Europe’s Carbon Market Crisis: Why Does it Matter?

The European Union's eight-year-old Emissions Trading System (ETS), the world's largest cap-and-trade carbon market, is broken.

Steam billows from RWE's Frimmersdorf coal power plant near Grevenbroich, Germany. The European Union's carbon market was meant to curb greenhouse gas emissions, but heavy industry has resisted steps that would make the system more effective, and fossil fuel more expensive.

The European Parliament this week voted 334-315 (with 60 abstentions) against a controversial "back-loading" plan that aimed to boost the flagging price of carbon, which since 2008 has fallen from about 31 euros per tonne to about 4 euros (about $5.20). Since the vote, the price has fallen even farther, to 2.80 euros. The collapsing market is hardly the kind of firm foundation needed for building a clean-energy economy. (Related: "Renewable Energy Not Growing as Fast as Necessary," and "IEA Outlook: Time Running Out on Climate Change")

"Now, the market is dead, as far as I can see," said Steffen Böhm, director of the Essex Sustainability Institute at Britain's Essex Business School.

What will be the aftermath of the ETS collapse? Here's a quick primer on what happened, and what it could mean elsewhere, particularly in California, which inaugurated a new carbon market at the start of this year. (Related: "California Tackles Climate Change, But Will Others Follow?")

Q: First of all, what's a carbon market?

A: The U.S. introduced the concept of using market forces to rein in greenhouse gas emissions during the talks that lead to the 1997 Kyoto Protocol, an international agreement to combat climate change. Ironically, Europe wasn't initially keen on the idea. But after it failed to enact an EU-wide carbon tax, Europe ultimately launched the ETS in 2005.

The basic idea is setting an ever-tightening cap on carbon dioxide (CO2) emissions, then issuing allowances up to that level. Major contributors of greenhouse gases-mainly power companies and heavy industry-face heavy fines if they don't have enough allowances to cover their emissions.

The cleanest companies can either bank the ones they don't need, or sell them to companies in need of more.

The idea is to make it more expensive to emit CO2, and to make green technologies-including renewable fuels, and carbon capture and sequestration-that are initially expensive more competitive with fossil fuels.

Trading certainly was happening; Bloomberg estimates that the ETS represents 89 percent of the $61 billion worth of carbon emissions traded worldwide.

But experts say a price of 30 euros ($39.20) or more is needed for the ETS to be effective at driving adoption of cleaner energy. (Related: "As U.S. Cleans Its Energy Mix, It Ships Coal Problems Abroad")

Q: So why has the price of carbon in Europe fallen?

A: "There were far too many allowances in the system in the first few years," Böhm said. Moreover, he said, Europe was flooded with "cheap CDMs," or clean development mechanism offsets that companies earned for funding green initiatives in developing countries. But what really pummeled the market was the 2008 Great Recession and the subsequent anemic recovery, said Tomas Wyns, director of the Center for Clean Air Policy Europe, a Brussels-based nonprofit, because demand for goods and power has dropped.

Q: Recessions do happen, so wouldn't that always be a problem for carbon markets?

A: Wyns certainly thinks so. The problem, as he sees it, is that while demand fluctuates, the supply of allowances is fixed. "There is no way to respond to the supply side in its (the ETS's) current form." One possible fix, Wyns said, would be a price-stabilization reserve that buys up allowances when prices are too low.

Q: Wouldn't a simple, straightforward carbon tax be a better solution?

A: Some economists think so, and that was certainly the first choice of many European policymakers. But in the EU, a tax needs the support of all member states, and that proved impossible. (Related: (Related: "British Columbia Rethinks Its Pioneering Carbon Tax" and "Coal-Fired Australia, Buffeted by Climate Change, Enacts Carbon Tax")

In the United States, Republican antipathy toward new taxes also makes a carbon tax unlikely. In addition, "taxes have a way of hitting the wrong people at the wrong time and can be pretty inflexible, as well," Böhm said,

Q: What would backloading have done, and would it have worked?

A: Back-loading would have taken a huge chunk of allowances out of the market for two years, creating a temporary scarcity that proponents say would have boosted the price of carbon. But Wyns estimates that, at best, it would have only pushed the price up to about 10 euros ($13.08), well below what would be necessary to effect change.

Q: Who opposed it, and why?

A: Mainly heavy industries that use a lot of energy, Wyns said. These industries-ranging from steelmakers to beer brewers-argued that if carbon prices rose, they wouldn't be able to compete against American rivals who are benefiting from cheap shale gas. "That's a very simplistic argument," he said, "but it plays well."  (Related: "U.K. Dash for Gas a Test for Global Fracking")

Q: Is that the end, then, for ETS?

A: Probably not. As Wyns said: "This is Europe; these things never end." He expects some sort of revised plan will surface eventually.

But Böhm, who is not a fan of carbon trading, said, "They really need to start from scratch." He doubts that will happen, because the political backlash from admitting failure would be too terrible.

Q: The U.S. Senate killed a cap-and-trade plan in 2010, and Japan has also backed away from one. Now, given the ETS debacle, is carbon trading essentially a dead concept?

A: No. California launched an ambitious emissions market last November (though it faces lawsuits), and Korea is considering one, as are seven Chinese provinces. "The good thing is other countries will learn lessons from Europe," Wyns said. Clearly, he would hope that future markets have a mechanism to respond to an oversupply of allowances. (Related: "British Columbia Rethinks Its Pioneering Carbon Tax")

"If it has to be a market solution," Böhm said, then there must be the political will to set a very tough cap. "But if you do that, you effectively have a carbon tax, which is why Europe's cap was not all that tough." He's also dismayed that California's plan accepts international credits. CDMs, he said, lead to "creative accounting" and not effective reductions in emissions. It is better, he said, to keep markets local.  (Related Interactive: "World Electricity Mix")