Storm clouds gathering around European carbon trading scheme: a growing credibility gap

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When they championed carbon cap-and-trade schemes, forward-thinking European environmentalists thought they had outmaneuvered their opponents in the mainly coal-fired power generation industry. Greens who wanted emitters to pay for pollution felt vulnerable to accusations that they want to hurt business and the economy. Their support for carbon cap-and-trade was a clever way to defeat these accusations. With such demonstrable faith in market forces, how could they be anti-business?

So, by proposing an ideologically correct carbon costing scheme, the greens won government support for cap and trade. The problem is, they forgot that in designing the carbon market, European governments were subject to the same political pressures as always.

As I have pointed out in other articles, the ETS is thwarted in its purpose—which is to reduce emissions by making carbon expensive, thereby forcing coal-based generators to use less emitting means of generating power—by two fundamental flaws in its design.

First, carbon caps are determined by a consensus between power generators, their home governments, and the European Commission. Power generators are naturally inclined to highball their emissions estimates for the coming year. That ensures they get more carbon permits to play with, which lowers the cost of carbon.

There is an equal incentive for individual governments to go easy on their home industries. If, say, Germany gets tough on its power generators and their operating costs go up as a result, then so do the operating costs of industrial power users in Germany. This hurts their competitiveness.

Second, ETS permits are distributed for free. Ironically, this currently gives power generators another source of financing during these times of low demand and tight credit. Low demand for power means generators are less likely to burn through their (free) permits. This frees generators to raise money by selling the permits—not exactly what the ETS designers had in mind. If permits were sold at auction rather than handed out for free, as is the case in the Regional Greenhouse Gas Initiative (RGGI), the sale of permits by generators wouldn’t be so lucrative.

This situation won’t last forever, of course. But there is still hope for industrial power users in Germany. If the ETS ever succeeds in raising carbon costs to a meaningful level, German coal-based power generators will relocate to countries like Poland with less-tough carbon caps, and still sell their product at competitive prices.

But by that time, the damage could be done. Reuters calls today’s ETS a “scam.” Given the plummeting public confidence in fancy financial instruments, how much more support will the ETS get when people figure out it rewards emitters rather than penalizing them?