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Carbon Trading on the Cheap

If the United States wants to build a market-based approach to reducing carbon dioxide emissions, it should learn from Europe’s failures.

Advocates of carbon-trading schemes in the United States like to point to Europe’s cap-and-trade program as a model worthy of emulation. The European Union’s Emission Trading System, which has been in place since 2005, puts a price on carbon dioxide pollution for the purpose of inducing industry to cut emissions of greenhouse gases and reduce the effects of climate change. European governments set annual caps on total carbon dioxide emissions that may be produced by a group of energy-intensive industries. They then hand out a number of allowances to each company, allotting them on the basis of past emissions. Each allowance, called an EUA, permits the company to release a ton of carbon dioxide into the atmosphere. Companies whose emissions exceed their allowances for a given year must buy more; those with fewer emissions can sell their allowances.

While other governments and authorities (including a consortium of U.S. states) are experimenting with carbon trading, Europe’s system accounts for more than three-quarters of such trading on a global scale. The trade in EUAs has amounted to more than 140 billion euros ($196 billion). Yet Europe has vanishingly little to show for all this.

In theory, limiting the supply of the pollution allowances helps to establish a price for the emission of carbon dioxide. That, in turn, is meant to provide industrial manufacturers and power producers with financial incentives to develop cleaner technologies. The reality has played out very differently, however. A glut of pollution credits, distributed without cost during both the first, transitional phase of the program and the current working phase, drove down the value of the EUAs. As a result, Europe’s carbon dioxide emissions remain priced well below 20 euros per ton. With the price of pollution so low, economists say, industries that generate and consume energy have no incentives to change their habits; it is still cheaper to use fossil fuels than to switch to technologies that pollute less.

“It is hard to tell if any investment decision in the last three to four years has really been shaped by the carbon price,” says Sophie Galharret, an energy economist with the French-Belgian power utility GDF Suez and a research fellow studying European energy and climate markets at Sciences Po, France’s elite university of political science and economics in Paris. “The perfect market should provide such incentives,” says ­Galharret, “but today’s real market does not.”

European Union's Emission Trading System

Indeed, many doubt that Europe’s trading scheme will drive innovation forward anytime soon. The European Union has vowed to cut greenhouse-gas emissions by at least 20 percent–relative to 1990 levels–by 2020. That translates into a 1.74 percent annual reduction in allowances available to companies covered by the trading system. But companies can easily meet the emissions goal without deploying new technologies. The trading rules allow the companies to receive “offsets” to their own pollution if they invest in projects that reduce or prevent greenhouse-gas emissions in developing countries outside the EU. The other half of the necessary reductions will be achieved if EU members make good on mandated increases in renewable energy. In other words, though the carbon market is described as the centerpiece of EU climate and energy policy, energy investors may ignore it for at least the next decade.

Such problems explain why, even as the United States looks to Europe for a market-based approach to controlling emissions, critics there are clamoring to further tighten the EU emission trading system, or to scrap the carbon market altogether.

Windfall Profits
Blame a combination of factors–bad information, the coddling of domestic industries, the recent economic downturn–for blunting the European Union’s emission trading system.

The European Commission proposed the carbon-trading scheme in late 2001 as a means of getting the European states to meet their commitment to reducing greenhouse-­gas emissions under the Kyoto Protocol. Barely three years later, European countries had allocated EUAs to more than 11,500 power plants and industrial facilities such as steel mills, oil refineries, and cement works, representing close to half of European carbon emissions. Nearly all the EUAs, which were valid for a trial period running from 2005 to 2007, were handed out free of charge in order to short-circuit complaints from industry interests that the added cost of pollution permits would crimp their global competitiveness.

At first the trading system looked healthy; virtual trading pits such as the London-­based European Climate Exchange thrived. Futures contracts on a 2007 EUA climbed steadily from about seven euros in January 2005 to more than 30 euros by April 2006. In 2005 alone, carbon exchanges traded 362 million EUAs with an estimated financial value of 7.2 billion euros, according to Oslo-based market consultancy Point Carbon.

Then, in May 2006, EUAs plummeted in value, to less than 15 euros. After recovering briefly in the summer of 2006, EUA futures settled at close to zero for the remainder of the trial phase. Emissions data released in May 2008 revealed that European states, relying on unreliable emissions estimates and under pressure from various industries, had handed out EUAs for 6,321 million tons of carbon dioxide during the first phase, exceeding total actual emissions during the period by 107 million tons.

Global recession is now undermining the second phase of the trading system, which started last year. The European Union set the cap for the 2008-2012 period at 6.5 percent lower than the cap for the trial period. Trading volumes initially exploded, according to Point Carbon. But the rally proved short-lived. The EUA price slid to an average of just 11 euros in the first quarter of 2009, as manufacturing slowed in the face of the recession.

The faltering trading scheme may be doing real harm. Free permits and weak carbon pricing have rewarded the heaviest carbon polluters while hurting Europe’s consumers. Most EU states gave extra allowances to heavy industries such as cement and steel, because they didn’t want to threaten the manufacturers’ international competitiveness; by the same logic, states gave relatively few allowances to producers of electricity, a commodity that must be generated close to consumers and thus is not forced into global competition.

This allocation strategy means that electricity consumers have felt the brunt of the price increases. Power producers jacked up the price of electricity to cover the anticipated costs of their allowances. Power companies also add a theoretical “opportunity cost” to their consumers’ bills for using the free EUAs they could have sold on the carbon market instead.

But consumers aren’t the only ones penalized by the trading scheme and its process of handing out EUAs. Power producers using relatively clean technology are also suffering. Perversely, coal-heavy utilities with the highest emissions benefit the most from carbon trading, since most states allot them more EUAs. This gives them an unfair advantage over producers generating power with natural gas or renewable sources, which release less carbon.

In other words, many European power companies have seen windfall profits under cap-and-trade.

The trading system “increased the price of power, but [power producers] didn’t face a real increase in their costs,” explains Jos Sijm, a senior economist at the Energy Research Centre of the Netherlands. Sijm estimates that in markets such as the Netherlands, the U.K., and Germany, the trading system increased power prices by a “quite substantial” 4 to 10 euros per megawatt-hour in 2005 and 2006. “For the Netherlands it led to windfall profits on the order of 300 to 600 million euros,” Sijm says. “For Germany, the amount of windfall profits would be much higher–a few billion euros.”

It would be easier to accept the profit taking as an unfortunate transitional side effect of the trading scheme if the program achieved its goal of reducing carbon dioxide emissions. But teasing out the program’s real impact on emissions is tough.

Emissions from power generation actually edged up by 1 percent over the previous year in both 2006 and 2007. Last year, emissions dropped by 3 percent, according to preliminary data released by the European Commission. But observers say the global economic recession probably accounts for most of that decrease. In any case, it is not likely that the trading system has prompted many technology changes. “If you really want to induce investments and major technological innovations, the price has to be higher and more stable,” says Sijm.

How much higher? Surveys of business leaders suggest that they will not seriously reconsider the way they use energy until the price of carbon exceeds 30 euros per ton. The late Dennis Anderson, a professor of energy and environmental studies at London’s Imperial College, concluded in 2007 that significant change will come only when carbon prices “move to the upper end” of a range that he put at 40 to 80 euros per ton. Anderson estimated that the 40-euro threshold would have to be met to make onshore wind farms and nuclear power a better investment than natural-gas or coal-fired power plants, while prices would have to approach 80 euros to make carbon capture and storage worthwhile. Even higher prices would be needed to make solar and offshore wind economical.

Economists at the International Energy Agency have recently calculated that holding global warming to a reasonable level would require an annual investment of $1.1 trillion per year. And it would require a $200 per ton price on carbon, said the IEA, to drive the necessary innovation.

Reluctant Reformers
Efforts to improve the EU trading scheme have been blunted by politics. Auctioning EUAs rather than giving them away would eliminate the windfall-profit taking and other perverse incentives wrought by free allocations. It would also generate revenues that some European countries promise to spend on alternative-energy R&D and energy-efficiency incentives, thus taking the sting from rising energy costs. But for the program’s second phase, now in effect, less than 10 percent of the total number of allowances are available at auction. And the European Commission’s proposal to auction all EUAs to power producers by 2013 took a hit when fast-growing, coal-dependent states such as Poland insisted on phasing in their auctions through 2020. Similarly, auctioning will phase in more slowly for those industrial sectors at greatest risk of competition from manufacturers outside the EU.

Meanwhile, politicians also opened the door wider to so-called carbon offsets, which allow companies to meet their emissions-­reduction commitments by financing rainforest conservation, renewable-energy investments, and other low-carbon projects in developing countries.

European industrialists argue that offsets make both economic and environmental sense, since climate change is global. The problem is that to the extent that offsets slacken demand for EUAs, they weaken the price signal that the carbon market is supposed to send to investors in Europe’s energy sector and industries. The price signal will be further compromised by a new mandate, endorsed by European leaders in December, that requires 20 percent of Europe’s energy production to be met through renewable sources by 2020.

No surprise, then, that some economists, as well as some experts in the power industry, advocate making adjustments to the emission trading system. Corrective measures under debate include a lower cap, tighter limits on offsets, or even a mandated floor price. Whatever the solution, many argue that the trading system will need to be significantly strengthened. “The ETS is not as tough as it needs to be,” says Michael Grubb, a visiting professor of climate change and energy policy at Imperial College and chief economist at the U.K. Carbon Trust, which advises business on low-carbon strategies.

What is especially disappointing is that even as the Europeans seek to undo many of the features that have made their carbon-trading system weak and dysfunctional, legislators in Washington seem determined to repeat their mistakes. Representatives Henry Waxman (D-CA) and Edward ­Markey (D-MA) introduced energy legislation built around a cap-and-trade system this spring, with the same concessions to carbon-intensive industries that neutralized the EU’s trading system.

The U.S. bill, as it stood at press time, proposes to cut emissions to 17 percent below 2005 levels by 2020–essentially taking the U.S. back to (rather than much below) 1990 levels. And, as with Europe’s trading system, a mix of offsets and renewable-energy mandates threatens to further undermine the carbon price. Analysts project U.S. carbon prices at a meager $15 to $20 per ton in 2020–barely a 10th of the price called for by the IEA.Most allowances, meanwhile, will be distributed without charge, despite the risk of windfall-profit taking and perverse market incentives. That move will also deprive President Barack Obama of revenues needed to fund the $150 billion, 10-year program of clean-energy R&D outlined in his 2010 budget proposal.

The prevailing wisdom among supporters of the Waxman-Markey bill is that Congress, wary of putting energy-intensive industries at risk, won’t pass anything stronger. Best to get a carbon price established in the U.S. economic system now, supporters say, and tighten the system later. But this cap-and-trade scheme could be weak enough to send a dangerously wrong signal to financial markets looking to invest in new energy technologies. If you have any doubts about that, just take a look at the EU.

Peter Fairley is a freelance environment and energy writer based in Paris.

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