As the price of EU carbon permits hits an all-time high of 70 euros per ton, questions of whether the EU Emissions Trading System (ETS) is living up to its promise are resurfacing.
The EU ETS, the world’s first emission trading system, was introduced in 2005 [pdf] to put a price tag on carbon emissions. The mechanism is built on cap and trade which assigns a finite number of carbon allowances to various greenhouse gas emitters in the aviation, electricity, and energy-intensive sectors of the EU [pdf]. The premise is that emitters who emit beyond their carbon allowances [pdf] must buy additional carbon permits from emitters who have not used up all their carbon allowances. As a result, excessive emitters are incentivized to reduce their emissions so that they do not incur additional costs. That is how it should work in theory; however, reality has shaped out to be completely different.
To shield their industries from carbon paralysis, EU governments granted 99% of the carbon allowances between 2005 and 2012, or Phase I and Phase II of the project, for free — thereby giving up tens of billions of euros of potential auction revenue. This effectively made the cap-and-trade system void as emitters had no incentives to reduce their levels of pollution with the abundant supply of allowances. With the introduction of Phase III of the project, in 2013, this was set to change as permits would be primarily allocated through auctioning. Eight years later, they halved the number of free allowances; however, for most of the period, the price had been hovering between 5 and 15 euros per ton, considered by many economists as too low of a demand to incentive a significant change in emissions. Albeit, some studies justify the lack of demand as a sign of polluters moving towards less pollution, therefore they did not need additional allowances as the supply was ample enough to cover their needs. This leaves open the question of why did carbon prices double between 2020 and 2021 if the supply had not shifted that much?
The supply of allowances clearly remains way too abundant for major emitters to be incentivized to buy allowances. During Phase I and Phase II of the EU ETS the emissions of the 10 largest emitting sectors were 100% covered by free allowances, since 2013, there has been a gradual decrease to 60%. Despite a 40% decrease in free allowances, emissions, when accounting for emissions embodied in gross imports, i.e. gross leakage, have only decreased by 5-10%. In other words, the supply of free allowances remains far too ample to justify the EU ETS as an effective supply-constraining mechanism especially when considering that the majority of reductions were explained by the transition to natural gas from coal. Data for 2020 shows a familiar downward trend for emissions. Therein, the spike must have come from the demand side but not from emitters rather speculators. Speculators are anticipating that the price of permits will only continue to increase following the EU Commissions’ commitment in 2018 to pursue reductions more aggressively which has led to the price volatility that has been seen in recent years. In times of price volatility, emitters postpone investment in low-carbon technologies as market signals are not clear and jumps in the price can backfire on abatement efforts. In 2019, the EU introduced the Market Stability Reserve to soothe the worries of emitters, stabilize prices, and scare off the speculators; however, so far, the benefits have been scant.
Bottom line: The data for 2021, the year that carbon permit prices doubled, has not come in yet; therefore, the implications of the surge cannot be analyzed with certainty but, so far, ramifications in the EU have included a sharp increase in coal use (in response to permit price volatility) which can’t be good for the environment.
* Please help my Environmental Economics students by commenting on unclear analysis, alternative perspectives, better data sources, or maybe just saying something nice :).