETS laid out a number of deeper structural adjustments to the program, changes that Commissioner Hedegaard said are political dynamite. "It is more difficult when you come to the more structural options that we will present a month from now," she said.

Proposals for such larger fixes include a tighter cap on emissions, canceling credits outright or lowering the total number of credits issued, according to Reuters. Indeed, the United Kingdom recently called for 1.8 billion credits to be permanently removed from the system to spur prices higher.

Some ideas from the financial and academic communities appear no longer to be under consideration, such as the creation of a central bank for the ETS that could adjust the number of credits in a downturn or the idea of setting a mandatory minimum price for auctions.

Of course, much of this feels like déjà vu. SPIEGEL ONLINE noted back in 2006 that phase two of the ETS was "expected to run more smoothly." But that didn't happen. With the downturn, significant industry profits resulting from the sale of unused emissions certificates, a fraud scandal and the simple fact of too many credits given away, some studies now politely refer to both phase one and two as "teething phases."

'No Man's Land'

All of this, however, should not suggest that the system is broken entirely. The conversation about the cost of carbon in Europe is firmly entrenched in boardrooms. The biggest producers of greenhouse gases are part of the program with an expected 50 percent of the EU emissions part of the plan by 2013. Some are optimistic that Europe will simply be able to work out the kinks along the way.

But as with many proposals for necessary reform in Europe, opposition to potential ETS fixes is substantial. Ironically, the main opposition to both short- and long-term fixes to the ETS comes from those who have profited from or been given special allowances in the program.

Industrial manufacturers, for example, received millions of unneeded credits during the recession that they then sold on to power companies, essentially a twice-removed subsidy for the manufacturing sector. Perhaps not surprisingly, the powerful manufacturing and business lobby, BusinessEurope, has objected to the backloading plan, according to Bloomberg. The estimate of windfall profits during the first two phases runs at €19 billion euros, according to a study put out in 2010.

"It's uncontroversial that the sale of allowances during the nadir of the recession was an important source of income for many companies," confirms Damien Morris, Senior Policy Advisor at Sandbag Climate Campaign.

The other major opposition to any ETS changes is coal-dependent Poland. Back in April, Poland's Environment Minister Marcin Korolec told Reuters that fixing the ETS could bankrupt industry in the country. Poland is one of 10 EU countries that can get exemptions from paying for allowances for up to seven years. But that's only if Poland agrees to invest in renewables and diversify, something the country has not been willing to do.

"We're sort of in no mans land at the moment," said Deutsche Bank's Lewis. "You've got a price out there that is costing the consumer an extra seven or eight euros a ton. Power is really what is affected. We're paying a higher power price than we would be otherwise because of the carbon market but we're not getting the advantage of renewable investments."

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