Economics of the EU Revision - Carbon Trading

Revision notes on aspects of carbon emissions trading in the EU

Carbon Emissions Trading
1. Emissions trade - launched Jan 2005 and is a market-based mechanism to incentivise reduction of C02 emissions in a cost-effective and efficient manner.
2. EU scheme operates through the allocation and trade of CO2 emissions allowances. It creates a market in the right to emit C02. One allowance represents one tonne of C02 equivalent.
3. Cap is set on the emissions – this creates the scarcity required for the market. At the end of each year businesses within the scheme are required to ensure they have enough allowances to account for their installation’s actual emissions. There are heavy fines for those without such permits (Euro 100 per ton)
4. The aim of carbon trading is to create a market in pollution permits and put a price on carbon. In this way, policy can help internalize external costs of firms’ production and encourage lower emissions to tackle climate change. In a cap and trade system, the volume permits would gradually decline. As the price of the permits rises, so the economics of investing in cleaner technologies will change.
i. Assets: If a carbon emitting business can under-use its initial allowance by better energy efficiency, it can sell its surplus on the market.
ii. Liabilities: If a business is faced by high costs to reduce its emissions, it must buy extra allowances

A market based system might work as shown in the chart below

Weaknesses of EU carbon trading scheme

1. The system has suffered from government failure because of the initial over-allocation of carbon quotas and national freedom to allocate carbon permits.
2. Allowances were handed out for free rather than being auctioned off in Phase 1
3. Not all industries are part of the scheme – aviation initially left out – scheduled to be included soon
4. In recent times, carbon price has collapsed - driving up the demand for coal fired energy! – A dirtier fuel! (example of law of unintended consequences)
5. Carbon prices have fallen further because of the recession hitting EU economy. The recession has caused reductions in output in steel, paper, cement and glass and a sharp decline in production has led to a sell-off of carbon credits
6. That has caused a drop in the market price of carbon permits - meaning there is less incentive for companies to stop polluting and there are fears for the future of many clean energy projects. Some economists have called for a minimum price to be applied to the carbon market. Grantham Research Institute believes min of Euro 40 per ton tom meet climate change targets.
7. There is political resistance to introducing tougher low emissions targets to drive the market price of carbon high enough to prompt cleaner fuel investments.