The EU crash test dummy

The European emissions trading scheme that has been in place for the past five years has been the crash test dummy for a market-based carbon price for policy makers around the world – with the emphasis on the words “crash”, “test” or “dummy”, depending on your political or economic point of view.

But as Australian policy makers sit down to the task of framing a carbon price, and consider the merits of an ETS vs a tax, the EU scheme is really the only precedent they have to refer to – apart from the successful schemes to remove nitrous and sulfur oxides in the US – so the experience is worth considering.

Dr Andreas Löschel, the head of environmental economics from the government-funded research institute ZEW (Centre for European Economic Research) is in Australia delivering a series of talks looking at the EU ETS, and whether it is a model to follow or one to avoid, and his observations are worth considering.

In short, they are as follows:
 
– It's easier to get industry acceptance by having a soft start, but then you get a whole bunch of firms not doing very much to reduce their emissions (40 per cent of German companies affected by the ETS had not undertaken any abatement efforts, according to a recent survey by ZEW) apart from lobbying for more free credits.
 
– It might be tempting to exclude some industries from an ETS and instead impose regulation (transport is an obvious example), but the command-and-control method creates huge price distortions. If reducing transport costs are so expensive that it is not worth considering as part of an ETS, then perhaps it's best not to bother at all and instead look elsewhere for abatements.

– Most companies are averse to actual trading in carbon credits, considering such activities to be speculative and not part of their core business. The energy sector was the opposite, because they are used to trading energy on a daily, or even hourly, basis.

– It might be worth considering some sort of fixed price, be it through a floor price, a carbon tax, or some other hybrid scheme, because without one not much will happen if the market price slumps to negligible levels, which it almost certainly will do with soft starts and lots of free allocations or compensation.

It has taken Europe about 10 years of development, but Löschel says by the time the third phase of the EU ETS comes into effect in 2013, the formula may be just about right – with real targets, auctions replacing free allocations, and centralised distribution of permits.

The first stage was marred by massive over-allocations to individual countries keen to protect their own industries – and companies were able to cash in excess credits before the carbon price effectively slumped to zero.

The second phase was broader and more ambitious, but is also suffering from over-allocation – this time because of the dramatic slump in industrial production caused by the global financial crisis.

“I think you have to credit the developers of the ETS in the political process,“ Löschel  says. “It was a big achievement – the first of its kind internationally. I think it is a success story, but one that needs to be developed.

“We have learned a lot about what's not going well, we have taken a lot into account into the design of the third phase and I am optimistic that the… ETS will deliver results we want to see.“

Löschel  says that decentralised allocation essentially meant that individual countries bloated their emissions to earn more credits, the grandfathering and distribution of free certificates essentially generated extra profits to some companies and a whole new industry in lobbying and rent seeking, and the EU has learned to be a lot more rigorous on the supposed dangers of carbon leakage.

“I think we are still not getting it right, we are giving out way too many certificates. Many of these sectors can pass on the cost to consumers and should not get special treatment. This is an important lesson to learn.”

The difficulty for Australia is that it does not have the luxury of 10 years of development to get it right, not if it is going to meet its pledge of a 5 per cent reduction target by 2020. So does it start with a big bang or ease its industries gently into the concept?

Löschel says there are no easy answers. “It would not be possible to start with a phase 3 type scheme in Australia. In Europe it was necessary to get industry in through a soft start …but that is a risky approach because when people see these rents it is difficult to reduce that over time, and we still have problems. I am curious to see whether a jump start is possible, or whether you have to follow the evolution of a scheme (like Europe).”

And he says that while a tax might at least give certainty to a price, and ensure at least some action, it still does not avoid the problem of lobbying and rent seeking. And there is great difficulty in making international links. But at least it is more efficient than a series of'command-and-control' policies. “In Germany we have 60-80 measures, which are inefficient and very expensive. I'd prefer to have a carbon tax than a whole bunch of regulations.”