Emissions Trading: The Answer to Climate Change?

Primarily due to fossil fuel use, greenhouse gas (GHG) emissions have increased substantially in recent decades, resulting in unprecedented climate change. The impact of this is extensive – for example, rising sea levels, increased violent storms, and increased floods and droughts. These severe carbon emissions are a form of negative environmental externality. This means no-one would pay for producing their emissions if unregulated, because the atmosphere is an open-access resource. Therefore, everyone would have an incentive to pollute endlessly. Throughout this article, the terms marginal cost of abatement (MCA) and marginal damage (MD) will be used extensively. Where, MCA represents the most cost-effective method of achieving a given cutback in emissions where all possibilities have been considered, while MD defines the additional harm by inframarginal pollution units.

Market-based instruments (MBIs) are methods that are aimed to influence pollution abatement. Tradable permits are one such MBI where permit owners can emit a given quantity of pollution over a certain period; by regulating the overall number of permits, the government can limit pollutants’ aggregate emissions. If the prevailing price of permits exceeds the firm’s marginal cost of abatement (MCA), the firms will sell permits. If the firm’s MCA exceeds the market price of permits, then the firm will buy more permits and continue to pollute. The questions that must be duly considered are twofold: how do emissions trading schemes work and are these systems sustainable regarding price stability.

The EU Emissions Trading Scheme (ETS) became operational in 2005, becoming the world’s first installation-level ‘cap-and trade’ system for cutting GHGs, and remains the largest. This aims to: “promote reductions of emissions in a cost-effective and economically efficient manner.” The origins can be traced back to 1992 when 180 countries agreed to avoid dangerous levels of human-made global warming and signed the United Nations Framework Convention on Climate Change (UNFCCC). Consequently, the Kyoto Protocol (KP) was signed in 1997 to specify a global joint initiative. Thus, the EU ETS was introduced as a policy measure to reach Kyoto targets. The EU ETS has an emissions cap (a maximum ceiling amount), so aggregate emissions don’t exceed pre-defined level and trading is based upon EU emissions allowances – ensuring permits always end up in the firms’ hands that value them most highly.

How Does Allocation and Trading Work?

EU ETS is currently organised into four trading phases, the first being pilot phase one (2005-07). Allocation of permits was based upon grandfathering: permits freely allocated to firms according to past emissions history. A penalty of €40 per tonne of CO2 was applied in this phase. However, after the first operational year, it became evident that too many EU allowance units of one tonne of CO2, or ‘EUAs’ had been allocated to businesses. Hence there was an oversupply, and prices consequently fell eventually to zero. Between 2008 and 2012, phase two imposed a tighter emissions cap by reducing the total volume of EUAs by 6.5% compared to 2005. The Member States could auction up to 10% of the allowances instead of free allocation, and the penalty for non-compliance increased to €100 per tonne of CO2. Nonetheless, the economic crisis of 2008, which reduced commercial emissions, resulted in another surplus of EUAs, resulting in prices falling from €30 to below €7.

Later, phase three, between 2013 and 2020, introduced modifications because permits didn’t generate substantial movements to renewable energy industries. Furthermore, mitigation technologies weren’t as cost-effective as anticipated and were subject to fraud. Emission caps became uniformly applied over the EU, whereby the cap decreases by 1.74% per year to reduce emissions by 21% in 2020 compared to 2005. The primary allocation method was changed to auctioning, generating significant revenue to be recycled. This phase’s main challenge was that because permits can be banked for future periods, the large surplus of EUAs transferred from the second to third phase leading to EUA prices of only €3-7. Therefore, the EU decided to postpone auctioning 900 million EUAs to the end of the trading period because of such backloading. Today, phase four is operational and will continue until 2028; this will feature a more ambitious emissions reduction pathway. The uniform cap on emissions will increase to 2.2% per year and is expected to deliver a 43% cut in emissions by 2030 compared to 2005.

Advantages of The EU ETS:

Tradable permits aim to produce the optimal amount of pollution: the intersection of MCA and marginal damage (MD) curves. At this point, the cost of diminishing the last ton of pollution is equal to the benefits in terms of damage avoided; this comes with numerous benefits. As mentioned previously, the auctioning of permits meant that the EU ETS raised $58,968 million in revenues since 2009, the highest of any operational ETS in the world. Each member state must spend at least 50% of these revenues on climate- and energy-related projects, furthering climate action. Moreover, permits have the least cost property and are dynamically efficient (providing an ongoing incentive for research and development into more efficient pollution control forms).

Carbon Prices Over Time and Implications of COVID-19:

Under the EU ETS, carbon prices have fluctuated significantly, most notably in 2008, where prices dropped drastically from €30/CO2 to €10/CO2 because of the financial crisis and over-estimated demand allowances during this time frame. Prices later stabilised between 2009 and 2011, and then fell further to €5/CO2 by 2013. This was because supply exceeded demand as the effectiveness of joining the scheme was substantially reduced. Such price volatility forms uncertainty for the investment decisions of companies involved.

COVID-19 is expected to negatively affect all ETSs for 1-2 years because of lower demand for allowances, according to a PwC report. This must be caveated with systematic behavioural changes and economic restructuring to a greener economy post-pandemic, and hence, the EU ETS prices may rise in the long term. In fact, the EU ETS carbon price is expected to average €36/CO2 between 2021-30. Some long-term drivers of high CO2 prices include the decision for phase fours more ambitious targets for reducing emissions. There was previously a target to reduce emissions 40% by 2030 compared to 1990 levels, which is now increased to 55%. This may further cause investments by financial companies seeking to profit in what is considered a bullish market, stimulated by the EU's climate policy.

Closing Remarks:

For ETSs to help prevent irreversible climate change, global carbon prices must be simultaneously high and stable – this can be achieved by developing upon the EU ETSs complex framework. It has been the case that more ETSs have been developed since, particularly, Brazil, Turkey and Japan are currently developing their own systems, with further examples taking shape. These will ensure that companies internalise their external costs of production, reduce GHG emissions, and create welfare gains for individuals. The question remains whether carbon prices will be predictable enough in this current EU ETS system to help solve the climate emergency.