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The Truth About Cap-and-Trade in Europe

Has cap-and-trade in Europe worked? WRI’s Senior Fellow Jill Duggan, who helped implement the EU trading scheme, sorts the myths from reality.

This piece is first in a series from Visiting Senior Fellow Jill Duggan:

Europe began its cap-and-trade system in 2005, with a three year learning period (phase 1). In recent U.S. Senate climate hearings, cap-and-trade critics pointed to the challenges of that first phase as a sign that cap-and-trade was a failure. But as more results are identified and understood, Europe’s first phase is looking more and more like a success. Today Europe has a stable cap-and-trade system, improved by the lessons learned when it was first implemented, and industry in Europe have certainty that carbon pricing is here to stay.

Price Stability

Price volatility for carbon is often cited as a problem in the EU Emissions Trading System (ETS). In fact, for the second trading period, the price has been relatively stable. The chart below shows the comparative stability of European Union Allowances (EUAs) -- the emissions reduction ‘currency’ (in blue) -- when compared to the price volatility of other commodities such as coal, oil, and gas.

<p><strong>Comparing the price volatility of European Union Allowances to the volatility of oil, coal, and gas</strong><br /><em>Source: United Kingdom Department of Energy and Climate Change (DECC)</em></p>

Comparing the price volatility of European Union Allowances to the volatility of oil, coal, and gas
Source: United Kingdom Department of Energy and Climate Change (DECC)

Overallocation or Emissions Reductions?

Another charge leveled at the EU ETS is that officials had allocated too many allowances for polluters in the first phase, with no real abatement (greenhouse gas emissions reductions) taking place. It is true that in May 2006, the results from the first year showed that there were fewer emissions than allowances. But was this overallocation or was it, perhaps, that European states, venturing into uncharted territory, had underestimated how cheap and easy it would be for companies to reduce their emissions? The earlier UK emissions trading system, for example, exceeded its five year target in the first year. Companies, once they started to implement greenhouse gas reduction measures, were quite effective at cutting back on emissions, and needed fewer allowances than predicted.

Real Action by Companies

Critics claim that the trading system has not changed behavior. However, a look at the numbers from the Community Independent Transaction Log (CITL), which tracks allowances from the EU ETS member states, shows that in 2005, when the price of carbon was high, emissions went down. As the carbon price fell in 2006, emissions went up. In 2007, the price was so close to zero that there was hardly any carbon constraint in Europe, and there were actually 11.6 million more tonnes of CO2 emitted than allowances allocated for that year. These numbers suggest that the carbon price did in fact influence behavior – it encouraged cuts when the price was higher in the earlier years providing for extra allowances, while a lower price led to an increase in emissions.

The figures fit with early analysis undertaken by economists Ellerman and Buchner, Barry Anderson and others that found significant abatement in the EU ETS in its first years of operation, meaning that companies took real action to reduce their emissions. More research is necessary to confirm these figures, and Ellerman and others will be publishing more analysis next year. But there are strong indications that the carbon price in the first phase was very effective in driving a reduction in greenhouse gases.

The EU Carbon Market Today

So is the carbon market working today? In 2006, only 15% of the companies covered by the ETS were taking the future cost of carbon into account. Point Carbon and others found that a year later, about 65% of companies in the trading system were making their future investment decisions based on having a carbon price – and that is precisely the response needed.

Europe has stuck with cap-and-trade because of its cost-effectiveness and its ability to deliver an environmental outcome.

What are the big lessons we can draw from the early EU experience? First, a market needs scarcity in order to create demand and a carbon price. Second, achieving the right level of scarcity right away is difficult, because governments and companies are nervous and tend to overestimate how difficult and expensive it will be to cut back on emissions. Reducing emissions in practice is much easier, at least in the early years, than we had expected, and that is good news, but it makes it harder to get real demand in the market at the beginning. These early challenges do not mean that cap-and-trade is fundamentally flawed, as some have suggested. Europe has stuck with cap-and-trade because of its cost-effectiveness and its ability to deliver an environmental outcome. Companies do not need to know what the carbon price will be in 2020 (just as they do not know the price for oil or coal will in 2020). They do need to know that there will be a carbon price in 2020, and in Europe at least, they know that the ETS is here to stay.

Critics should step back and look at the overall picture of the EU ETS rather than make judgments on its various elements. In future pieces we will explore issues raised about the EU ETS, and show how many of the criticisms have thus far been misplaced and how Europe has addressed some of the early lessons.

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