This Is No Way To Run A Market

Yesterday I wrote on the successes of the European carbon market. Well, a new piece from The Economist ($) points to some flaws in the way the market was established.

Among the shortcomings, the pollution credits were not auctioned off so companies would be forced to look at the the amount they would need given the caps. To top that off, the governments didn’t really know how many credits would be needed and just gave them away based on a half-assed guess. The companies ended up with far too many.

On top of this, the credits program only lasts three years, and after that no one knows where the caps will be set or if the program will be extended. This is the exact opposite of what the U.S. did with the 1990 Amendments to the Clean Air Act. It was made clear when the SO2 caps would begin, drop and then reach a permanent aggregate amount. There was five years notice for the beginning and the decreases were scheduled out in detail. Knowing that the legislation was permanent, companies made the necessary trade-offs and investments to permanently drop the level of SO2 output. It went into the decision to build new plants (which is why so many natural gas plants were built in the 1990s) and the decision to close plants or use them as peakers.

Leave it to Europe to make such a mess of a market. It has had its successes, as noted in my earlier post, but not nearly to the level possible. Here’s a bit from The Economist:

Three problems have emerged. The first is the consequence of handing allowances free to existing polluters (a process known as “grandfathering”). The polluters pocketed them, passing on the extra cost of production to their consumers. Moreover, once trading took off, the price of allowances rocketed to €30 ($40) a tonne. Developing countries, meanwhile, were selling permits for about half that (because they cannot yet be traded, and are regarded as riskier). So polluters have been cashing in their allowances, buying cheap CDM permits—and keeping the difference. According to a report by IPA Energy Consulting, Britain’s power companies alone have profited to the tune of around £800m ($1.5 billion) a year.

The second problem was that when the scheme started there was little information about how much pollution the 13,000 factories were emitting. The original levels claimed by member governments were not much more than guesswork, and not surprisingly were generous. Now that levels are being monitored, it turns out that Europe is not emitting as much as it thought it was. When this emerged last month, the price of carbon allowances crashed.

Third, the current phase of the ETS lasts for only three years. Nobody knows what level of allowances will then be set. Since the payback period for cleaner power-generating technology is at least five years, there is no incentive for producers to invest in cleaner technologies.

Why couldn’t they simply follow the American example? Wait, that question answers itself.

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Robert Prather
About Robert Prather
Robert Prather contributed over 80 posts to OTB between October 2005 and July 2013. He previously blogged at the now defunct Insults Unpunished. Follow him on Twitter @RobPrather.