Carbon Pricing: The Story So Far

Update 02-2021: the EU ETS carbon price is now €42.00/ton (It’s possible to check daily price updates via Ember)

When considering the task of putting the Paris Agreement into effect, the UNFCCC guidelines do not go into much detail. The economic case for maintaining temperatures at 2°C undoubtably needs further impetus, and this is where groups like the G20 can be used to motivate governments to meet their NDC pledges – given a few simple, helpful policy recommendations they can use to start the ball rolling on climate change.

United by the objective of maintaining financial stability and promoting progress, the G20 is influenced by industry lobby groups and NGOs – one being the Climate Transparency Initiative, who are tasked with providing members of this group with clear, independently reviewed information regarding the progress of reports and studies outlining our path to safe levels of carbon emissions. And so it is this group who produced a recent paper drawing four main recommendations on which economic progress within agreed safe climate limits could be made. These ‘recommendations’ made to governments are: a) submit plans as to how countries intend to decarbonise by 2050 b) strengthen low carbon infrastructure investment, with a focus on renewable energy c) end fossil fuel subsidies (already agreed by the G7, effective from 2025) d) Introduce a price on carbon, be it tax, levy or emissions trading.

It is this last point – carbon pricing – that many economists and policy experts agree to be the most effective and cheapest way to curb the carbon dioxide emissions that are warming the planet. However, many would also say that it is merely a complimentary policy tool, and that other more direct policy measures such as feed-in tariffs, smart regulations and direct investment by governments in R&D and infrastructure play a much larger role in aligning industry with lower-carbon pathways.

The issue of carbon pricing is thorny and as with much climate policy, the devil is in the details. Carbon pricing – or more specifically the system of cap-and-trade or emissions trading – is gaining popularity worldwide. With China rolling out a cap-and-trade system in 2017, an estimated 50% of the global economy will be putting some form of price on carbon; including New Zealand, Mexico, Korea, Japan, Chile and Canada as well as the RGGI (Regional Greenhouse Gas Innitiative) in some American states and finally Europes’ flagship climate policy, the EU Emissions Trading System. With the more widespread success of its climate and renewable energy policies, many people are focusing on Europe and specifically the EU ETS as an indicator of what does and doesn’t work about pricing carbon.

Unfortunately, untangling the EU ETS is not a simple exercise.

The EU ETS

The European Union has ultimately been successful to date with regards to its climate targets, with the 2020 emissions reduction target of 20% below 1990 levels now only 1% away. However, the overall contribution of the ETS to this reduction remains uncertain, and as a result it has been the subject of criticism given its status as Europe’s ‘flagship climate policy’.

The EU ETS is the world’s first cap and trade system and still its largest, covering 45% of the EU’s emissions and allowing companies to also buy offsets for carbon reduction measures around the world in order to reduce the total amount of carbon emitted. Essentially, a cap is set on the amount of emissions a certain sector is allowed to release, and is reduced over time. This cap is based on a ‘best-in-class’ system by which a number of companies are chosen to lead on a number of metrics, including the amount of CO2 they emit. Thus, when a cap is set for one sector as a whole, they can aspire to reach the level of CO2 output of the best-performing companies, usually by adopting similar practices and efficiency standards – ensuring that the industry is moving forward led by example. After the cap is set, and lower-performing companies are emitting carbon beyond this level, they need a permit or allowance (a EUA) which they may purchase from a special trading platform that allows companies who have reached their targets to sell the allowances they don’t need, thereby creating a system of trading in allowances. The system is designed so that ideally the cost of these allowances or pollution permits (EUAs) should either rise over time or stay the same. This is achieved by ‘tightening’ the cap on the emissions released each year, in line with targets. Currently, this reduction is set at a 1.7 percent per year, until 2020.

And this is where the problems begin.

The price of allowances has dropped to record lows, and shows no sign of increasing. The reason for this is that there are far too many allowances on the market, and companies do not need to increase the price of allowances they wish to sell because nobody needs them. In effect, allowances exceed emissions, leading to a situation called ‘over-allocation’. This happens for a number of reasons. Primarily, this is because member state governments listen to wealthy industry lobby groups who prefer large emissions budgets, and so the cap is set too loose. The gap is further widened by unexpected events such as recessions, meaning that companies are producing and therefore emitting less. Moreover, the technical reasons include the fact that companies are allowed to keep unused allowances indefinitely, thus capitalising on downturns and potentially using allowances as a revenue stream. Furthermore, the cap itself is not as effective is it should be because emitters may also purchase carbon offsets internationally for far lower prices than the cost of allowances, and then trade the excess allowances they have accrued, generating what is commonly referred to as ‘windfall’ profits.

Windfall Profits

In effect, the Commission continues to underestimate the ability of large emitters to pass through ‘carbon pricing’ costs to consumers, as emitters lobby that carbon leakage would result, whereas in reality they pass through costs as well as selling excess allowances, thus accruing cited ‘windfall’ profits. Carbon Market Watch estimates that heavy industry in the EU has benefited from the EU ETS during the period 2008-2015 in three ways:
1) windfall profits from surplus pollution permits €7.5 billion
2) windfall profits from offsets €0.8 billion (the low price of offsets allows them to sell their emissions allowances for profit)
3) windfall profits from cost-pass through to consumers €16.8 billion

The main reason for the large quantity of allowances distributed is due to what the industry terms ‘carbon leakage’. According to Carbon Market Watch, “carbon leakage is the situation in which, as a result of stringent climate policies, companies move their production abroad to countries with less ambitious climate measures, which can lead to a rise in global greenhouse gas emissions”. It is the central premise of all industry arguments relating to carbon pricing despite the fact that it has not been found to have occurred during the 11-year period that carbon has been priced. The reality is that the price of carbon, as measured by allowances, has been continually low, and falling. This means that it has had little if any effect, and ultimately puts into question some of the motivations behind the governance of the ETS as an effective tool for reducing emissions.

Looking at the EU ETS in perspective

Overall, the EU ETS is a useful and necessary policy instrument, but it is not being used to its full potential, and its current ineffectiveness could be construed as a technical failing when in fact it may be the result of political motivations.

First of all, at its most basic level it is instigating a closer level of accountancy when auditing carbon emissions. Second, it is seen to function on an international stage and has the power to encourage other countries to adopt similar schemes, as has been witnessed by the approaching rollout of the Chinese ETS in 2017. Ultimately, this brings the system closer to a scenario when it can be used to far greater effect, by resolving the primary objection presented by industry lobbyists in that the concept of ‘carbon leakage’ will be unsupportable.

To summarise, the reality is that because of the EU ETS, heavy industry are making significant profits; of which they are not sufficiently obligated to invest back into carbon reduction strategies, and the costs for the system are being borne by the consumer and taxpayer. It would seem that the very existence of an ETS at all is considered achievement enough.

Revisions

That it could work better is widely recognised – in fact, all that would need to occur would be a few simple interventions as proposed by implementation of the Market Stability Reserve (MSR) scheduled for 2019, which will start to better regulate the provision of allowances and the system by which they can be used, such as ending the practice of carrying permits from year to year. The MSR will hopefully ensure that allocations more closely follow requirements so that the large number of allowances provided do not inevitably become a subsidising mechanism. It could be that political motivations for the governance of the EU ETS and the resulting lack of a meaningful carbon price may in effect be more to do with an extended period of ‘training wheels’ while other issues within the EU are given priority. As such, it can be seen as useful but prone to abuse and realistically only wholly effective after further widespread global adoption.

Eventually, carbon pricing will be the only way to start weeding out the heavy polluters but understandably, it needs to be set up so as not to damage industry unnecessarily. Knowing that the carbon price remains consistent (and could be increased) is a strong motivating factor for these industries to maintain awareness of their emissions, and pursue less carbon intensive options when available. However, we can only hope that it does not become a convoluted method of subsiding the very industries that it purports to curtail, such as coal and other heavy emitters, simply because these industries are gaming the system and the regulations become irrelevant. Time will tell.