With the slowdown, carbon prices have crashed in the European Union, triggering an argument about the implications. Should governments intervene, asks Mahua Acharya
Carbon prices in the European Union fell to below ¤9 a tonne in February, from nearly ¤31 in July 2008. As the world slipped into a recession, demand for fuels, consumer goods and industrial output has fallen. Allowances, the carbon permits of the European Union, have lost almost 70 per cent in value since the economic meltdown. And although prices are climbing again, it could be a while before they are back to trading at 2008 levels.
The major reasons for the fall are straightforward. Falling industrial output means less carbon dioxide is emitted, implying that the same manufacturers don’t need as many emissions permits as they had envisioned. Power consumption is lower, as is the need for allowances among the power companies. As a result, industrials and utilities alike have sold large quantities of these permits into the market, which has resulted in lower carbon prices. Simple demand-and-supply economics.
Increased pressure on the financial sector has also played a role in the carbon price fall, in a more complex way. Many financial institutions have either closed or downsized their carbon desks and have sold off all their holding carbon permits.
The implications
Looked at simplistically, the overall reduction in the output of greenhouse gases because of slow growth could be celebrated as a triumph for the environment. But what could some further implications of the fall in carbon prices be, and would regulatory structures help counter some long-term detrimental effects?
The falling carbon prices have naturally spurred great discussion amongst market-players around whether governments should intervene, whether demand and supply should be altered, or whether other forms of regulatory controls should be introduced.
Arguably, depressed carbon prices, especially if prices stay low for a prolonged period, could affect energy investments in Europe — and elsewhere. The International Energy Agency, for example, recently called for government intervention, suggesting that without such support, low prices coupled with cheap coal and oil could deter new investments in renewable energy and lock in a future of coal-fired power generation in Europe.
Some have suggested that the European Commission should set up a Central Carbon Bank, whose function would be similar to the regulatory functions of other central banks. Such a bank, they say, would have specific policy targets with respect to price bands, and supply could be adjusted to provide the price certainties that are necessary to spur low-carbon investments.
Others, fearing that prices may fall even further, have been calling for governments to simply establish a minimum price for carbon.
Then there have been calls for EU governments to tighten national caps, or modify the rate at which the emissions permit supply will decrease from 2013 to 2020. The argument is that such levers could influence today’s supply by signalling a change in the reduction rate in the future.
So what?
Do these measures meet the objective of an emissions trading scheme — that is, to create a market mechanism to reduce emissions?
It is well understood that the market functions best with regulation. But artificially tinkering with prices would not reflect a true market. On the contrary, it could deter new entrants, introduce unpredictability, and eventually stunt the growth of a still-nascent market. Plus, any intervention when prices are low will necessarily set a precedent for intervention when prices are high. Instead, one way to have the carbon market take account of declining output is to correct the methodology by which the permits are issued.
More fundamentally, it is important to recognise that the carbon market, unlike other markets, isn’t one that is formed in and of itself, i.e. it never came into being organically or on its own. First, the demand for carbon dioxide reductions is politically-created. Second, carbon emissions are a result of something else: They’re the result of economic growth.
By and large, the higher the economic growth, the higher the emissions, and vice-versa. So, if the objective were to have higher carbon prices, the proper way to achieve this would be to stimulate economic growth. But if the primary intention of the emissions trading scheme is to reduce emissions, then the market should be left to respond to underlying market signals and find its own equilibrium.
The argument that low carbon prices could deter energy investment is a broader issue, one in which the carbon market is only a component. No doubt there is a link between carbon prices and energy choices. But it is not the only determinant in investment decision-making. If it is the EU’s objective to bring more renewable power onto the national grids, a far broader array of policy and financial instruments would be needed to achieve this.
So, a discussion of whether or not to introduce price controls in the carbon market risks treating the symptoms rather than the cause. As industrial output declines, so should the total number of allowances in the market. This means making changes to the design of the scheme, not introducing floors and caps on prices, or other artificial controls.
The author has been working in the carbon market for the past decade. She was most recently with ArcelorMittal
