What's Really Going On in the European Carbon Market

The author of today's article, Annie Petsonk, is International Counsel at Environmental Defense.

When European countries ratified the Kyoto Protocol, they pledged to reduce their greenhouse gas emissions. To prepare, they designed the European Union Emissions Trading Scheme (EU-ETS), now the world's largest greenhouse gas cap-and-trade system.

Since the launch of the EU-ETS in January 2005, allowance prices have been volatile and are currently hovering around zero.

Click on graph to enlarge.

Many people point to these figures and proclaim the EU-ETS a failure. Here's why they're wrong.

The most important misconception is that the current EU-ETS is the roll-out of the Kyoto Protocol. The Kyoto Protocol hasn't even begun yet! It runs from 2008-2012. The current EU-ETS is a pre-Kyoto pilot phase – "phase 1". Its purpose is to "learn by doing" as a way to prepare for meeting Kyoto goals starting in 2008 – "phase 2".

This preliminary phase also provides historical data on which to base allocations when the Kyoto Protocol goes into effect. This is crucial. The two biggest problems with the phase 1 EU-ETS are both a direct result of its being a pilot phase with no history to draw from:

  • The initial allocations of emission allowances were too generous. Since companies had not previously been required to track and disclose emissions, there were no hard numbers on which to base allocations. So companies were asked how much they'd need to emit, and naturally they said, "A lot!" When emissions data became available and companies saw that cutting emissions was easier than they anticipated, the price of allowances plummeted.
  • Companies were prohibited from banking pilot phase allowances into the 2008-2012 (Kyoto Protocol) phase. Banking allowances – cutting emissions below what's required and saving unused allowances for future use – is a powerful incentive for innovation. But it could not be used in this pilot phase because there was no historical data. With no history, there was no way to know what constituted a "cut" that could be banked. The requirement that companies sell unused allowances immediately contributed to the price drop.

Despite these start-up pains, it's working. The EU-ETS is reducing emissions and stimulating innovation [PDF].

If it was easy to meet the cap, why have companies made these changes? It seems that mere anticipation of mandatory emission limits can spur innovation. That anticipation is reflected in carbon forwards, which have stayed around $20 to $30 per ton even as this year's prices flat-lined. With prices like that on the horizon, companies have an incentive to invest and innovate now.

The EU-ETS is a success because its basic design is sound:

At climate negotiations a decade ago, it was the Americans who pushed for market approaches. Now America is resisting while Europe races ahead. Without a comparable U.S. market to spur innovation, our technology will surely lag, and America will have to import the new green technologies of the future.

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