Carbon Briefing: Is there any hope for EU carbon trading?

  • 01 Feb 2013, 14:00
  • Mat Hope

Credit: Ell Brown

Europe's carbon price has dipped - again. It currently costs major polluters in the European Union around €3.30 to emit a tonne of carbon dioxide  - about the same price as an energy saving light bulb. This means that emitters are currently releasing greenhouse gases that contribute to climate change at very little cost.  

The latest dip comes at the end of a bad month for the carbon price  - which dropped below €5 for the first time last week. And there was more bad news last night: Deutsche Bank has stopped trading in the EU Emissions Trading Scheme (EU ETS) - further damaging the market's image. We look at what recent events mean for the future of the troubled scheme. 

The EU ETS's bumpy history

Companies buy and sell permits to emit carbon dioxide under the EU ETS. If they emit less than their permits allow, they can sell the excess for a profit. The scheme is meant to reward those that cut their emissions, and it relies on a shortage of permits. 

The price of the permits has been in a steady decline for a while now - as the graph below shows - but it has had problems from the very beginning.

ETS price drop

The EU ETS price from August 2012 to January 2013. Source: Bloomberg

One of the main problems is over-supply. There are currently too many permits in the system which means that polluters don't need to cut their emissions. This also means that the price for the permits is low because supply is greater than demand.

One way the EU could deal with this is by intervening in the market to remove some permits - known as backloading. The European Parliament is currently considering a proposal that would stop 900 million permits being released into the market - preventing the equivalent of 900 million tonnes of carbon dioxide being released into the atmosphere.

But it doesn't look good - last Thursday, a European Parliament advisory committee recommended that parliament vote against the plan. This sent the permit price tumbling to a record low of €2.81. The price quickly recovered to just under €5, but the crash shows how vulnerable the EU ETS is to political uncertainty.

Market confidence

Some say the variation in price is what you get if you decide to cut emissions using a market mechanism instead of alternatives like a carbon tax. Dr Cameron Hepburn of The London School of Economics tells Carbon Brief:

"A risk of the way that the scheme is designed is that you can get large movements in price either up or down and the reason is that there were no soft or hard price management mechanisms built into the design of the ETS."

This means that when the price drops too low to be effective at cutting emissions, there is currently no way of stopping it. Hepburn says one potential solution is to set a reserve price below which the permits don't get released into the system - preventing the price dropping too low and helping to fix the issue of over-supply.

As it is, it's all about market confidence. The advisory committee vote dented investors' confidence that the EU would intervene to fix the market, and the Deutsche Bank announcement yesterday may have led other market players to reconsider their participation in the ETS.

The future

It's not over yet, though - the current price dips are just "preliminary skirmishes" before the bigger issue of market reform is properly addressed, says Damian Morris from carbon trading NGO Sandbag. He says the arguments over reform will really "test the mettle of politicians" and their commitment to the EU ETS. 

Three important dates are coming up that could decide the fate of the scheme in the long run. The European Parliament environment committee are set to vote on 19 February on the backloading plan that the advisory committee recommended rejecting last week.The vote could be pivotal for the future of the EU ETS. Konrad Handschmidt from market analysts Bloomberg New Energy Finance tells Carbon Brief:

"If there is backloading in the way they propose, which is 900 million permits, it moves the market close to being balanced by the end of 2015". 

This means the excess permits would re-enter the system to be bought up, reducing the over-supply and lifting the price. If the committee agrees to the plan then it will need to guide it through a European Parliament vote set for 15 April.

Before that vote, the European Commission will consider other expert proposals for ways to reform the EU ETS - for which the deadline is 28 February. These could include suggestions to cancel some allowances and adjust the EU's 2020 emissions target, both of which could have a significant effect on how the market operates. The debate about those proposals will be an important indicator of how seriously the EU is taking market reform - and it could have a knock-on effect on the permit price.

Low prices are bad for climate change

The market reforms are important because "it's very problematic for long term efforts to reduce climate change to have low prices", Hepburn says. Polluters can keep contributing to the problem of climate change without having to pay and have no significant incentive to reduce their emissions if the price remains at its current level. 

So politicians in the EU need to make some smart decisions on market reform if the EU ETS is going to work effectively to address climate change. Either that, or they're going to have to find an alternative.

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