Eco-nomics: Problems with Cap and Trade in Europe

Photo: Der Spiegel/DPA

Der Spiegel has the story of the collapsing CO2 permit market in the EU.  Permits are so plentiful at the moment that the price has plunged reversing the calculus and actually promoting rather than discouraging coal burning.

The EU is alarmed. The European Parliament's Industry Committee plans to vote later this month on whether Brussels should reduce the number of carbon certificates it provides. A vote in favor would see the EU auctioning off 1.4 billion fewer credits than planned during the next trading period from 2013 to 2020. The cut of roughly 8 percent, it is hoped, will push prices back up.

Yet this type of market intervention reveals the system's central design flaw: Politicians determine the total amount of CO2 that industry in the EU may emit, a limit that applies years into the future, without any way to know how the economy -- and thus the demand for trading certificates -- will develop during that period.

Five years ago, when Europe was experiencing an economic boom, Brussels was generous in providing businesses with free certificates for the trading period from 2008 to 2012; companies were forced to buy only a small portion of their emissions credits. But soon afterwards, many businesses were forced to scale down production as the financial crisis, and then the debt crisis, took hold in Europe. Germany consumed less energy -- 4.8 percent less in 2011 -- and industry as a whole required a lower number of certificates than expected.

Aha! Seems like a job for economists to understand things like derived demand, induced innovation and the like. More than that it seems like there need to be more flexibility in these permit markets - like linking permit numbers to certain conditions, for example.

And then here is a classic situation of one policy undermining another policy aimed at similar goals:

With the certificates so cheap, generating power from environmentally harmful fuels becomes even more of a good deal than usual -- which explains why brown coal consumption increased by nearly 4 percent in 2011, bucking the general trend.

Even more paradoxical, CO2 prices are so low partly because of the billions Germany spends on renewable energy. This decreases the demand, and with it the price, for emissions certificates. That in turn allows coal, a notorious danger to the climate, to be more competitive. In other words, emissions trading isn't stopping climate change, but actually speeding it up.

They go on to propose a CO2 tax, but I'd go one better, a carbon tax at the source. Of course you'd then be stuck again on the appropriate size of the tax...