This is an analysis of the carbon market in Europe, its basis, its failures and its impacts all over the world.
Here’s a very strange thing: Europe’s decades-long effort to reduce carbon emissions has been thrown into a shambles because utilities and manufacturers are exceeding their carbon-reduction targets.
That’s right. Exceeding them. It almost sounds like a joke, but it’s not.
Europe’s $100 billion carbon market, an innovative force in the powerful carbon-reduction approach known as cap and trade, has ceased to function the way it’s supposed to. The resulting chaos in Europe’s energy and environmental policies is threatening carbon-reduction initiatives in Australia, Asia, and elsewhere.
And it’s all because of a failure of political will in Europe to override the market’s built-in lack of flexibility and fix the imbalance between supply and demand.
Cap-and-trade systems are based on government-imposed targets for reducing greenhouse-gas emissions. In Europe, the emissions-reduction targets were set prior to the 2008 financial crisis, which as we all know presaged a deep recession and a eurozone debt crisis. Because of the economic slowdown, industrial activity has dropped more than 20% in certain sectors of the Continent’s economy, and most industrial companies are using much less energy than they were a few years ago. In fact, they’re operating at such a comparatively low level that as things stand now, many of them, including utilities, will be able to emit as much carbon as they want for the next decade without hitting their limits.
This has drastically reduced the incentives for them to invest in or deploy clean-energy technologies or to modernize their energy-infrastructure assets. Utilities are already planning to build new coal plants and are burning more coal, which in Europe is a lot cheaper than natural gas but emits twice as much carbon (as well as emitting other pollutants such as mercury and particulates).
Because so many companies are below their emissions caps, they don’t need to buy the pollution permits, aka carbon credits, that would allow them to exceed their allotted limits — the market is awash in unwanted credits. Markets fundamentally don’t work when they are “long” — that is, flooded with things no one wants. A tension between supply and demand is a necessity.
So the European carbon market clearly has a design flaw. Unlike other markets, it has no mechanism for correction when supply and demand are severely misaligned. The supply of carbon credits is fixed through 2020 — not by a regulator or a committee, but by law. A change requires approval by the European Parliament and a majority of the 27 country governments.
European policy makers have proposed a multistep process to correct the immediate imbalance caused by the weak economy. But a few weeks ago, the proposal’s first step, which would have delayed a scheduled auction of nearly a billion new carbon credits, ran smack into European politics. Swayed by arguments, particularly from coal-reliant Eastern Europe, that restoring proper market pricing would increase energy costs and possibly hinder growth during a time of deep recession, the European Parliament said no.
There’s no way to determine precisely how much effect the postponement would have had on carbon prices. But it certainly would have demonstrated the EU’s willingness to serve as a steward of a critically important market and reaffirm the importance of having a stable and progressive energy-regulatory environment for the private sector. By saying no, the parliament signaled that it had made a U-turn after decades of being the world’s strongest and most consistent political force on climate and the environment.
The effects were immediate: Carbon credits crashed, dropping more than 35%. Prices have risen a bit since German Chancellor Angela Merkel said recently that something must be done to fix the market, but they’ll remain depressed as long as no specifics are forthcoming. That means future carbon-credit auctions, which help fund clean-energy initiatives, will yield lower revenue. Share prices for European utilities and industrial companies have fallen too, threatening a wave of credit downgrades and increasing companies’ cost of capital.
But the worst effect of the vote is the uncertainty it injects into global carbon-reduction initiatives. Suddenly, doubt has been cast on major initiatives such as building a Continent-wide fleet of natural-gas power plants to phase out coal generation, let alone much more futuristic schemes such as theDesertec project (exporting solar power from the desert countries of North Africa). And it will be much harder to attract private capital to infrastructure projects through public-private partnerships.
There’s even a possibility that each of the EU nations will pursue its own energy and climate policies. A patchwork of 27 sets of regulations would further hurt the energy-investment climate and lead to a less stable, less efficient, and more costly energy system in Europe.
Numerous other carbon markets and national regulatory regimes are directly or indirectly tied to Europe’s. For example, Australia’s newly implemented carbon tax, which is set to become a traded carbon market in a few years, is directly linked to the EU’s market, meaning that Australia’s much smaller market could be flooded with cheap EU carbon permits, as has happened with New Zealand’s market.
The disarray in Europe could even slow the momentum of strong new cap-and-trade initiatives that aren’t linked to the Continent, such as California’s AB32 program (which has learned an important lesson from Europe about the necessity of establishing a floor price for carbon credits). China, the world’s largest carbon emitter, is developing a series of regional carbon-trading systems that are expected to grow into a national carbon market toward the end of this decade. Will the European debacle affect China’s plans? It’s unclear, but Europe’s market failure certainly doesn’t help.
Carbon prices in Europe may remain depressed for years. But carbon markets will eventually recover. Pricing carbon remains the only scalable, long-term solution to providing incentives for shifting the global economy to a more sustainable energy mix. Even though European companies are currently below their emission caps, the world still needs to be making constant progress in developing and implementing low-carbon energy sources. With greenhouse-gas concentrations in the atmosphere having just now reached an ominous milestone at 400 parts per million, a weak economy can be no excuse for delaying action to reduce greenhouse-gas emissions.
There is evidence that dysfunctional cap-and-trade markets can improve: The Regional Greenhouse Gas Initiative (RGGI), a northeast U.S. cap-and-trade system that was oversupplied from the start, is showing signs of life now that there’s political traction to recalibrate its emissions targets and restore supply-and-demand balance.
Even in Europe, there’s hope: Now that they’ve had a few weeks to consider the potential consequences of their inaction, lawmakers may be willing to revisit their opposition to intervening in the market. The remedy for the market’s problem is perfectly clear: Regulatory authorities must be empowered to repair supply-and-demand imbalances and restore proper price tension. As Merkel put it, it shouldn’t be taboo to revise a system that’s based on a set of growth assumptions that have proved false. The only question is whether European legislators can summon the political will to put the obvious remedy into place.
(Source: Harvard Business Review)