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EU ETS Reduced Emissions Despite Over-allocation

February 22, 2010


The critics of emissions trading are many and their critiques varied. Some are sceptical of whether market based mechanisms can deliver real outcomes in terms of long term emissions reductions. This often seems to go hand in hand with an implied assumption that it is the unfettered thirst for resources unleashed by capitalism that is the root cause of the problem. In the asbence of a very strong independent government that can stand up to the armies of lobbysts, speculators, industry election financing, etc unleashed by the capitalistic system, emissions trading can’t help but be watered down to the point of environmental ineffectiveness.

The first phase of the EU Emissions Trading Scheme, these critics sometimes argue, was a case in point. “Look”, they say, “the EU gave in to lobbyists and gave out close to 100% of the permits for free. This lead to billions in windfall profits for participants in electriticity markets, thus distorting the incentive to spend money abating, instead it encouraged them to put more money into lobbying for better allocations.”

There are a number of issues to seperate out here. Some will have to be left for future posts. But I wanna make three comments.

1. Free allocation, windfall profits and auctioning.

Any massive government intervention into markets is going to involve compromises for reasons of political acceptability. Carbon taxes – the other real alternative to a cap-and-trade market – are no guarantee of a more equitable initial distribution of the burden of responsability and cost for reducing emissions. Look at New Zealand’s history for example.

Perhaps the most important point to note is that a problem of this scale is about political pragmatism as much as it is about short term equity concerns. Note that I say short term equity concerns, because my view is you need to just get something in place first, and then improve it over time, after you’ve done the heavy lifting of just putting a price on carbon. Moreover, if you look at the EU ETS, and the issue of windfall profits, you’ll see that they are going to increasingly auction permits to industry from 2012, including 100% auctioning to the energy sector…so the problem is being improved over time. Climate change is a long term issue, so not to be too vulgar, but let’s not worry too much about a bit of pork in the short run if it helps save the planet!

2 Volatility.

For other critics of carbon markets, their distrust of market mechanisms was confirmed by the crash in the price of EU ETS carbon permits ( a k a “high volatility”) that occured in 2006, after which the price declined steadily to zero by the end of the First Phase in December 2007.

The reality is however, that the price crash occured because of two reasons: 

A. The EC, faced with the difficult task of allocating an emissions cap for so many countries, actually over-allocated the number of permits to member states. Remember that the European system is complicated by the fact that every member state bargains and exaggerates a little to get more free allocation for its industries. However because the EC had only recently begun collecting emissions data on all the countries, it had an insufficient basis to test claims by member states. That’s now changed.

B. The free allocation system plus the fact that it was Phase 1 meant that there was no transparent price history or credibly aggregated price signal on where the value of permits for carbon emissions really existed. The phasing-in of full auctioning of permits starting 2012 will change this, as well as the windfall profit problem. And, in fact, the greater stability of the prices of permits now, in Phase 2, seems to show that the market is learning how to value carbon permits more accurately.

Source: Bluenext

Further to the question of volatility, it should be pointed out that the volatility of the CO2 price, in terms of the cost burden it has imposed on firms, was nothing compared to the volalitity of global energy prices during the past five years.  Check out, for example, UK Gas and Electricity prices over the last 6 years below:


So the critique of “too much volatility” for me seems a little hard to swallow.  Sure, you can raise the issue of long term price signals, but that’s an open question that still needs to be resolved with due research. Jumping to conclusions based on pre-determined ideology doesn’t help the debate.

3. An industry driven system can’t reduce emissions.

Ahem… Back to Denny Ellerman. Check out MIT’s Denny Ellerman in this article here.  Denny’s just released a book of reference giving the most comprehensive ex-post analysis on Phase 1 of the EU ETS, with France’s CDC Climate Research, and University College Dublin. And what’s the headline result?

The widespread view that the EU’s emissions trading scheme (ETS) has failed to deliver expected reductions in emissions “cannot be sustained on the basis of the evidence”, according to a major new study of the first phase of the scheme which hails the cap-and-trade initiative as successful and a “path-breaking” policy experiment.

It assesses the first phase of the EU ETS, which ran from 2005 to 2007 and was widely regarded as a failure due to an overallocation of emission allowances that resulted in a slump in the price of carbon.

However, the researchers estimated that despite the price of carbon falling to almost zero, the scheme still led to a reduction in greenhouse gas emissions of between two and five per cent against business-as-usual scenarios, resulting in carbon savings of 120 million to 300 million tonnes during the three-year period.

Carbon market sceptics are not going to be happy…

  1. TheElicitor permalink

    What are the key considerations policy makers need to keep in mind when setting a cap to ensure that it’s fair to all parties participating in the scheme.

    • The Carbon Economist permalink

      Good question.

      The first point to make is that the smaller the size of the cap for the carbon market as a whole, the higher will be the emissions allowance price. This is because the cap is basically the supply of a scarce resource (emissions rights) and it is being reduced when the cap is tightened, while demand stays the same.

      The second point to make is that the burden of setting a cap is, in a sense, borne equally by everyone in the market. This is because the carbon price of permits will be the same for all market participants, so everyone pays the same price for using the same scarce resource (rights to emit into the atmosphere).

      Moreover, because some participants have higher abatement costs (costs of reducing emissions) than others, being able to trade permits actually avoids disproportionate effects on different participants. this is because high abatement cost participants can buy emissions permits from low abatement cost participants. High abatement cost participants have an incentive to buy permits in the market at the market price because it is a more economical option: it allows them to delay their own costly abatement until it is easier and cheaper to achieve by buying permits instead. Low abatement cost participants have an incentive to reduce emissions and sell excess permits because it is economical for them too: it is cheaper for them to reduce emissions (e.g. via switching fuels) than to buy permits at the market price. thus, they make a rational economic choice to reduce emissions and sell excess permits to those participants who value them more highly.

      Of course, industries typically want to avoid paying any carbon price at all, but I’m afraid that this is no longer a situation the world can afford to accept.

      There can be some flow on affects to vulnerable consumers of carbon pricing, because producers will tend to pass on carbon costs if they can by raising the price of their products. So here the solution is to take revenue the government earns from selling the emissions permits at auction and use some of the money to compensate these vulnerable consumers.

      There is also an argument for possibly giving a small portion of emissions allowances away to producers for free in some industries. This is only true for producers which compete in international markets and where they might lose “too much” market share if they face a carbon price buy other international rivals do not.

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