April 16, 2013

Opinion piece: Carbon Capitulation

Further efforts are needed to restore the EU carbon market’s functioning after the EU Parliament rejects a key reform proposal.

On April 16, the European Parliament rejected a proposal by the Commission to ‘set aside’ (delay) the planned auctioning of carbon allowances within the European Union Emission Trading Scheme (EU ETS). The delay was perceived as necessary because the supply of emission allowances has been based on higher­ rates of economic growth. Due to the lower levels of economic activity, the demand for allowances is significantly less than the supply of emission allowances due to weaker than previously projected output from power generators and heavy industry (companies must hold one allowance for every tonne of CO2 emissions).

As a result, the EU ETS no longer has market scarcity and thus cannot work as intended. Lack of market scarcity means that investors in low-carbon technologies are unable to invest with confidence. The implication is that when the economy recovers, the EU could be above its longer term emission reduction targets and face the risk of spiking carbon prices. This could make reducing emissions unnecessarily more expensive. The Parliament’s vote also creates a risk that EU member states will introduce policies that move the EU away from a ‘Single Market’ approach to addressing climate change. For instance, the UK’s carbon floor price sets a higher carbon price for UK power generators. Investing in low carbon technologies could become more expensive for companies and consumers if member states introduce their own rules and carbon prices. This would lead to companies having to spend time understanding different regulations and may lead to investments not being made in the most economically efficient way across Europe (which is part of the original purpose of the EU ETS).

Until recently, the EU ETS had been successful in putting a price on carbon emissions that encouraged companies to change their operating practices and promoted technology innovation. The ETS also encouraged many developing countries to create thousands of emission reduction projects as companies regulated by the ETS can receive credit for investing in verifiable renewable energy, energy efficiency and projects which destroy industrial gases.

Lessons have also been learned from the EU ETS by the growing number of countries and regions that have developed or are working to implement carbon markets including Australia, Brazil, California and several eastern US states, the Canadian provinces of Alberta and Quebec, Chile, China, Japan, Mexico, New Zealand, South Korea, Thailand and Vietnam.

In the immediate aftermath of the vote, the carbon price dropped by one third to around €3/tonne, while share prices of clean generators dropped by up to 8%. The share price reactions to the vote may be slightly overdone, but the carbon market is now likely to remain in structural surplus and the price is unlikely to recover. The current carbon price is now half the level seen in January and is down far more from over €20/tonne two years ago.

The ‘set aside’ proposal will now go back to the Parliament's environment committee for further consideration. The European Commission is likely to increase its efforts to develop other medium term structural reform proposals such as adopting a tighter carbon target, retiring carbon allowances or creating a mechanism to give greater flexibility in carbon allowance supply. The prospects for these reforms are significantly lower as a result of the Parliament’s vote, and in any event would take time to agree and implement.

Opinion piece: Carbon Capitulation
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