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CO2 – ten years of emission trading: Does it work?

Anders Nordeng  Senior Carbon Market Analyst, Thomson Reuters Point Carbon Commodities Research & Forecasts

Anders Nordeng  Senior Carbon Market Analyst, Thomson Reuters Point Carbon Commodities Research & Forecasts

Thomson Reuters senior carbon market analyst Anders Nordeng on the controversial buying and selling of emission rights to cut CO2 pollution.

Buying and selling emission rights continues to be seen as a controversial instrument for cutting CO2 emissions. Some argue that it doesn’t work. Some accuse it of being equivalent to the indulgences of the Catholic Church of old, whereby Western governments and companies buy remission for their sins – only to go on polluting as before.

The opposite is also heard: that developing countries use it as a ploy to draw investments to industry and infrastructure projects by feigning a positive effect on the global climate.

If these allegations are true, how is it possible that emission trading is still around and even expanding? The simple answer is twofold: Some once-important markets have seen volumes and prices dropping to a point at which their future existence seems doubtful. For the markets that do thrive, we shall argue that the allegations are not true.

This year the European Union Emission Trading System (EU ETS) celebrates 10 years of existence as the world’s biggest carbon market (or cap-and-trade scheme), covering 4,000 operators of fossil power generation and heavy industry representing around 50 percent of Europe’s total output of CO2.

A cost-effective way to reduce emissions

Every year compliant companies report how many tonnes of CO2 equivalents they emit and surrender a corresponding number of emission permits. They basically have two options: They can surrender a permit to cover their pollution or become more efficient and reduce emissions organically. Say Firm A is a steel producer that opts to reduce emissions by making its production process more energy efficient, emitting less carbon to produce one ton of steel. Firm A may then possess excess allowances it can sell on the market. For Firm B on the other hand, implementing abatement measures is more costly, and it lacks sufficient allowances to cover its pollution. Firm B determines it is more cost-effective to purchase a permit on the market from a seller like Firm A.

The ETS thereby allows reductions to occur in the most cost-effective manner, as companies who can abate most cheaply do so; other companies buy allowances if abatement is more expensive than the market price for a permit. Furthermore, firms are incentivized to abate “organically” as permits increase in price and can be traded at a profit. In theory, this is environmentally sound because from an atmospheric standpoint, it doesn’t matter where pollution occurs – CO2 emissions in Poland and France have the same warming effect.

A key feature in the EU ETS and most other carbon markets is that the cap (the maximum allowed level of pollution) is reduced gradually, so that the annual number of permits shrinks steadily. Under current rules the permits allocated in Europe will reach zero in 2059, implying that by this date all power and industry production would have to be without carbon emissions.

Emission trading systems have been in place in North America since 2009. China started a pilot programme in 2013 that covers seven cities and provinces and is expected to start a nationwide system in the coming years. In January, South Korea became the first Asian country to launch an operational nationwide ETS covering 525 companies and 66 percent of Korean emissions.

One of many instruments for emission abatement

What all these initiatives have in common is that they are cap-and-trade systems. This means that an emission ceiling (the cap) has been set, that a certain number of companies have been designated as compliant (normally based on emission volumes), and aggregate emissions must stay below the ceiling. The government has the possibility to increase its climate ambitions, simply by lowering the cap (thereby forcing companies to cut more).

Any discussion on the relative merits of cap-and-trade should start with the acknowledgement that it is only one of several instruments that can be used to reduce emissions. One obvious alternative is detailed regulation of how much each installation is allowed to emit; another option is to levy a carbon tax per tonne of CO2, either on all major sources, or on selected sectors of emitters.

Tax system or cap-and-trade is fundamentally a choice between price control and volume control. In the first case you can decide the cost of emitting one tonne of CO2 but the volume of achieved emission reductions will be at the discretion of each and every factory owner’s profit calculation. In the second case, you decide the amount of emissions you will allow, but the price per tonne of cuts will be decided by the compliant companies’ perceived need for permits. If they think the number of permits in circulation is higher than actual/future needs, the price will drop; in the opposite case it will increase.

Climate targets achieved in Europe

So much for the theoretical framework; what can we learn from empirical evidence? In Europe, emissions from companies covered by the EU ETS have decreased from approximately 2,000 million tonnes (Mt) per year in 2005 to approximately 1,800 Mt in 2013. During much of this time there have been complaints about the surplus of permits and low prices, and this is why the system is subject to constant regulatory adjustments. But in the end, the low prices we have seen are telling us that the EU is well on track to meet its current climate target of emitting 20 percent less CO2 in 2020 than in 1990. As no further reductions are needed, the permit price should obviously be low.

But are reductions of 200 million tonnes over 10 years good or bad? Companies believe that a 10 percent reduction (200 of 2,000 Mt) was a painful cut achieved at the expense of international competitiveness. Environmentalist NGOs believe it is far from sufficient. In the end, this is not a fruitful debate; criticism of the ETS as a failed instrument should be directed at the politicians for failing to set a more ambitious target.

Another, more justified question is whether achieved reductions can really be attributed to the ETS. How can you measure the relative effect of emission trading compared to other emission abatement instruments? For instance, in Europe generous subsidy schemes for renewable energy have contributed vastly to the rapid deployment of solar and wind generation that has replaced much fossil generation. Furthermore, since 2008 the continent is going through its most severe economic depression since the 1930s.

So, of the 200 Mt abated emissions, how much should be credited to the EU ETS, how much to the renewables programme and how much to the recession? Several studies have been conducted showing very different results. What is clear though is that both the growth of renewables and the recession have reduced the demand for emission permits. Similarly, it is clear that if demand for permits had been higher, emissions would still have been capped by the ceiling (and the price of permits would have increased).

A new international climate agreement in Paris?

Carbon pricing, mainly in the form of cap-and-trade, will continue to be a key element in the climate policies of major emitters such as the US, China, the EU and South Korea. It allows politicians to set a fixed emission target and be assured that it will be met. Furthermore, emitting companies tend to prefer cap-and-trade over a tax, as it gives them more flexibility. This is an important element in jurisdictions where there is simply not enough political support for a carbon tax.

After years of difficult negotiations, world leaders will meet again in Paris in December 2015, hoping to reach a new international climate agreement. Unlike the Kyoto Protocol that covered only 11 percent of global emissions (Europe plus a few others), the idea this time is to spur abatement in all major economies. Last November, the US announced it aims to cut emissions by 26-28 percent by 2025, whereas China will strive to peak its emissions before 2030. More countries are expected to present targets in the run-up to the climate summit.

The US and Chinese targets are set to be achieved by direct regulation of polluting industries. Europe, on the other hand, is mainly relying on cap-and-trade. In the end, to avoid runaway climate change, all climate policies will have to be more ambitious than we see today. Emission trading systems can do their part by reducing the allowed level of emissions.

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