The EU-ETS: Fix it or shut it down, please

According to Bloomberg (3 April 2012), “EU carbon allowances for December fell as much as 4.6 per cent to a record [low of] 6.05 Euros a metric tonne on the ICE Futures Europe exchange in London after preliminary data released yesterday [2 April] showed emissions from factories and utilities in the region dropped 2.4 per cent last year. That implies a third consecutive annual surplus of emissions permits”.

Many commentators argue that because Europe is in the midst of an existential crisis (together with a credit crunch and an unemployment mess), this is a difficult time to fix the EU emissions trading scheme (the EU-ETS).

This is wrong: a properly functioning EU-ETS will create more economic growth, more jobs and more efficient use of resources. This is because a proper price signal from the EU-ETS will drive billions of dollars into energy infrastructure in Europe, and improve energy efficiency and reduce energy consumption (plus improved air quality and associated health benefits). At the same time, a properly functioning EU-ETS will also result in more revenues to governments, via the auction of (fewer) allowances at higher prices.

Instead of these indisputable benefits, major pollution emitters continue to receive windfall profits courtesy of the European consumers because of a structural flaw in the design of the EU-ETS.

Here’s what the EU has managed to do so far:

  • Enact a cap and trade system with vision and promise;
  • Forget the law of supply and demand, and set up the system with a fixed supply of emission permits (using optimistic growth scenarios for Europe) over a considerable timeframe but ignore the fact that demand varies daily and with economic conditions;
  • Omit safeguards in the system (e.g. a floor price or a mechanism to adjust supply to demand);
  • Give (literally) €15 billion (my conservative estimate) in free cash to European emitters over the past five years (in the form of free European Union Allowances or EUAs) and allow them to pocket this cash while passing inflated costs to consumers.  Here’s a simple example of how this worked:
  1. EU determines that the emissions of Polluter Z over the next five years will be 110 tonnes of CO2.
  2. EU gives Polluter Z 100 tonnes of CO2 in the form of free EUAs worth, say, €10 each (so cash value = €1,000).
  3. Polluter Z in fact emits 80 tonnes of CO2 due to economic conditions and buys some permits at a reduced price from emerging markets (substitutable for the EUAs) at a 25 per cent discount to the 10 Euro value of the EUAs.
  4. Polluter Z surrenders permits covering 80 tonnes of CO2 (cost = less than €800).
  5. Total cash profits so far made by Polluter Z: more than €200.
  6. Note that Polluter Z was able to buy some of its emission permits from the emerging markets at a significant discount to the value of the EUAs received for free (because the EU-ETS has another structural flaw which means that instruments fungible most of the time –emerging market emission permits –trade at a significant discount to European emission permits); sell the expensive European ones for cash and present the cheaper emerging market ones when needed to show “compliance.”
  7. Also note that banks and other intermediaries were in effect given free money through this discount, because they were able to provide swap and other facilities to the polluters to enable this risk-free trade.
  8. While we are at it, let’s allow utilities to assume in their five-year plans that prices for permits will average €20 and to file a request to regulators to compute their costs accordingly and therefore increase prices to reflect their forecast (and inflated) emission permit costs.
  9. Finally, let’s make sure there is no obligation to disclose any of the above in the financial statements of Polluter Z in order not to be transparent.
  10. Net result #1:  Polluter Z pockets more than €200 by banking its excess allowances while basking in the comfort of knowing it can continue to emit pollution for some time to come without having to make any investments in new technology, locking in polluting technologies for even longer than it would have done without the EU-ETS at all.
  11. Net result #2:  Utilities pick the pockets of the European consumer who ends up paying more for energy even though the utilities received most of their emission permits for free.

The EU-ETS is not doing what it is supposed to do:  It is not reducing emissions (reductions in emissions are in fact due to the fall in economic output, the rising cost of living, the fall in real income for European consumers, and national policies supporting renewable and energy efficiency) and it is not giving a meaningful price signal to allow industry and investors to plan investment decisions.  It is, in short, meaningless and wasteful.

Ironically, the powerful bloc with the non-functioning emissions trading scheme is the same one that went to Durban and led the world in continuing to move towards a global solution to climate change.  A cap and trade system such as the EU-ETS works with human nature, not against it, by incentivizing the reduction of pollution via market-based mechanisms.  People hate being told what to do and this type of an incentive mechanism is proven to be superior to command-and-control bureaucracies, provided however that it is designed correctly.  Sadly, the EU-ETS has become the poster boy of flawed cap and trade designs.

Specialists have provided the EU with comprehensive analysis and recommendations of what needs to be done. See for example this report from Climate Strategies (http://www.climatestrategies.org/research/our-reports/category/60/343.html) which argues that a combination of measures is required, including a set-aside of EUA allowances, a minimum price for future national auctions, a floor price and “accelerated negotiations on post 2020 strategies and commitments.”

I presume the EU is not a kindergarten and that the European Council will shortly take responsibility for this mess and fix it, especially in light of the numerous energy challenges Europe is facing. Those challeges include exploding energy costs, the need to replace ageing generation capacity, more competitive US energy (and therefore economy) with the paradigm shift introduced by shale gas recovery, and a slow economic recovery in Europe without a price signal to allow for urgent investments in energy efficiency within Europe.

Failure to fix the EU-ETS now will undermine confidence in the EU’s status as a global leader in the fight against climate change. What’s worse, as I argued above, is that it will lock in more polluting technology and make it increasingly difficult for the European economy to meet future GHG emission reduction targets. And that it will make it even harder to compete with newly energy efficient industries and energy rich nations.

If the European Council doesn’t want to fix its ETS, or is unable to, it should shut it down:  There is no point carrying on with the EU-ETS in its current, sad state.

This is the first of a two-part blog on emissions trading systems. Read the second part: Decisive Korea v Divisive Poland: Part two of ‘The EU-ETS: Fix it or shut it down’

Assaad Razzouk is Group CEO of Sindicatum Sustainable Resources, a global sustainable resources company headquartered in Singapore.

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