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A Cautionary Tale from Europe

The woes of the European cap and trade program have attracted almost as much attention as the ongoing Greek Tragedy of the financial crisis over there. What happened teaches some fundamental lessons about climate politics and policies that U.S. readers would do well to contemplate (even without considering the various scandals involving VAT fraud and offset manipulation).

The EU emissions trading system (“ETS”) originated in the heady days of Kyoto. The Europeans originally favored a carbon tax, but were talked out of it by Al Gore et al. on the basis that cap and trade was more market-friendly and had been successful in addressing acid rain in the US.  It had two other advantages – it was not a tax (the EU Commission has no taxation authority) and international offsets offered a neat mechanism to meet developing countries’ demands for financial help reducing their emissions.

So in 2005 the EU introduced the ETS, covering facilities emitting over 25,000 tons per year of CO2, representing about 50% of EU emissions.  Each country would distribute free allowances in the early phases to minimize the potential for economic disruption and reduce industry opposition.  The problem was that countries distributed way too many allowances, and then compounded that by skewing those allocations to favored industries.  In turn, those skewed allocations led some of the less favored companies to go bust or move production out of Europe, leaving the favored recipients with a load of allowances that, when things went bad, they had to dump on a market where there were few buyers.

Phase 2 began and  allowances rose to around 30 Euros early in 2008 – plenty high enough to encourage fuel switching, and to support many renewable programs without subsidies  – though that did not stop either the EU Commission or individual governments from mandating or subsidizing them. Then came the financial crisis.

Businesses went bankrupt and their allowances were sold to pay creditors, cut back production and sold allowances they no longer needed and / or sold allowances they had banked for future use, simply to help their cash flow.  The result was a catastrophic drop in the allowance price: by more than two thirds – from over 30 Euros to under 10 – between July 2008 and January 2009.

The general government assumption was that this was just a typical market over reaction and that things would stabilize (and the price return to “normal” levels) before the start of Phase 3 (2012-2020), for which allocation amounts were being established.   In Phase 3 the EU would for the first time auction a significant part of the allowance pool. Their aim was to avoid the embarrassment of the first two phases when electric utilities pocketed the free allowances and as usual, set prices on the basis of their marginal costs (including the allowance price) – resulting in windfall profits.  The EU also wanted to extend the auction to other industrial emitters but were persuaded  to provide large amounts of free allowances to trade exposed businesses (or, in more WTO-compliant official language, “to prevent carbon leakage”).

The European version of the financial crisis and accumulated economic problems continued longer than anyone possibly imagined in 2008.  Having recovered to about 15 Euros in 2010, the price crashed again, reaching less than 3 Euros in January 2013 (and it still languishes in low single figures).  So the cry went up from NGOs, renewable, nuclear and natural gas interests and climate “hawks” such as the UK’s statutory Climate Change Committee that “something must be done”, and that something was to reduce the allowance supply.

Opponents of intervention agreed that there were too many allowances, but pointed out that if you create a market system but then allow politicians to unilaterally change the supply, you create two problems for the price of one: undermining confidence in the whole system, and doing so in the hope that this time the politicians will get the allocations “right”, whatever that might turn out to mean.

The EU also had a legal problem in that the temptation to interfere had been foreseen and prohibited in the original ETS legislation, ironically to stop governments from issuing more allowances to reduce prices.  So the EU and member states could not change allocation quantities without new legislation, which would be a very lengthy process and likely a non-starter for poorer Eastern and Southern European countries.

Stuck with the existing allocations, the Commission’s Climate Directorate came up with the bright idea of reducing allowances in the early Phase 3 auctions and then adding them back to the later ones, thereby keeping the total allowances in line with the law.  They could do this through regulation (although still needing EU parliamentary consent).  Because banked allowances can carry over to a subsequent phase, the elegant but unspoken intention was that the excess allowances auctioned near the end of Phase 3 would carry over to Phase 4, where they could be mopped up by setting a proportionally tougher Phase 4 (2018-28) target in a few years’ time, accumulating green credibility points each step along the way.  However, the EU parliament voted down the proposal to remove allowances from the early auctions.

Where next?  History suggests this idea gets reintroduced with more political arm-twisting and back-room deals to try to shift the countries who opposed it.  But our suspicion is that this is dead until happier economic times return to Europe (politicians do not win votes by raising energy prices in tough times), and that in the interim Brussels should think about an alternative to Phase 4 (perhaps a carbon tax in member states, which the EU does have the authority to impose) that does not have the same fundamental political and economic flaws.