Last Saturday (August 27, 2011) The Times featured the EU Emissions Trading System (EU ETS) on its front page.  Carbon markets are becomingly increasingly important and should appear in the mainstream media, but it’s also important that the media provide accurate context to fully explain often complex issues to the public.  This particular story suggested that the EU ETS was being manipulated by power companies, enabling them to pass on to their consumers the full cost of carbon on the allowances that they are granted for free:

Flawed green scheme

costs households £120

“. . . . an investigation by The Times has found. Energy companies such as Scottish Power, EDF Energy and Centrica, the owner of British Gas, have pocketed about £9 billion in free windfall profits by manipulating a carbon trading scheme.”

As with many other policy instruments, the EU ETS has changed over time and has become stronger and more effective.  The issue of allowances is complicated but the simple fact is that concerns regarding the free allocation of allowances were corrected by the European Parliament way back in 2009 for the upcoming Phase III of the ETS which starts in 2013.

Let’s examine the history of the scheme. The European Commission and Parliament decided, during the ETS design and legislative process (2001-2003), that allowances should be granted for free to most participants in the first two phases of the trading system (2005-2012 inclusive). This was done to ensure the softest of starts for the EU economy, particularly for industries that exported outside the EU, or competed with imports, and therefore couldn’t pass on carbon costs to their customers. What was less recognized at the time, although anticipated by a number of observers, was that in some electricity markets, particularly the deregulated UK market, the carbon price that traded at the margin would be the one that set the electricity price, thereby granting those holding free allowances infra-marginal rent.

It may be the case that the electricity companies didn’t have to pass on the cost of their ‘free’ allowance allocation to their consumers, but it should be stressed that pricing at the margin isn’t manipulation, rather it is exactly how markets should function. For the most part, they do work this way. The price of many goods and services is set by the marginal supplier, with those able to produce the same goods or services at lower cost profiting from this. 

With the benefit of hindsight, what was wrong about Phases I and II of the ETS was to create such a circumstance artificially, but as noted above, this rent opportunity ends with 100% auctioning of allowances to the power companies in Phase III onwards.

The only reason this construct persisted for a number of years is because the Commission has maintained a hands-off approach to the ETS in order to assure the market of stability and give confidence to those investing in it. It rightly took the view that the market would be much worse off if government was constantly changing the rules by which it operated. Within a known window of change the free allocation to electricity producers was ended, but could only be enacted from the start of the next operating phase, which is January 1st 2013. Auctioning for this period will begin in a few months time, in 2012.

The Times article also makes a link between free allocations, the overall performance of the market and the modest CO2 reductions achieved during Phases I and II. However, there is hardly any relationship between the reductions achieved by the system and the mechanism for distribution of allowances. The overall reduction is set by the number of allowances distributed. This then establishes the price at which allowances trade and it is this opportunity cost which guides project investors. Most experts noted that in Phase I of the ETS there was considerable over-allocation, as the Commission had limited data upon which to base the likely demand for allowances. As a result the system traded near zero for some months before Phase II got going. Phase I had no mechanism to correct for this over allocation as banking into the future was not allowed in this “learning by doing” period.

Actual CO2 reductions in Phase II continue, but the recession linked to the global financial crisis has taken some steam out of the market, as has been the case in so many sectors. Most observers now agree that a Phase II surplus is accumulating and that this will be banked forward by market participants. This has led to the call for a set-aside of allowances within Phase III which will ensure a robust CO2 price.

But none of this is related to the free allocation approach taken in Phases I and II.

The EU ETS has not been perfect, but it is a learning process that continues, evolves and improves. Other jurisdictions considering the use of emissions trading have learned a great deal from it. For example, the north-eastern US Regional Greenhouse Gas Initiative (RGGI) noted the issues with electricity producers and implemented full auctioning from the outset.  We need to recognise that the European Union broke new ground with the ETS, that early teething problems have been resolved and the system is improving.

We know from both the economic theory and practical implementation (US sulphur trading system) that emissions trading / cap-and-trade is the most flexible and lowest cost approach to reducing emissions against a fixed future target. But the system constantly bares its soul for all to see through operational transparency, which in turn makes it an easy target for criticism. The alternative is to have government demand CO2 reductions, specify the power generation mix and order up wind turbines or nuclear reactors with much less price transparency and almost certainly higher cost to the consumer. In this period of fiscal uncertainty, the carbon market approach must be the preferred option.

But such good news, setting out a reasonable, measured and effective way of moving towards a lower carbon European economy, doesn’t usually sell newspapers!