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Greenhouse Gases: Reviewing the European Trade

Lessons from the EU Emissions Trading Scheme emerge after two years.

Fortnightly Magazine - February 2007

the first place. This does not seem to happen. What otherwise would be an opportunity cost becomes a real cost and seems to focus more attention on value leading to more efficient price setting. So, GHG allowances should all be auctioned with an allocation of ARRs in lieu of allocating allowances themselves.

Impact on Emissions

Notwithstanding the debate over whether the system is long or short, the protocol clearly is causing changes in observed operating behavior. In the short term, the major opportunity to reduce GHG emissions is by substituting gas for coal, especially in power production. All other methods take time. They involve capital investments. But if you simply run gas plants in lieu of coal plants then GHG emissions drop.

There are two reasons for this. First, natural gas produces approximately half the CO 2 of coal for a given amount of heat released. Second, many gas plants are more efficient than coal plants, which further increases this advantage. Normally, though, gas prices are so much higher than coal prices that coal will tend to be burnt in lieu of gas. When EUA prices are sufficiently high, the economics are reversed. Then one would expect gas to be burned in lieu of coal. And this is exactly what is observed.

New Investment

Evidence of any ETS impact on new investment is limited. Much of the blame for this can be laid at the door of regulatory uncertainty. Phase 2 ends in 2012, which is well within the payback horizon of most new capital investments. The lack of certainty has profound impacts. Will there be a Phase 3? What will it look like? Until these questions are answered, a liquid forward market will not exist. Without a forward market, the price signals that do exist to change short-term dispatch are missing when it comes to choosing between new technologies for investment.

In conclusion, the EU ETS is having a clear impact on greenhouse-gas emissions, providing efficient economic incentives to modify the day-to-day behaviour of emitters. Implementation has not been free of issues however. Chief amongst these have been uneven participation between net buyers and net sellers, negative public reaction from windfall gains from higher electric prices, and unnecessary volatility as a result of poor information flow. All of these issues readily can be addressed, and expectations are that Phase 2 will proceed more smoothly, a Phase 3 will be announced, and that more sectors of the economy will be pulled in. The sooner a Phase 3 is announced and its details published, the sooner the ETS can begin to motivate long-term investment in carbon-neutral technology.

 

Endnotes

1. A cap-and-trade scheme is a market in which the legal right to produce an undesirable byproduct is traded between producers. Legislators limit the number of these rights and the market price determines where mitigation occurs. Those that find it cheaper to mitigate do so and the others buy allowances.

2. This is no small feat. Each gas has a different half-life as well as a different effectiveness in trapping heat. Is a gas