In 2002, the European Union ratified the 1997 Kyoto Protocol on climate change, which requires that global greenhouse-gas emissions be reduced by 2012 to an amount 5 percent below 1990 levels. To do its part, the EU is relying largely on market mechanisms. Companies that operate certain carbon-emitting facilities, such as coal- or oil-fired electrical generating stations, are granted “allowances” – the legal right to release a certain amount of carbon dioxide into the atmosphere each year – and may buy and sell these allowances as they wish.
Such a market, in theory, gives companies an incentive to reduce emissions, so that they can avoid buying extra allowances and sell their surplus ones. But the European Union Greenhouse Gas Emissions Trading Scheme, which opened in January 2005, has already run into some unexpected glitches. In April and May, data leaked by some member states and the European Commission showed that in the first year of the market’s operation, most EU countries handed out more allowances than were needed. Total allowances exceeded the actual amount of carbon emitted by at least 67 million tons, or 3.4 percent, according to PointCarbon, a research firm based in Oslo, Norway. The news disoriented carbon traders and caused allowance prices, which had risen steadily since the market’s opening, to plummet from about 30 euros per ton of carbon dioxide to a low of less than 10 euros per ton.
Low allowance prices mean companies have little incentive to reduce their emissions. Governments have been so generous when allocating permits that this first, experimental phase of allowance trading – which lasts through 2007 – is unlikely to lead to real emissions reductions, says Christian Azar, a professor of physical-resource theory at Chalmers University in Gothenburg, Sweden. What’s needed, says Azar, is a cap on allowances.