The EU prides itself to have established, in 2011, the European Union’s Emissions Trading System (ETS). The EU ETS is claimed to be the cornerstone of the European Union’s policy to combat climate change and a primary tool for reducing industrial greenhouse gas emissions cost-effectively. Involving 31 countries, it is the first and thus far the biggest international greenhouse gas emission trading system. But I argue it is also a failure.
As Australia joins a carbon tax and trading system there is much to learn from examining the effectiveness of the EU ETS and what controls need be implemented in a system to deliver the desired outcomes.
The price of carbon in the European Union’s Emissions Trading System (ETS) just fell below $7 per tonne of CO2 for the first time since it was initiated in 2011. This represents a collapse from the price of near $28 per tonne in 2011. In fact, by mid 2011 the price had already fell down to $10. Seven dollars is comparable to the price of carbon in voluntary systems, such as those in place in the US and should, therefore, be considered a failure of the trading system, as there is no point in regulating carbon price if it ends up having the same price as it does in a voluntary system.
The role of any environmental tax is not to collect funds for the state to compensate for the environmental costs of actions that are not embedded in the price system (i.e. so called environmental externalities), but to act as a deterrent promoting the development of alternative, cleaner technologies. The consequence of the collapse of the cost of carbon emissions in the ETS is that companies have no incentive to migrate their processes to low-emission technologies, as it will be cheaper to just pay the tax. This results in a failure of the EU ETS to meet its goals.
The EU ETS works on a ‘cap and trade’ principle where the total amount of greenhouse gas emissions is reduced over time so that total emissions fall. The target is that emissions will be 21 % lower in 2020 than in 2005. The allowable emissions are distributed among companies, which can buy or sell them and can also buy limited amounts of international credits from emission-saving projects around the world.
Whereas total emissions could be regulated by law without the need for a trading system, the trading system placing a price on carbon was expected to provide incentives for companies to lower emissions and, thereby, achieve a more efficient reduction in emissions than imposed by the slowly shrinking cap.
The ambition is that the EU ETS be expanded to other nations that are establishing comparable schemes, such as Australia. The European Commission and Australia have reached an agreement in principle to link the EU ETS with the Australian system in mid-2015. Shall this happen at current carbon price in the EU ETS and the targeted starting price in Australia, the consequence will be that Australian companies will purchase EU emission permits en masse, thereby quickly drawing down the price of carbon to a level as low as that in EU.
A low greenhouse emission price will never provide incentives to achieve the transition to a CO2 neutral society: it will not drive investment to carbon capture technologies, nor increased efficiency, nor promote renewable energy.
Hence, the current system, that simply regulates total emissions, the cap, and leaves the regulation of the cost per ton entirely to the market of trading permits will not achieve its goals. To achieve the goals the cap and trade system must be complemented with a regulated minimum price on carbon emissions, i.e. must be a cap and trade bottom-line system.
What should this bottom line be? This bottom line should use as reference the calculated social cost of CO2 emissions. Moreover in doing so, it should be considered that, unlike many other gasses which are relatively short-lived in the atmosphere, CO2 emitted to the atmosphere has a life-time of centuries to millennia, so that the every tonne of CO2 emitted exerts impacts over a very long time, and can be considered effectively, irreversible (Solomon et al. 2009).
The social costs of CO2 emissions have been calculated at about US$43 per tonne of CO2 (Glaeser and Kahn 2010), implying that a carbon tax of $7 a tonne only covers one sixth of the impacts the emissions have on society. This implies that humanity is absorbing about 85 % of the cost of the impacts caused by the emissions, as the impacts are felt globally although the benefits and advantages derived from the processes of emissions are felt only within the societies trading the goods produced.
I argue here that the carbon tax and trade system will only achieve the desired outcomes if both the cap is progressively reduced and a bottom line carbon floor price implemented that is progressively raised to close the huge gap between the market-regulated price of CO2 and its social costs.
The upward regulation of the bottom-line should provide incentives for the migration to low-emission technologies. The profits collected from emission permits should be used to pay for the costs of adaptation to climate change not only in Australia but internationally, particularly in the nations that, with very low emissions per capita, are already suffering the impacts of climate change. These are the neighboring island states threatened by sea level rise in the Pacific and Indian Oceans.
Carlos Duarte is the Director, Oceans Institute at University of Western Australia
Glaeser, E.L., and M. E. Kahn. 2010. The greenness of cities: Carbon dioxide emissions and urban development. Journal of Urban Economics 67: 404-418.