The Price Isn’t Right: Saving Europe’s Flagship Climate Change Initiative

CO2 Emissions ETS price

BRUSSELS—The European Union’s flagship climate change project, the Emissions Trading System (EU ETS), is in a slow-motion crisis that threatens the EU’s ambitions for a green economy. The original purpose of the EU ETS was not just to reduce emissions from factories and power stations — which it has done very successfully — but also to send a signal to the market that carbon emissions would come at a price, preferably of about €30 per tonne of carbon. The magic of the market would then encourage companies to slash their emissions and to invest in innovative, low-carbon technologies like solar power without the heavy hand of government direction.

But the recession has conspired against this outcome. Over the past three years, the price of carbon allowances has been steadily dropping, descending last week to just €6 per tonne of carbon dioxide from an average of over €20 per tonne during the whole of 2008. Even though emissions from the power sector are limited under a cap that is lowered every year, the demand for carbon allowances has been so weak that the vital price signal to spur clean-technology innovation is absent. The excess supply of emissions should not matter because companies are allowed to “bank” their allowances for use in future years, but at the moment there is simply an oversupply of carbon allowances to sustain a high-enough price.

If the unthinkable were to happen and the collapse in carbon prices in the EU ETS were to become permanent, what would become of EU climate policy? Europe would have an impossible time meeting the target of reducing its greenhouse gas emissions from 1990 levels by 20 percent by 2020 and 80-95 percent by 2050. Individual EU countries would have to set diverse regulations and standards that would be vastly more complex and expensive for industry than the current EU-wide ETS. A carbon tax on fossil fuel energy could send a similar price signal — possibly with more certainty for industry — but new EU-wide taxes are not easy to introduce. A collapse would also destroy hopes that the EU ETS could eventually form the basis of an international market, linked to imitator trading programs from California to Australia to China.

Last week, EU energy and environment ministers met informally to discuss ways to tackle the oversupply of carbon allowances, either by setting a minimum price for allowances or removing surplus allowances from the market. After Connie Hedegaard, the EU Commissioner for Climate Action, brought forward a review of the EU ETS to later this year and signalled her openness to delaying the supply of new allowances, their price jumped to above €7 per tonne for the first time in months.

This fix will not come easily. EU policymakers are reluctant to send a signal to the private sector that the carbon price is subject to arbitrary change, although many market participants are calling for intervention precisely to ensure that the price will not collapse. But the biggest obstacle comes from divisions between the EU member states. Poland, which depends on coal for about 90 percent of its electricity, is quite happy with the current low price of carbon allowances and is reluctant to see measures that could drive it up again. In the end, Poland’s agreement is not essential — changes to the EU ETS require the support of a majority of EU member states, not unanimity — but EU leaders are keen to avoid a rift on this signature policy.

The Commission’s review of the EU ETS will inevitably evolve into a larger debate about the future of the program and its effectiveness. This will be closely watched abroad, including in the United States where, despite presidential elections in November, there is an outside chance that legislators could turn to a carbon tax as a way of raising new revenues to reduce the federal deficit. If there is one message that U.S. policymakers should take from the EU experience, it is that putting a price on carbon — whether by a trading scheme or a tax — works, but it must be set at the right level if it is to drive the innovation necessary to transform energy systems and lower emissions.

Thomas Legge is Senior Program Officer with the Climate & Energy Program of the German Marshall Fund of the United States in Brussels.