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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

options available are ranked and the set of lowest-cost compliance projects is implemented.

Consider a small system of four polluters, A, B, C, and D. The following table illustrates the GHG produced by each and the cost of reducing that production:

If a “fair” allocation of mandatory reduction were to be made of, say, 10 percent to each, the reduction would be 45 tonnes and the total cost to society would be EU570.

If each were given an allowance allocation of 90 percent of its emissions, the starting point looks like this:

Now C can reduce GHG production at a cost of EU7/T and B has a cost of EU20/T so B should try buy from C or D. If B buys 15 from C; and A buys 10 from C; and D buys 15 from C then the end point looks like:

So the overall cost of compliance went from EU570 under proportional mandated cuts to EU315 under cap-and-trade irrespective of how the costs were shared among those affected.

Allocations

Allowances were granted to participants to mitigate financial hardship. In theory, the initial allowance allocation is not relevant to the efficiency of the outcome. It matters not who first owns the allowances, nor even whether they paid for them. It matters only that they are traded freely. Freely traded allow-ances will find their way into the hands of those for whom reduction cost exceeds allowance cost. As we shall see later, the assumption that they are freely traded is an important one. Separate from any argument of windfall gains from allocation, allocation to those who do not actively trade them can lead to market-price distortions.

Size and Windfalls

Approximately 2.2 billion tonne-equivalent of allowances are allocated per year under the EU ETS. When prices were in the mid EU20 per tonne-equivalent, this equated to roughly EU 50 billion or one half of 1 percent of European annual GDP.

Industry and utilities receive most of this as a free allocation. The opportunity cost of surrendering an allowance instead of selling it is well known because the allowance market prices are public. This is reflected in power producer bidding behavior and so is collected through energy prices. The effect of this allocation plus this unsurprising, in fact, desirable bidding behavior created a substantial transfer payment from end consumers to utilities and industry with some associated controversy.

Information Effects

In late April 2006, the EUA market collapsed. Prices were more than EU30 per tonne on a Friday and dropped dramatically over the following Monday and Tuesday, trading in single digits at times. The EU had released the 2005 compliance figures, showing a larger-than-expected surplus of allowances—or equivalently, lower-than-expected emissions. Amongst all the accusations of “cheating” and impugning of national character that ensued, one point stood out: The market was operating on insufficient information. Most independent information services consistently had predicted shortfalls based on their fundamental analysis. The market liked the story.

As always, it was easy to point fingers afterward but the problem really lay with the lack of interim information. Compliance information was