Lessons in carbon trading

The most extensive evaluation to date finds that the European Union Emissions Trading Scheme is robust and successfully cut the region's emissions in its first three years, explains Michael Grubb.

Pricing Carbon: The European Union Emissions Trading Scheme

& contributors Cambridge University Press: 2010. 390 pp. $59, £35 9780521196475 | ISBN: 978-0-5211-9647-5

Pricing Carbon is a long-awaited analysis of the first major attempt to set a price on carbon emissions through the European Union Emissions Trading Scheme (EU ETS). With its empirical focus, this myth-busting book demonstrates the scheme's achievements and flags its ongoing challenges. These are set out in careful studies by international experts in energy policy and environmental economics, including primary authors Denny Ellerman, Frank Convery and Christian de Perthuis.

The book centres on the first phase of the EU ETS that ran in 2005–07. It explains how the scheme was set up to place a price on carbon by capping carbon dioxide emissions, thus demonstrating a key mechanism in market-based economies. Previous attempts in the early 1990s to implement carbon or energy taxation in both the EU and the United States crashed. Thus when the EU tried again a decade later, it borrowed from the cap-and-trade system that was used successfully to control sulphur emissions set by the US Clean Air Act. The resulting EU ETS dwarfs all other similar developments. It introduced a legally binding CO2 cap covering almost half of the emissions from 27 European countries (30 are included in the scheme today) and more than half a billion people. It is also the lynchpin of the Kyoto system of emissions control. As such, the EU ETS has become a political football.

Capping CO2 emissions places a price on carbon. Credit: J. REZAC/GREENPEACE/EYEVINE

The way in which carbon-trading allowances were allocated remains the most contentious issue. The scheme's first phase ended with a carbon price that fell to zero when it emerged that the number of allowances handed out — almost all for free — exceeded actual emissions (see 'EU carbon futures'). Pricing Carbon dispatches the widespread assumption that this surplus of allocations implies that the scheme has not cut emissions. The book estimates that the EU ETS saved 120 million to 300 million tonnes of CO2 over those three years — an overall reduction in emissions of up to 5%. Crucially, big savings were made in emissions from both the industrial and energy sectors. In Germany, a 6% cut in CO2 emissions was achieved across both sectors, demonstrating that emissions can be reduced even in one of Europe's most efficient industrial countries.

The book's analysis of trading patterns also shows the impact of the scheme on emissions reduction. Irrespective of the initial spread of endowments produced by the politics of permit allocation, the freedom to trade resulted in a more efficient final distribution of emissions abatement, as intended. Those with insufficient allowances reduced their emissions to minimize the cost of buying more, while many of those holding extra ones still cut their emissions with the expectation of being able to sell the excess. All had to monitor and forecast their emissions, and some of the changed patterns of behaviour and investment persisted even after the price itself had collapsed.

However, there is a gap here in the book's discussion. I have argued elsewhere (M. Grubb and F. Ferrario Climate Policy 6, 495–501; 2006) that there is an intrinsic risk in trading systems of giving away too many emission allowances. This is suggested by four pieces of evidence: a historical tendency to inflate projections of industrial emissions; the inherent advantages that industry has in the bargaining process; past experience in setting industry emission targets; and the accumulating history of cap-and-trade allocations. It is a pity that the book doesn't examine the nature and cause of the first-phase permit surplus more closely — although it is comforting to find that it didn't matter as much as common sense would suggest.

The chapters on industrial competitiveness and costs are an eye-opener to those expecting dire news. Adverse economic effects have been “imperceptible”, according to the authors, amounting to around a hundredth of a per cent of gross domestic product (GDP). Because only the most energy-intensive sectors were likely to be affected by the scheme, and these contribute a tiny part of the GDP of industrialized countries, such a benign outcome might have been anticipated. Nevertheless, profuse emitters such as the cement, steel, aluminium and refining industries wield a lot of political power, and their acceptance of the scheme is important for its success. In the end, most of these industries gained from the system by passing on the cost of carbon, and by selling allowances generated from both their initial surplus and an actual reduction in emissions.

The book says little explicitly about the ongoing debate over whether tax or trading is the best way to curb emissions. The authors simply insist on the political and distributional realities that favour an evolutionary trading approach, in which the level of free allocation can be reduced in each phase, pointing out that “there would have been no EU ETS unless allowances in the trial period had been allocated for free”. It would have been interesting if they had elaborated on the reasons and implications for this more fully. Because carbon taxation both sets a price and transfers vast amounts of money from powerful industries to governments, the political obstacles to this transfer of money have always stymied attempts to generate a carbon price through taxes. In emissions trading, by contrast, it is the free allocation of allowances that gives the extra liberty needed to jointly solve the problem of setting a price and handling the distributional consequences.

Credit: SOURCE: EUROPEAN CLIMATE EXCHANGE/T. LAING

The strength of Pricing Carbon is also its weakness. The authors are so keen on the empirical focus that they largely eschew judgement, even as to whether the system has been a success. Nonetheless, the book is suffused with the sentiment that establishing a credible cap and price on CO2 emissions on a grand scale is a triumph of policy, one that is still a world first after more than five years. I agree that it is a huge feat. The EU got many crucial things right: the basic market design; the focus on well-monitored, sizeable point-source emissions; and the sequential phases that have allowed the system to develop and improve.

The world's greatest experiment in carbon pricing is not out of the woods yet. Although the system will continue, with major design features agreed up to 2020, countries are still embroiled in battles over how to allocate allowances. The current modest carbon price will not support new low-carbon investments, and the establishment of tougher rules could risk driving established industries to non-EU countries. Hopes that other regions will develop similar schemes, laying the basis for a more coherent global response to emissions, are currently taking a battering. The EU regards its emissions scheme as the flagship, but there is little sign of an international fleet. Even so, for those who want to learn the real lessons of the EU ETS experience, there is no better source than Pricing Carbon.

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Grubb, M. Lessons in carbon trading. Nature 465, 691–692 (2010). https://doi.org/10.1038/465691a

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