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Commentary: Saving Europe’s Key Weapon against Climate Change

Sep 10, 2014 | Dallas Burtraw

Climate change is widely regarded as the greatest threat to the global environment. But the centerpiece of the European Union’s climate policy is being hobbled.

That centerpiece is the cap-and-trade Emissions Trading System (ETS), under which companies buy and sell carbon reduction credits. The cause of the problems plaguing the European market is the presence of a two-gigaton surplus of emissions allowances. The oversupply is the result of a number of factors, including the economic downturn, the influence of carbon taxes and other complementary policies in several member states, an influx of certified reduction credits from international offsets, the banking of allowance leftovers, and the early auctioning of next phase allowances.

"A price floor could prove to be an efficient fix for the European Union’s current Emissions Trading System surplus problems."

The surplus has created a problematic decline in the price of emissions allowances, which dropped as low as €2.81 in April 2013. Through the fall of 2013, prices hovered near €5, recovering somewhat to near €7 in early 2014. While low prices are generally good news, these are an order of magnitude lower than the estimated €32 to €63 needed to motivate investments necessary to achieve the European Union’s emissions reduction target.

If this situation looks familiar to some market followers, it’s because almost every previous cap-and-trade program has overestimated the costs faced by firms, causing initially high prices to fall.

What can be done? Solutions often suggested include revising emissions targets or retiring allowances. But these options would introduce new information and change the balance of supply and demand in the market, creating uncertainty for investors eyeing future price trends. For that reason, while initially intuitively appealing, they tend to fall from favor.

Another option exists to save the European climate emissions reduction market, and I believe it deserves more attention: the adoption of a price floor.

A price floor easily could be enforced by introducing a minimum price in allowance auctions. When a market’s price dips below the price floor, a portion of allowances is held back from being sold; this restricts supply and supports healthier, more stable market prices. That is part of the reason that a price floor is generally considered an important feature of good auction design. In fact, as my son pointed out to me, this is the same mechanism that one sees on eBay, where a seller can introduce a minimum price for bids that will be considered.

Detractors of the price floor idea have mischaracterized it as a tax, but it is certainly not a tax. A large portion of emissions allowances in the EU trading system are still given away for free, and they would not be affected. In fact, recipients of those allowances would benefit from the price support for the value of the allowances as an asset in the market.

One of the biggest benefits of a price floor is its nondiscretionary and rule-based approach, which helps markets to better anticipate future changes. Because it can automatically adjust the strictness of its parameters without waiting for administrative action, a price floor offers more transparency than many alternatives. The mechanism also encourages participants to invest in low-emitting technologies by ensuring the minimum value of emissions reductions. It potentially supports the recirculation of auction revenue toward research and development or innovative investments while mitigating the impact of interference from complementary policies.

The European Commission is considering the adoption of a policy that is in some respects similar to a price floor—and that is commendable. However, the system also is more administratively complicated without corresponding benefits.

The proposal is for a price stability reserve that would be triggered by the liquidity in the market. Each year, regulators would look back two years to observe the difference between allowances that have been issued and those that have been surrendered to cover emissions. The difference constitutes the allowance bank. If that bank grows above a maximum amount, a portion of the allowances to be introduced to the market in the current year would not be made available, and they would be added to a reserve. Otherwise, if the bank falls below a minimum amount, additional allowances would be drawn from the reserve and added to the market. The allowances would not ever leave the market, but their availability would be made flexible to adjust the liquidity, with the hope that this will influence the allowance price path.

The greater complexity, in my view, should cause immediate reservations. Any trading program for a government-created intangible asset such as emissions allowances must be as transparent as possible if it is to garner the public acceptance and support necessary for success.

The better approach would be the simple price floor. Both policies would bolster prices and reduce variations in allowance values, but a price floor could prove to be a more efficient fix for the European Union’s current ETS surplus problems because it will lead to more predictable and cost-effective outcomes—and greater public understanding, acceptance, participation, and support.