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Saving the EU emissions trading scheme may mean abandoning key principles

  • 06 Mar 2013, 15:40
  • Mat Hope

Credit: Yanni Koutsomitis

The EU emissions trading scheme has been struggling to stay afloat, and the latest attempt to save it has stalled in the European Parliament. New research suggests a fundamental rethink - and abandoning some of its key principles - is needed to save the scheme.

A new report from the London School of Economics (LSE) says the EU needs to be more active in influencing supply and demand in the emissions trading scheme (ETS). It produced the proposal in response to a European Commission consultation on long term structural reforms to the scheme. The commission is looking at ways to prevent the carbon price hitting January's record low of below 3 euros in the future. We take a look at the proposals trying to reboot the scheme.

Backloading

Companies buy and sell permits to emit carbon dioxide under the ETS. Each permit allows participants to emit a tonne of carbon dioxide. 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. 

But the ETS has a real problem with oversupply. There are currently too many permits in the system which means that polluters don't need to cut their emissions and the price of permits has slid to record lows. 

The oversupply is largely due to the economic slowdown since 2008. Energy demand is low, so power plants - one of the main sources of emissions in the system - don't need all their permits. This means there is a significant surplus of permits that gets larger every year. As the table below shows, since 2009 there has always been less demand than supply: 

EU em surplus tableSource: European Commission, The state of the carbon market 2012

The European Parliament is currently considering a proposal to withhold 900 million permits from the market between 2013 and 2015 - known as backloading. 

But the plan has hit a snag. While the environment committee voted to approve the plan in mid-February, it failed to get enough votes within the committee to take the plan straight to the European Council. This means the whole parliament will now vote on the plan - and it is not at all certain it will get enough votes to go through. 

Even if MEPs do accept the plan - and the council also gives it a thumbs-up - backloading is generally accepted as only a temporary fix. The permits would be released back into the market in 2019 and 2020 - increasing the supply once again, regardless of the level of demand. 

Market analysts Reuters Point Carbon has said if the permits are not cancelled, then prices could remain between €8 and €10 per tonne between 2013 and 2015, later collapsing to €6 in 2020 when the permits are reintroduced. Sarah Deblock from the International Emissions Trading Association previously told us backloading simply doesn't work as a "standalone measure". 

Recognising the need for longer term reform, the European Commission has come up with a shortlist of measures that could be implemented to breathe fresh life into the ETS - from reducing the overall number of permits, to extending the scheme to other sectors, or setting up new mechanisms to manage the carbon price.

New institutions

A new report from LSE says the last of these is the key. It argues that without a way to control the balance of supply and demand in the system any other reforms remain vulnerable to large economic changes of the sort that hit the ETS after 2009.

The report says:

"A key lesson we have learnt from the past is that the absence of institutional rules permitting adjustments of the cap in the face of new information contributed to the need to invoke overlapping, potentially less-efficient, regulations."

It suggests the EU needs to find new ways to respond when demand significantly peaks or dips due to outside influences like economic booms or crashes.

One option would be for the EU to set up a new institution which holds a permits reserve. It would then act like a central bank for the ETS - buying and selling permits into the system as demand shifts. 

Alternatively, the EU could set a price 'ceiling' and 'floor'. The price ceiling would be set at a level which the EU deems harmful to economic productivity. If the carbon price got that high, more permits would be supplied to bring the price down. The price floor would be set at a level below which the ETS stops reducing emissions effectively. If the carbon price got that low, the EU would remove some permits to bring the price back up.

Both of these mechanisms would match supply and demand, making sure there isn't always a large surplus - as is currently the case.

LSE isn't the only one to suggest controlling supply offers a remedy. Trade association the Climate Markets and Investment Association proposes that if participants don't use a certain number of surplus permits within three years, an equal number should be removed permanently from later supply. It says this would ensure emissions were reduced on average for any consecutive three years.

But not everyone is happy with the idea of the EU interfering in the market. 

Coal industry representative the European Association for Coal and Lignite warns "any interference through the set aside of allowances or backloading of allowance auctioning will discredit the ETS" as it won't be seen "as an efficient market-based mechanism, but as a scheme subject to political manipulation". It argues the reforms are contrary to founding principles of the ETS as an emissions trading market.

Reform politics 

So debates around the reforms are not just about making the market work effectively, but the politics behind how it works. 

The LSE report acknowledges that regulating the supply of permits "would be difficult to reconcile with the fundamental principles of an emissions trading system". Implementing the reforms means the EU playing a much greater role in influencing how the carbon market functions. Nonetheless it argues the tradeoff is worthwhile to save the scheme.

The EU faces stark choices over how it is going to keep the ETS going, and positions within the European Parliament appear to be hardening. But allowing the scheme to limp on as it is at the moment could damage the EU's ability to manage its carbon emissions. The future is uncertain for the EU's flagship climate policy - and the controversy over backloading looks likely to just be the start.

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