Friday, May 19, 2006

The European emission trading scheme: market volatility teaches some early, hard lessons

There is a lot of flak and confusion surrounding the recent drama over the EU’s emission trading scheme (ETS). The price of carbon permits crashed last week when some market participants suddenly revealed they had more permits than expected. (For the scheme to be effective, permits must be scarce and therefore expensive enough to encourage emitters to invest in reduction technologies or processes.) The price then spiked when Germany announced it was rescinding its excess permits, thereby making permits scarce once again.

Meanwhile, a Scottish consultancy says that the ETS actually enabled Great Britain’s electric power generators—who make up the highest emitting sector in the country—to profit handsomely in the scheme’s first year of operation. Many believe the European Commission granted too many permits to this sector. As a result, utilities generated power using cheap, carbon-intensive coal rather than pricey, less-carbon-intensive natural gas. This allowed them to keep costs down, which, the consultants suspect, produced the alleged profits. If this is true, it will be an embarrassment for those who supported the ETS. The scheme is supposed to discourage business as usual, not reward it.

All of this points to problems in the way permits are allocated and reported. I have already mentioned the European Commission’s possible over-generosity in approving some countries’ emission forecasts (the so-called National Allocation Plans, or NAPs). Some feel permits should be allocated by auction rather than handed out for free, as they were in Phase 1 of the ETS. Others want an investigation into the late reporting of the excess permits.

This will produce a new round of political and bureaucratic wrangling, but these issues will be resolved. The fundamental problem is the yawning gulf between the (too-low) carbon price in the ETS-covered sectors and the carbon tax that will be required to reduce emissions in the non ETS-covered sectors. Many people feel existing taxes on gasoline are already too high. Over-generosity with the NAPs keeps the gulf wide. Look for the EC to tighten the allocation rules.

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