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Captured By Carbon: Why An Emissions Trading Scheme Needs a Floor Price

February 19, 2013

​​​​The Australian government plans to link its fixed-priced system for tackling climate change to the emissions trading scheme (ETS) of the European Union (EU). Meanwhile, the Europeans are wondering whether a straight and predictable carbon tax such as Australia's would not have been more efficient for them in the first place. The EU's floating carbon price has fallen to levels where it's more profitable for some businesses to keep polluting than to invest in green technology and it's apparent that too many emissions rights have been issued. Regina Betz, joint director at the Centre for Energy and Environmental Markets at the Australian School of Business, says an effective ETS needs to include a floor price for carbon to limit intervention from politicians and thereby provide certainty for business.

In the perfect world of a market economy, every product has a price. If something is high in demand, prices soar; if supply outgrows demand, prices sink. This basic rule of business is precisely why economists consider an emissions trading scheme (ETS) to be the ideal instrument to reduce the output of harmful gas into the atmosphere: corporations have to buy share-like permits that allow them to emit CO2 for a price driven by supply and demand. If a company invests in green technology and therefore emits less, it needs to buy less pollution credits - or may even sell some from its own portfolio.

An ETS is seen as a market-driven tool to lessen emissions and so the Australian government has decided to switch from the present fixed-price system that demands A$23 per tonne of carbon emissions - aka the carbon tax - to an ETS by 2015.

The model for Australia’s future approach to combating climate change is the ETS of the European Union (EU). Since January 2005, the EU has defined the amount of emissions it considers in harmony with its climate goals. Today, the EU is committed to reducing greenhouse gas emissions by 20% by 2020, the base point being the level of emissions in 1990. The acceptable amount of annual emissions is distributed in the form of carbon credits among 11,000 European emitters, including utilities and steel or concrete producing corporations in 30 countries. Everything else is then dealt with by the market - or at least that's the theory.

Unsustainably Low Prices

In practice, the price of EU carbon credits has been highly volatile and has lately fallen below €4 (A$5.19) a tonne. At that price it is cheaper for the Europeans to continue polluting the atmosphere than to invest in emissions-reducing green technology. As a result, European critics are now wondering if a simple, predictable and stable carbon tax would not have been more efficient for Europe.
Regina Betz, joint director at the Centre for Energy and Environmental Markets at the Australian School of Business, agrees. "All the data indicates that so far the EU ETS has not achieved a great deal in avoiding emissions," she says.

Betz obtained her PhD in Germany while working at the Fraunhofer Institute for Systems and Innovation Research in Karlsruhe and has been part of the team that designed the auction that is needed to allocate carbon credits to Australian corporations when the trading phase begins. Her verdict about the EU ETS is harsh: "Its cap is too loose and a price floor could have helped, [as] foreseen in the Australian scheme."

Prices are low because the EU pre-defines the amount of emissions credits years in advance and is therefore flying blind on how the economy is evolving and how many reductions other policies - such as those to enhance renewables and energy efficiency - are delivering. The number of pollution rights for the period, 2008-12, was decided in 2006 when no one had foreseen the global financial meltdown, a sovereign debt crisis or a Euro crisis. Nevertheless, during all the turmoil many European corporations cut production. German enterprises, for example, used 4.8% less energy in 2011 year on year and many did not need the carbon credits allocated to them. According to a study by the British environmental lobby Sandbag, German steel producer Salzgitter owns 7.5 million more emissions credits than it needs; its competitor ThyssenKrupp harbours a surplus of six million emissions rights. In selling these, the EU ETS has become a source of income for the companies rather than a cost factor.

Too Many Emissions Rights

With the price of carbon credits being so low, it makes no sense for European industry to invest in green technology and experts claim that is why the usage of brown coal in Germany rose by about 4% in 2011. In other words: the EU ETS is not slowing down climate change, it is accelerating it. Or at least that's the bottom line of a study by Hauke Hermann from the German think tank, Öko-Institut.

To trigger green investments, the price per credit needs to be at least €20, believes Andreas Löschel from the Centre for European Economic Research. "From the start the EU offered too many emissions rights. The desired shortage will not materialise under these circumstances," Löschel says. Nor will higher prices. As a result, EU Commissioner for Climate Action, Connie Hedegaard, wants the right to adjust the system and plans to take millions of emissions credits off the market during 2013.

Ignoring the Costs

The European system is clearly in trouble. So why does Australia plan to give up its working carbon tax in favour of an ETS that will be linked to the EU's?

According to Betz, both systems have their downsides. Fixed-price systems are unpopular because they are regarded as taxes: "An environmental tax is not very helpful when prices are set too low due to political reasons, as the example of the New South Wales tax on air pollutants has shown. There, the tax is so minor that business can ignore the resulting costs." But the benefits of a fixed-price system have to be acknowledged: prices are transparent and predictable. "Businesses know exactly what they are dealing with and investors will benefit from predictability," she says.

Betz sees undeniable advantages in an ETS: a market-driven system is more attractive than a tax in many people’s view. "And when prices get too low, companies with an interest in green technology start to protest almost as loudly as the NGOs. An ETS very quickly has a lobby which may help to improve the effectiveness, [whereas] taxes never do," she says.

But the downsides of this tool are still prevalent, as the EU ETS has shown. Says Betz: "Our research seems to be indicating that companies did trade not only to comply with the regulation but other motivations such as speculation and market power may have driven their trading decisions - and that certainly was not the goal of this market."

Betz acknowledges Canberra’s decision to link the Australian system to the EU ETS in 2015 as a first step towards a global carbon price. However, she is critical about the implementation: "We are abandoning a better system for a worse one," she says.

Betz is especially worried about the decision to give up any minimum or floor price and expects that, as a result, the price of Australia’s carbon credits will become as low as Europe’s are today. She believes that with this decision, Australia will import a lot of political uncertainties: "If the EU decides to place more carbon credits on [the market] or to take some off, the smaller partner in the Pacific will also be impacted by the consequences."

And how easy would it be for Australia to de-link from the EU ETS, if necessary? "Getting rid of such a system is never easy," Betz says, pointing to the troubled European currency union that offers no pre-defined emergency exits.

Keep It Simple

Hedegaard's plan to take millions of emissions credits from the market can be seen as an attempt to create something like a floor price. Therefore, Betz asks: "Why don’t we aim at keeping it simple and try to agree to a minimum price with the Europeans in the first place?"

A universal floor price on a common market would not only reduce volatility and speculation, it would also grant businesses peace of mind for their investment strategy in green technology. A floor price would also help limit future intervention from politicians.

"If Hedegaard takes emissions rights off the market, she also sends the signal to business that politicians will continue to meddle with the trading scheme. That creates instability. But a definite floor price - with a little in-built rise every year - is stable, predictable and transparent for all involved," says Betz.​

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