30 june 2009

The EU Emission Trading system: too little too late?
(A Clingendael International Energy Program briefing paper)

Luc Werring, June 2009

[4C note: Clingendael, the Netherlands Institute for International Relations, is a think tank that advises the Dutch government, Parliament and social organizations. We have copied only the last third of this study, omitting the detailed description of the European ETS and the notes. For those who would like to consult the complete document online, click here]

Is the EU ETS going to deliver tangible results in greenhouse gas reductions in the EU?

For the proponents of the ETS the answer to the above question is obviously yes. Their reasoning is rather simple: we have set a cap, that cap will be guaranteed by strict monitoring and will be met in the most cost effective way as a result of ETS. They are not at all worried about the recent price drop for allowances from 20 €/ ton to 15 €/ ton, because they consider it to be very good for the economy that apparently it is now cheaper than expected to meet the cap.

The first problem of this theory is that the allowance price has until now been rather volatile and is also unpredictable as regards its development in the future, whilst the necessary reforms in our energy system are to be based on long term planning. It is claimed that the market always sets a realistic carbon price, but that is simply not true. It is the level of the cap that sets the price as this price will develop on the basis of expected supply and demand of allowances. And the level of the cap is a pure political decision like setting a carbon tax. The EU ETS cap in the climate package was agreed when everybody still believed in an average annual growth of the EU economy of 2.3 %. Now the economy is shrinking around 5 % and so are the industrial production and emissions of GHG. However, the cap as it was set in the climate package remains the same, so it will even take longer than expected before the assumed scarcity of allowances may drive up the price to a level that will generate investments in alternatives. Maybe this will not even happen at all, given the scale of the recession and the wide open back door to cheaper CDM’s!

The EU emission figures for 2008 as released in May 2009 show already a decrease of emissions in the ETS sector of 3.06 % compared to 2005. Although the Commission could not indicate which part of it was the direct result of ETS, it downplayed the impact of the economic crisis and presented this figures as a proof that it all works well. However, it looks rather obvious that for instance a worldwide decline of steel production of 30 % would indeed have an influence on the decline of CO 2 emissions. The reason that the price of allowances has not dropped even more drastically can be explained from the equalizing effect of the decision that the allowances of the second period can now be banked and used in the third period as well, so effectively until 2020.

Instead of taking advantage of the slow down of the economy by combating climate change with more success, the market based approach of ETS could well result into postponement of strategic decisions and investments. It is interesting that a company like Exxon declared recently to prefer a clear carbon tax in order to have certainty for their climate investments.

The second problem of the assumed effect of market forces of carbon prices is that they are anyhow far too low to make important changes happen.

An allowance price of 20 € /ton CO2 would mean around 1 cent per kWh. This is totally insufficient to bridge the gap between fossil fuel electricity and renewable electricity (4 ct per kWh extra is needed for on shore wind) or to compensate for the extra costs of carbon capture and storage (CCS), which would add to the price of coal generated electricity at least 3 ct per kWh. This means the market of ETS allowances on its own would only push for strategic alternatives in energy generation at a carbon price of at least 80 € and that only when this price is stable enough to give long term confidence to investors. At lower prices the main effect probably will be a fuel switch from coal to gas or simply closing down industry. This is confirmed by recent studies that indicate that the main factor determining the CO 2 price until now and in the near future is the price difference between coal and gas.

Indeed, the individual power industries have always an incentive to produce less CO 2 because that would give them a competitive advantage. However, if there is not enough competition they can simply pass the extra costs to the consumers. Power industries with large assets in hydro and nuclear electricity will have this competitive advantage immediately anyhow and will make large profits. These profits may lead to buying their competitors and a reduced number of competitive players in the market and thus less competition.

Energy intensive industry needs large quantities of allowances. They can make money if they can sell their surplus and will have to pay for the allowances that they will need on top of those that are given for free. So there is indeed also an incentive for them to reduce CO2 emissions by efficiency. However the question is why these industries would not have done that already as energy is such a large part of their costs. It can easily be calculated that paying an emission allowance price of 20 €/ton has the same effect as a rise of the oil price of 10 $ per barrel. So if an oil based industry receives 70 % of its allowances for free then an allowance price of 20 € equals the effects of only 3 dollar price difference per barrel oil on their balance. The main issue for the EU industry is indeed that a higher oil price is paid by everybody in the world and the ETS price only in the EU. Once this effect would have been neutralized by a global carbon market, the global industry would react like with higher oil prices and we have already seen the effect of a fluctuation of that price of 100 $ per barrel!

Finally, also for the consumers an increase of the price of electricity of 1 ct per kWh at an allowance price of 20 € is by far not enough to bring a change of behavior. Moreover, for transport and direct(non electric ) heating the consumers will not pay any allowance.

It can certainly be stated that the EU ETS system is in principle a very clever way to bring the greenhouse costs to the market and it may have the desired impact in the long term, but unfortunately there are enough reasons to doubt about at least its short term effectiveness by its instability and the absence of strong incentives to cause strategic changes. There is therefore a growing awareness that it would be wise to start developing enough safeguards for a scenario in which it will not work according to theoretical models. Unforeseen developments such as the current economic crisis may render the system powerless for a long period and there is no time to lose in experiments.

Complementary action to the ETS is needed

As the CO2 reducing actions that should be triggered by the market mechanism may in practice occur too late or not at all it may be rather risky to rely so much on the ETS and neglect other measures that could have a more guaranteed performance. In fact, ETS has too often been welcomed as a good reason to stop or delay other activities that are more straight forward solutions to reduce carbon.

Nevertheless, such other measures were already partly introduced:

· The European renewables Directive will deliver its 20 % share of green energy independent of the economic recession and with a predictable schedule.
· The standards for appliances set by the European ecodesign Directive and the implementing national measures will deliver energy savings without further economic incentive and independent of economic recession.
· The car industry is forced toe downsize their products independent of oil price by means of the 130gCO2/km benchmark.

These measures and national subsidies and tax measures all deliver GHG reductions which partly fall in the ETS sector and that will make allowances even cheaper for the remaining sectors that are to be covered by ETS alone.

Therefore, it seems there is no good reason to stop here and to take the risk that finally too little will happen in the important remaining sectors, notably the power industry.Additional regulations that could complement ETS include:
· Performance standards for power industry and energy intensive industry
· Tax measures (preferable internationally harmonised) to discourage CO2 emissions , especially in transport
· Binding targets for the application of energy saving technology like CHP
· Binding targets for energy efficiency in final demand such as in the building sector.

The use of such regulations could be rather forceful but “command and control” policy is often considered to be old fashioned and turned down because of sub optimal allocation of resources. However, if the ETS would indeed deliver what is promised it would not do great harm if standards were set on top of the ETS system and it would create a level playing field right from the beginning.


· The EU ETS is a clever system based on sound economic theory but the effects until now are overestimated by opaque calculations and by taking adjustments of earlier mistakes inallocations on board as a success of the system.
· The future impact of the EU ETS is totally dependent of the price of an emission allowance and that price is set by the cap. In time of recession this cap ought to be adapted (lowered) in order to maintain the desired drive for strategic changes. However adaptation of the cap in the EU institutional process is a very slow political process so a quick and adequate reaction to changing circumstances is unfortunately out of the question.
· The large possibilities of using "cheap" CDM's and the over allocation of allowances based on economic growth figures that are outdated will probably remove the necessary incentives to actively reduce emissions in the ETS sector in period until 2020.
· Complementary actions should be initiated without further delay, notably EU wide performance standards for power industry (e.g. maximum quantity CO 2 per MWh) and binding standards based on benchmarks for the energy intensive industry

Because of the seriousness and urgency of the underlying problem, the primary goal should not be to keep the costs for mitigation of climate change as low as possible, but rather to have a mechanism that bites enough in the short term to convince all stakeholders to make extra efforts in changing the energy system. In theory this may finally also happen with a cap and trade system when the market is fluid, everything is in balance and the control is perfect. However, how high will the concentration of GHG in the atmosphere be when we know for sure that this works well?

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