ETS is really becoming absurd

I was shocked these past days by two pieces of really jaw-dropping news about emissions trading in Europe:

1. A Dutch client told me that as paper manufacturers, they fear that the new phase allocation rules will oblige them to shut down their cogeneration unit.
2. Peter Vis, an official of the EU Commission expressed his worries that a directive that would oblige ETS companies to improve energy efficiency would undermine ETS prices.

This news confirms my worst fears about ETS. It has become a goal in itself and the people involved in it seem to have completely forgotten that ETS is only a means to reach a more important goal: reducing carbon emissions. As I have said before in this blog, carbon emission trading is largely a failure. The main flaw is the fact that the two trading phases that we have had so far were over-allocated. This led to very low carbon prices. This means that the price of carbon is not stimulating carbon reduction measures. The EU Commission understands this and is anxious about not having over-allocation for the next trading phase, and we can understand this. However, if this means that they become scared that energy efficiency improvements reduce carbon emissions, this is absolutely absurd.

Ad 1: If you reduce the allocation of emission rights to a company that runs a cogen unit, it becomes economically sensible for this company to shut down the cogen unit. By doing so, the company will reduce its gas consumption and hence its carbon emissions, which reduces the cost for buying extra rights. It will then buy its electricity from a power company. Anybody with some basic understanding of energy efficiency will understand that the end result is an increase in overall carbon emissions.  Having an on-site cogeneration unit is the more energy efficient way of producing paper. If ETS causes paper manufacturers to fall back on less energy efficient production methods, it completely misses its goals.

I know that supporters of ETS will argue that the increased demand of grid electricity will cause carbon and electricity prices to go up, so that ultimately the paper manufacturer might be forced to start up the cogen again. In theory this is true, but this argument misses two points: 1. The adaptation of carbon and electricity prices will not be one-on-one, as the paper manufacturer is just one of the many emitters of carbon dioxide and just one of the many clients of the power producers, 2. There will be serious time lags between the decisions to shut down or start up the cogen and the price reactions.

This argument is actually a good illustration of why ETS is going wrong. It is a good policy in theory, but when you practically apply it, you run into a multitude of difficulties. ETS is a good example of a too optimistic application of the efficient markets hypothesis. This hypothesis assumes that all market participants have real-time access to all supply and demand information. Hence, the price is always a correct representation of supply and demand balance at that moment. In reality, there are serious time lags in the access to information. The owner of the paper company will decide to shut down his cogen based on carbon prices and electricity prices at that moment. Prices will adapt over a few months. It will take the paper manufacturer another few months to realize this and to take the decision to start up the cogen again. Supply and demand data of carbon dioxide emissions are simply too chaotic for anyone to have an accurate and timely view on them. Therefore, prices are based on assumptions about supply and demand, not the real data. That is the reason why ETS has failed, and will continue to fail, to give a consistent and reliable price signal.

Ad 2: I was not present at the conference where Mr. Vis made his comments and I hope that his words were misrepresented in the press. However, Euractiv quotes him as saying: "We're big supporters of energy efficiency," he said, "but we have to be careful not to undermine a system that is in place now – the ETS – which is a global leader". So if I understand Mr. Vis correctly, he would be unhappy if companies cut their carbon emissions so much that emissions drop below allocations, causing prices to fall. He is chief of staff of the EU’s Climate Commissioner!

I understand part of Mr. Vis’ argument. It is indeed confusing to have two policies in place that have the same goal of reducing carbon emissions by industrial companies. The one, ETS, wants a market based approach to stimulate reduced emissions. The other, an energy efficiency directive, is a command and control approach to oblige companies to reduce. Mr. Vis is right about the fact that the EU needs to choose which approach. However, is he right in assuming that the market-based approach is so much better?

If he fears that the command and control approach will lead to emissions dropping below ETS allocations, he admits that obliging efficiency improvements is the more effective policy. If we adopt that approach, carbon emissions will drop more than with ETS, that is what Mr. Vis is saying. Well, Mr. Vis, isn’t that a good thing for the climate? Isn’t your boss supposed to protect the climate rather than the ETS? Shouldn’t you promote the more effective policies?

Mr. Vis will probably argue that ETS is more cost-effective.  I am not so sure about that. ETS has been around now for the past six years, and it has been nothing more than an operation that transferred money from the electricity consumers to the electricity producers, without any real contribution to reducing carbon emissions.  I wouldn’t exactly call that cost-effective.  Billions of euros have already been spent on emissions trading. By electricity consumers that saw their power price rise due to emission rights prices. By investors that took wrong bets. By participants in the ETS to deal with the administrative burden that it imposes on them. A massive waste of money.

Of course, this waste has been due to the over-allocation. But will ETS be cost-effective in case of a shortage of emission rights? The ETS theorists assume – once again, based on the efficient market hypothesis – that in the end total emissions will completely match the allocation. This supposes a degree of rationality and access to information that is simply not there. Who will decide, on the 31^st of December of the last year of the trading phase, how much all the participants in ETS should consume, so that the emissions match the allocation? Theorists even assume that this will lead to some sort of equilibrium price, something that I don’t even understand from a theoretical point of view. What many theorists fail to understand, is that in ETS the supply side of the equation is static. The overall amount of emission rights that are available is fixed in the initial allocation. This is very different from other markets. It means that there is no cap on how high prices can rise. And this is a potentially very dangerous situation. In case of a real shortage of allocations, I think that there are two probable scenarios:

1. Everybody realizes very soon in the trading phase that there is a shortage and starts to buy emission rights. We get a massive price spike, which leads to increases in electricity prices that cripple the EU economy. The resulting economic crisis causes emissions to drop below allocations, causing a price crash by the end of the trading period.
2. The large majority of ETS participants that have less than 100.000 tons of emissions, continue to be very passive about emissions trading. They realize only very late in the trading phase that they have shortages of emission rights. By 2012 there is a massive scramble for rights that are not there.

I sincerely hope that I am wrong, but I am very scared that if the EU indeed manages to impose a short allocation on the market, we will see an extreme price spike. This will cause an economic crisis in Europe. Is that what you call cost-effective, Mr. Vis?

There are many reasons why Brussels can be dubbed ‘The capital of absurdity’. The commission’s fundamentalist approach to ETS is one of them. Another one is the absurdist character of Belgian surreal painting, of which René Magritte is the best example. Writing this blog made me think of Magritte’s painting “Golconda”. We can only hope that the authors of EU climate policy come back down to earth before they unleash ineffective, economy-wrecking policy on us.