Carbon price collapse threatens the EU's climate agenda

The EU’s emissions trading scheme (ETS) works by capping the output of carbon dioxide and then distributing allowances to emit the gas to large energy users. The tighter the cap, the more expensive it is for firms to produce carbon dioxide. The European Commission is relying on carbon pricing to encourage companies to invest in new green technologies. It also hopes that the EU ETS will form the basis of a global carbon market. However, carbon prices under the scheme have fallen by two-thirds in just over six months. At December’s UN conference in Copenhagen, the EU will want to persuade big emerging economies such as China and India to take action to curb their own output of greenhouse gases. It will be hard to do so, however, if Europe’s flagship environmental policy is not working.

Firms will only invest in new technology if they are confident that carbon prices will be high enough to justify the cost. At their late-March level of €12 per tonne, prices are too low to make such investment worthwhile. Indeed, the current state of the carbon market poses a bigger risk to the future of the ETS than the previous collapse of carbon prices. Prices fell to just €1 in 2007 because too many allowances were distributed for the first phase of the ETS (from 2005 to 2007) and firms were not permitted to hold on to surplus permits for use in the subsequent phases (2008-12 and 2013- 20). However, the price of carbon for use in phase two remained above €18 per tonne during 2007 (and hence well above current levels), because investors were confident that emissions caps in the latter phases would be tighter. In terms of encouraging investment, it is the future price that matters.

There are cyclical and structural reasons for the current weakness of carbon prices. The cyclical reason is the decline in Europe’s industrial activity, and hence energy use, since the middle of 2008. With the supply of carbon allowances fixed and emissions declining, prices have inevitably fallen – and further reductions cannot be ruled out. The EU economy is certain to shrink by more than 3 per cent this year. The release of carbon dioxide by industries covered by the carbon market could decline by as much as 10 per cent. Moreover, the economic recovery will not begin until well into 2010 and could take a number of years to gain momentum. The EU economy will not grow anywhere near as fast between 2008 and 2020 as was assumed when the emissions caps were set, and hence emissions will be considerably lower than forecast.

The ferocity of the economic downturn has also highlighted two structural weaknesses in Europe’s carbon market. First, the EU fixed the supply of carbon allowances until 2020. This was done for good reasons. Investors needed to be convinced that the cap on emissions would be sufficiently tight to ensure consistently high carbon prices. However, the lack of a mechanism to amend the emissions allocations in the light of changed economic circumstances is now leading to the very volatility in prices that the Commission sought to avoid.

Second, the method of distributing the allowances is exacerbating the weakness of carbon prices. In phase two of the ETS (2008 to 2012), the vast majority of allowances will be allocated for free. In phase three (2013 to 2020) energy generators will have to purchase them through auctions. But auctioning will only be introduced gradually for the other industries covered by the market. The upshot is that very few businesses are actually paying to emit carbon dioxide at present. And as it becomes apparent that emissions will remain weaker than projected for a number of years, they will be able to put off buying allowances until well into phase three. If all businesses had to pay to emit carbon dioxide now (or at least from 2013), prices would have declined by much less.

If EU emissions are falling why does it matter if carbon prices are low? The answer is that the lower carbon dioxide emissions stem from temporary factors. A structural fall in emissions (one that will not be reversed once the economy recovers) requires investment in new technologies, such as carbon capture and storage (CCS) and renewable energies. But companies will only make such investments if they are confident carbon prices will recover. And on current trends, CCS will not be commercially viable before 2020.

Weak carbon prices also threaten to paralyse the Clean Development Mechanism (CDM). Under the CDM, European emitters can earn carbon allowances by investing in projects to cut emissions in developing countries. The rationale for this is two-fold: it is often cheaper to reduce greenhouse gases in poor countries than in rich ones, and it leads to the transfer of capital and technology to developing countries. In the process, it gives these countries a stake in an embryonic global carbon market. Unfortunately, at their current levels carbon prices are too low for it to be worthwhile for firms to invest in CDM projects.

Carbon prices will need to rise quickly to preserve the credibility of the EU’s ETS. Given the dire economic outlook, the Commission may have to intervene in the market to ensure this happens. It could, for example, tighten the post-2020 (phase four) emissions cap, which is not yet set in stone. Given that emitters can retain allowances from phases two and three (2008-12 and 2013-20) for use in phase four, reducing the number of allowances available in the post-2020 period would help to prevent further falls in prices now. But this alone will not be enough to ensure that prices rise rapidly. The Commission should also announce that from 2013 auctions will be subject to minimum prices. Those allowances that do not meet the reserve price would then be withdrawn from the market. Such a move would increase carbon prices and reassure firms that prices will remain high enough to warrant investment in low carbon technologies.