Carbon permits worse than junk bonds

The European Parliament overnight delivered a body blow to the investment credibility and environmental effectiveness of carbon pricing across the globe, and particularly in Australia. 

It voted to narrowly reject a proposal (334 votes against vs 315 in favour) to relieve the huge glut of excess emission allowances that have depressed carbon prices under the scheme. This proposal, known as ‘backloading’, would have withdrawn 900 million European Emission Allowances (EUAs) from sale in the next three years, only returning them at the back-end of the decade.

Reaction from the market was swift. EUAs plummeted 40 per cent to land at a next to useless €3.18 or $A4.

This has direct flow-on implications for the value of permits under the Australian carbon trading scheme, as our scheme was to recognise EUAs as directly equivalent to Australian carbon permits from 2015 onwards. Because the Australian scheme will apply no restrictions that would in practice bind to limit the use of EUAs, the Australian carbon price is expected to be set by EUAs as of July 1, 2015.

While there is a strong consensus amongst environmental economists that a broad-based carbon trading or pricing scheme is the most efficient mechanism to reduce carbon emissions, this EU decision poses serious questions as to whether politicians are capable of implementing it effectively. 

Measures to significantly reduce carbon emissions require long-term investments often with lifetimes measured in decades. For carbon pricing to be effective it needs to provide credible price signals to investors over similar time frames. To date political uncertainty surrounding these schemes has failed to provide such long-term, investment-grade credibility. 

Back in January I pointed out that this huge political uncertainty put EUAs one rung below junk bond status, and Australia’s decision to link to the scheme was like fixing our currency to that of the Venezuelan bolivar. Well today the Economist labelled EUA’s “below junk status” and the Financial Times labelled them as equivalent to a Bitcoin, a virtual currency that can be created by anyone with enough computing power. 

So where to next for the EU carbon market?

Well, while things are looking pretty grave for the EU emissions trading scheme, there are still some hopes of revival.

Firstly the European Parliament vote actually went against the wishes of national governments (France, UK, Germany and much of the old Western Europe) that hold the vast majority of votes on the European Council. What turned the vote negative was that all but four of the UK Tory members voted with Eastern European members, and against the position of their own party’s government.

Also it is possible that reform of the European ETS could be achieved through an alternative mechanism. It’s worth noting that originally it was thought the backloading initiative could be implemented without the need for a vote from the European Parliament. There are other ways of reviving the market for EUAs.

The European Climate Commissioner, Connie Hedegaard, observed:

"The [European] Commission of course regrets that the European parliament has not approved the backloading proposal. However, it is worth noting than when it was suggested in the second vote that the parliament finalised its rejection right away, this was not supported. The proposal will now go back to the parliament's environment committee for further consideration.”

In the end the backloading proposal was only meant to be a temporary quick fix, and there are a range of more significant and permanent reforms to the ETS under active consideration. However all of these would most likely take several years before they are implemented.

In the meantime the EU carbon price is likely to languish.

Implications for Australia

Naturally opponents of action to address climate change will seize on this news to declare that Australia is moving too far in advance of other countries. 

This would represent a bad misreading of the situation because national governments in Europe are taking their own carbon control measures separate to the ETS.

The UK Conservative government, as just one example, has implemented a floor price on carbon via a tax. Scandinavian countries have in place a range of taxes to deter consumption of carbon fuels. And Germany’s renewable energy policies are playing a far more influential role in reducing its electricity sector emissions than the carbon price ever did.

However this event illustrates that Australia should never have removed the carbon price floor mechanism from its ETS. Practical political realities mean that a tonne of CO2 under one scheme is not the same as a tonne of CO2 under another, because target or baseline setting is subject to political deliberations just like currency.