New Thinking Blog: The European 2030 package and the governance of the carbon market

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New Thinking Blog: The European 2030 package and the governance of the carbon market

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The European 2030 package and the governance of the carbon market

Matthew Lockwood, IGov Team, 10th February 2014

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As most observers of climate and energy policy know by now, the European Commission has put forward a 2030 draft package that has a carbon target, but no nationally binding renewables or energy efficiency targets. The European Parliament voted last week for a more ambitious package including those last two elements, but it has no power to impose this on ministers who will meet in March to potentially seal a deal.

If we are left with just a carbon target, this puts carbon pricing through the EU emissions trading scheme at the heart of climate and energy policy, displacing renewables. As the 2030 draft proposal document puts it:

“In their responses to the Commission’s Green Paper, there was a broad consensus among stakeholders that the ETS should remain the central instrument to bring about the transition to a low carbon economy.”

I think this is a mistake, as continuing the development of renewables will be crucial for a future sustainable energy system. Nevertheless, we will also ultimately need carbon pricing at a global level, to ensure that all that really low-cost coal is left in the ground. So making carbon pricing work is important.

But the big question is: is the ETS up to the job? Remember that the point of the ETS was not just to keep a lid on carbon emissions in any one year, but to create long-term price signals to drive investment, especially in the power sector. Put more crudely, it is supposed especially to stop new coal-fired power stations being built.

The problem with the carbon market to date is that it has failed to do that. The carbon price collapsed in the midst of the financial crisis, from around €30/tCO2 in mid-2008 to around €7/tCO2. It is currently around €6/tCO2. In fact the price also collapsed in 2006, when it became clear that too many allowances had been distributed. As a policy-constructed market with fixed supply, price volatility was obviously going to be a problem. However, it is only now that a more flexible arrangement for the supply of allowances is being considered – and that would not come in until phase 4 in 2021, i.e. 16 years after the market was set up. The other way to stabilise prices would be to have a floor price, set at a level roughly where policy makers think the minimum should be. Unlike the UK’s Carbon Floor Price, this should really be set via a reserve auction price not a tax laid on top, and should apply to the whole ETS not one country, but there are currently no plans to do this.

And the overall outcome is that the ETS is not really stopping new coal-fired plants being built – Germany has just brought three new plants on line, and Poland is starting work on another. There are other deficiencies with the ETS too, such as the allocation of free allowances to energy intensive industry; in the current phase lasting up to 2020, only half the allowances have to be paid for. This lowers the price of carbon and can give companies windfall profits at the expense of consumers.

None of the design problems of the ETS, or their solutions, are analytically that complex. Many economists have long pointed them out, and indeed presumably feel frustrated as they see the credibility of what they see as the central plank of climate policy (i.e. carbon pricing) being shredded before their eyes. So the question you have to ask is, if the problems and solutions are relatively easy to see, why aren’t they engaged with, or rather, why they have been engaged with so slowly? And the answer has to lie in the governance of the ETS.

The process of target setting and allowance policy gives the Commission a central role, but it is heavily influenced by industry lobbying (along with environmentalist counter-lobbying), and by the positions of Member States, who are in turn lobbied by the same groups in their own capitals. The outcome is not quite lowest common denominator, since agreement from smaller dissenters can be achieved through side-deals and arm-twisting, but it is close. Given the structure of the EU, it is not clear that much can be done about this, and it implies that schemes might be better designed by national governments, for example China, which is currently piloting a number of potential designs.

Where change might be made is in the length of phases and the possibility of reform within phases. The argument for long phases is that it provides certainty for investors, and a widely-made recommendation in the early days was to extend the phase length. Thus phase 1 was 3 years long, phase 2 was 4 years and the current phase 3 is 8 years. The problem with this argument is that it assumed that the design was basically right, the market would provide a good price signal for investors, and that the key issue was then certainty. These assumptions were all wrong, and it is clear that the ETS is still in the policy learning phase. This means that it needs to be more open to on-going change. This can be seen, for example, in the fact that an adjustment to how allowances are made over time in phase 3 – i.e. backloading – has had to be made to avoid the complete collapse in market credibility. But this has been a long painful process.

The plain fact is that we are still trying to make the ETS work, and locking in market design for long periods is slowing that process down massively, without any particular gain in terms of credibility or effectiveness. There are alternatives, including a return to shorter phases for a while, or the possibility of windows for reviewing design built into phases, as happens in so-called ‘re-openers’ in energy network regulation.

There are other problems with carbon pricing, including real challenges to do with the politics, which I have discussed elsewhere. But even setting those aside, unless we have a good hard look at the governance of the ETS, we risk ending up with no effective way of choking off coal. Meanwhile, in the absence of an effective carbon price, the case for strong renewable energy policy is even greater. The 2030 proposals are falling far short of what we need.

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