Emissions trading: Time to make it work

There is broad consensus that carbon pricing should be one of the key measures to deal with global warming, yet there has been no effective emission trading scheme anywhere in the world.

World Bank Group President Jim Yong Kim.MONUSCO Photos cba

Few dispute that polluters must pay for the carbon they put into the atmosphere, while money should be saved for those who are able to cut their emissions. Without much stronger economic incentives it will likely be impossible to get anywhere close to the ambitious global targets everyone signed up to in the Paris Agreement.

Currently, around 13 percent of global emissions are facing a carbon price, either as carbon taxes or mandatory emissions trading schemes, according to the latest State and Trends of Carbon Pricing report from the World Bank. This will go up to between 20 and 25 percent if the Chinese national Emission Trading System (ETS) will be implemented this year as planned. Of the 189 countries having made emission reduction pledges for the Paris Climate Agreement, currently 40 countries are putting a price on carbon and some 60 more are considering carbon pricing schemes.

Emissions trading

Carbon pricing can be done by taxes or through emission trading. A carbon tax will set a fixed price on emissions (but not a maximum emissions limit), while an emissions trading scheme sets a maximum level on pollution (but not a fixed price on emissions). Both taxes and emissions trading schemes will reallocate resources to the less carbon intensive sectors of the economy.

The picture is pretty depressing and it is hard to argue that emission trading in any meaningful is pushing the world closer to the targets that were adopted in Paris

Most of the countries that have implemented or expanded carbon pricing in recent years have chosen to use emissions trading: Korea, New Zealand, states and provinces in Canada and the US. The EU chose emissions trading rather than a carbon tax ten years ago. China aims to have a nation-wide carbon market that will cover most of its emissions in place within the next few years.

However, in spite of increasing coverage and the obvious theoretical benefits, we have yet to see a truly effective carbon market. And yes, we can have endless debates about what “truly effective” actually means, but let’s skip that. To me it simply means that the emissions trading schemes we have seen so far have failed to price carbon at a level that has triggered substantial emission reductions.

It has simply not become the tool it could have been to drive abatement in Europe and other regions that have implemented emission trading schemes. In 2016 – the first year after the adoption of the Paris Agreement -– we had an average carbon price of €5.36/t in the European carbon market (EU ETS). That is a 31 percent drop from the previous year and far below the €20-30/t needed to trigger key abatement measures like fuel switching from coal to gas in most countries.

Other regions had only marginally higher prices than Europe and carbon markets around the world are to various degrees oversupplied with allowances. Overall, the picture is pretty depressing and it is hard to argue that emission trading in any meaningful is pushing the world closer to the targets that were adopted in Paris.

So should we scrap the whole idea of capping emissions and use the market to identify the cheapest abatement options? I don’t think so, and here is why.

Modest ambition

Blaming emissions trading for not cutting emissions is in many ways the equivalent to killing the messenger of bad news. The fundamental problem is of course that policy makers have been afraid to set ambitious reduction targets and/or to implement policies to achieve them. Without ambitious targets you will not have large emission reductions – regardless of whether the preferred policy tool is taxes, direct regulations or emissions trading.

No policy instrument, be it emissions trading, subsidies or hard regulations, will ever be more effective than policy-makers allow it to be

The oversupply we observe in carbon markets around the world is a perfect illustration of this point. Modest policy ambition has resulted in a generous allocation of carbon allowances and there is no need to implement a lot of abatement measures. Why spend money on cutting emissions when you can buy cheap allowances in the market (or even better get everything you need for free)?

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The Korean emissions trading scheme has in recent years been the only market without a significant oversupply. The verified emissions for 2015 showed that the scheme was marginally short, at least before the option to use offset credits from non-trading sectors was taken into account. However, the Korean government did recently announce that the allocation will be increased in 2017 in order to avoid significant costs for industry.

Although this has been taken as just another example of a failed carbon market, I would argue that the problem is more fundamental. It shows that countries around the world are still reluctant to implement ambitious climate policies, and that no policy instrument, be it emissions trading, subsidies or hard regulations, will ever be more effective than policy-makers allow it to be.

When will the market catch up?

On top of the modest ambition, non-climate related factors like the financial crisis have of course contributed to the oversupply in carbon markets. Taking Europe as an example, emissions in the EU ETS dropped with more than 10 percent from 2008 to 2009 and remained at low levels for several years. Without a corresponding adjustment of the supply of allowances the surplus was piling up these years. This is one reason why the oversupply in the EU ETS is currently in the order of 2.5 billion allowances – much more than the total annual of emissions from all installations covered by the scheme.

With the current policy it is not unlikely that there could be another lost decade without an effective carbon price in Europe

Another reason is that the EU has implemented policies on other areas such as renewable energy and energy efficiency that have led to emission reductions in the EU ETS. The more ambitious member states are also putting in place national climate polices for example to phase out coal in the energy sector. From a climate perspective it can hardly be a problem that some countries are moving ahead with more aggressive policies, but if you want to have an effective carbon market as the main tool in the climate policy mix it is clearly a problem that other – and less cost effective measures – are doing the job.

In Europe and even other carbon markets we are to some extent in the middle of a “perfect bearish storm” where falling costs on renewable energy and improved energy efficiency are just extending the lingering oversupply from the financial crisis. This gives persistently low prices, and the more impatient member states are moving ahead with domestic climate policies – which again are cutting emissions and thus keeping the carbon price at a low level.

At some point this will likely turn around and the EU ETS (helped by reforms like the Market Stability Reserve and a steadily declining cap) will consume the oversupply and force installations to make deeper emission reductions. However, exactly when this will happen is still very uncertain and with the current policy it is not unlikely that there could be another lost decade without an effective carbon price in Europe.

The real test is yet to come

In spite of the real life failure, I do believe that carbon markets can be an effective way to cut emissions of greenhouse gases. From a regulatory perspective, the hard cap on emissions gives a high degree of certainty that a specific emission reduction target can be met. From the industry perspective, emissions trading can be more effective and flexible than other measures, as the market will help realize the abatement options with the lowest cost first and give a carbon price signal to guide the longer term investments.

If China gets it wrong it is bad news for everyone who believes in carbon markets, but even more so for the global efforts to solve the challenge of global warming before it’s too late

However, the real test of the effectiveness of carbon markets will only come when policy makers put in place ambitious reduction targets and trust emission trading schemes to a key measure to deliver the required cuts. This test could come in Europe or other existing markets currently in the middle of reform processes that in a best case scenario will increase ambition and effectiveness of these schemes.

Yet, the most critical test will likely come in China where a federal emission trading scheme is currently under implementation. The potential to achieve huge emission reductions with a well-functioning market and even modest carbon prices is enormous in China. If the world’s largest emitter gets it right it can be the ultimate proof that emissions trading schemes can deliver results in line with the theoretical benefits that are well known. If China gets it wrong it is bad news for everyone who believes in carbon markets, but even more so for the global efforts to solve the challenge of global warming before it’s too late.

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