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Why emission trading fails

By Benedict De Meulemeester

By Benedict De Meulemeester on 28/08/2009

The Dutch economic daily ‘Financieel Dagblad’ published an article by Sven Stevenson that declares that EU emission trading is failing to help curbing carbon dioxide emissions. The author is actually expressing what many involved in the European market for trading carbon dioxide emission rights know for some time now. The system isn’t working like it should. It hasn’t avoided the emission of a single gram of carbon dioxide. The price signal that emission rights send to potential investors in emission abatement technology is much too confusing. Such investments are made on a long term scale. How can you count on any emission rights cost savings if the price is jumping up and down all the time? Many projects in renewable energy and energy savings are currently running in Europe. Some reasons for investing in them are:

-          other policies such as voluntary reduction agreements, feed-in tariffs for renewable energy, tax reductions in return for savings programs, etc.

-          the rising cost of energy,

-          protecting competitiveness by raising efficiency in energy-intensive industries,

-          the public mood, building a sustainable business is ‘hip’.

Some of these are connected with emission trading. In countries such as Belgium or the Netherlands the mechanism for allocating the initial emission rights is connected with the voluntary reduction agreements. Moreover, having to comply with emission trading regulation has forced the companies concerned to consider their carbon dioxide emissions and energy consumption policies. But this means that renewable energy and energy savings investments come as a side-effect of emission trading policy. And this was not the aim, the aim was that the emission rights market would give a clear and direct financial signal to companies to cut their emissions. And that is clearly not the case at this moment.

I remember 2003 – 2004, when we were preparing for the first phase of emission trading. I was a big enthusiast of the idea of emission trading. And indeed, in theory, the idea of introducing a market mechanism for solving an environmental issue looks great. Every professor agreed. The market mechanism would ensure the overall efficiency of individual company’s efforts to curb emissions. Those companies that could reduce at the lowest cost would do so first, so that the overall cost would be reduced. The efficient market hypothesis, which presumes that markets produce rational results, supported this idea.

Five years later, I see so many flaws in the functioning of the emission trading scheme, that I have lost all enthusiasm. The fundamental problem is, I think, a time-scale issue. A market, such as the one for emission rights, is essentially short-term. The price shifts up and down constantly, reacting on the ‘news’, the latest information available. The aim is to give an incentive to companies to make investment decisions. Those decisions are essentially long term. So, bringing together a market mechanism with investment decision-making, means that you actually add an important market risk element to the investment decision. An energy manager that proposes an energy savings investment can no longer say: ‘the return on that investment will be 10%’, he has to say, if the emission rights price is low, it will be 5%, if it is high it could rise to 20%. And uncertainty over the return is not exactly something that promotes investment decisions.

On top of that fundamental issue, there are multiple practical issues that make emission trading for carbon dioxide extremely difficult to implement:

  1. The allocation is an extremely thorny issue. Carbon dioxide emissions rise together with energy consumption which (until now) has risen along with economical development. I agree that improving efficiency produces beneficial economic effects. But if you limit the amount of carbon dioxide that a company or a country can emit, you also limit its potential growth. If its sales grow faster than the efficiency improvement rate, the overall emissions will go up. Companies that see their sales grow will hit the roof of their allocations and will have to buy the extra rights to be able to continue to grow. That is how individual companies experience their emission rights allocations. That is also how countries experience it. Therefore, the negotiations over the initial allocations are extremely hard. Everybody wants to get a piece of the pie that is as large as possible, as they want to create maximum room for economic growth. In a political context, the allocations are the result of compromises. And if you compromise a little bit here, and a little bit there, the result is: over-allocation. If everybody gets a larger piece of pie, the pie becomes larger.
  2. Controlling the emissions demands an extensive administrative apparatus. This is one of the more tangible results for many participants in the emission trading scheme: the huge amount of time that they spend on administration and reporting.
  3. Spot, future, exchange-traded, OTC, short-selling, put options, CER to EUA swap, etc. I could go on and on spitting out jargon that serves to understand how this market works. The conclusion is: it is very complicated to comprehend this market. For consultants such as us, this should be good news. But I have seen over and over again that the large majority of participants in the emission trading scheme simply give up and don’t take the trouble of understanding it.
  4. The EU system has a fundamental flaw to it, namely that companies cannot opt to just pay the fine (100 euro for every missing emission right). If a company fails to enter the same amount of rights as its reported emissions, it is obliged to pay the fine ánd submit the missing emission rights anyway. So far, over-allocations have produced collapsing prices. But just imagine what would happen if a real shortage of emission rights would occur. Companies would have to scramble for emission rights that are not there. This would produce extreme price rises. Can you imagine what the reaction if the public would be if a steel mill has to shut down and put 3.000 workers on the street because the price of emission rights has become sky high?

Auctioning initial emission rights instead of allocating them for free would solve the big allocation problem. But it will not solve the other problems. And it will not avoid the uncertainty over future prices. Which means that the emission rights market will continue giving a confusing signal to companies on whether to invest in renewable energy and/or energy savings. Can we remedy these ills? Or should we rather conclude that after almost five years of experimenting with emission rights, it has become clear that it is not the ideal tool for climate policy that many have supposed it was? Should we start looking for something else?

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