Catching Europe's Cold

Fortnightly Magazine - August 2009

When prices for emissions allowances collapsed in Europe’s carbon market a year after trading began, critics said the collapse proved a regulatory product couldn’t be traded internationally. Sure, they said, the U.S. acid-rain market worked, but it was never an international market—and it couldn’t be, given the propensity for governments to protect their own economies.

That’s what happened in Europe, when EU member states overestimated their future carbon emissions, creating more allowances than their industries really needed. Rampant sandbagging virtually guaranteed carbon prices would collapse, as they did in early 2006. Since then, Europe’s carbon prices have recovered to only about 15 Euros per ton—below their €33 high before 2006, and far below the U.S.$50/€$36 a ton that many analysts consider the minimum necessary to begin the low-carbon revolution.

This weak price recovery might prove carbon-market critics correct, or perhaps it merely shows the modest value of free allowances, during a recession, in a market full of “grandfathered” emitters. The answer might remain unclear until 2013, when the more stringent phase 3 of Europe’s emission trading scheme (ETS) begins and a greater share of allowances will be auctioned rather than given away as they were in phases 1 and 2. Plus, if the EU’s proposed reforms are accepted, then the EU and not individual member states will be in charge of setting emissions caps.

Now that the U.S. House of Representatives has for the first time approved mandatory greenhouse-gas constraints, the sickly history of the ETS becomes particularly worrisome for America. Will the Waxman-Markey bill—the American Clean Energy and Security Act—avoid the ills that have plagued the ETS? To find out, Fortnightly turned to one of Europe’s foremost experts on carbon cap-and-trade; John Scowcroft heads the environment and sustainable development policy unit at EURELECTRIC—roughly Europe’s version of an Edison Electric Institute.

 

Fortnightly: How does the Waxman-Markey approach compare to the EU’s emissions trading scheme (ETS)?

Scowcroft: Clearly the similarities are the cap-and-trade system and allocation of carbon credits. The European cap is more ambitious, but we’re starting from different places. The key questions will be whether we have equivalence in emissions credits, and whether monitoring, reporting and verification are equivalent to those in the ETS. If you’re comparing schemes, those are the things to look at. Do we have the same product?

From the power industry’s point of view, we’re looking at two different sorts of markets. By and large, in the United States you have regulated tariffs, and in Europe we have liberalized competitive markets, where the market sets the price. The differences between the two schemes takes that into account.

 

Fortnightly: How does Waxman-Markey account for the U.S. regulated structure?

Scowcroft: One of the big issues in starting a cap-and-trade scheme is that you’re changing the ground rules, and you’re looking at the possible problems of stranded assets as you move to a market where carbon has a price. The way Europe handled that is different from the way Waxman-Markey is seeking to do it. In Europe, allowances are allocated entirely to emitters. Because those allowances have a value in the market, they have a price structure. But under Waxman-Markey the allocations are made to local distribution companies (LDC). Instead of emitters auctioning them straight away, you give them to someone else who, in essence, auctions them. The revenue is recycled through the LDC and they will sell the credits on the market for generators to use. LDCs will use the allocations to diminish the impact of the cost on their consumers. It’s a complicated way of doing it, but I understand the reasons.

 

Fortnightly: I’m not sure I understand it. Why not just allocate the credits directly to the sources of the carbon and cut out the middle man?

Scowcroft: It has to do with the structure of markets, where you have merchant generators and regulated generators, and regulated LDCs. If you’re a regulated company, will the regulator allow you to pass through the costs? That’s the key issue. In Europe, economic logic takes care of the cost, but in a regulated market, the regulators might say you can’t pass through the costs. Or they’ll let you pass them through but they’ll find some other way of getting their money back.

 

Fortnightly: So in theory, by allocating allowances to retail distributors, Waxman-Markey shields consumers from the costs.

Scowcroft: There was a lot of debate in Europe about whether the obligation should be placed on the emitter or on someone downstream. The decision we came to in Europe was that emitters ought to be responsible for emissions, as opposed to their customers or some third party. What you’ve got with Waxman-Markey is a sort of downstream scheme, where the [generator’s] customer is responsible for managing the allowances. They have a choice as to how they manage the obligation.

The reason for this difference has to do with the difference in viewpoints between the U.S. and European power markets. Having deregulated the electricity market in Europe, we don’t have tariffs, just prices. There’s an assumption that competition will keep prices down, which is true up to the point you can make enough money to invest in new plant. In the United States, regulated tariffs are negotiated with the regulator, and therefore I understand why we’d give allowances to the person who’s selling to the customer. That way you can shield the customer from the impact.

 

Fortnightly: A big question is whether this will work to reverse climate change. Arguably it won’t work without global effort and a global market for carbon credits. Do you think the Waxman-Markey bill puts us on the right path toward an international trading market?

Scowcroft: Yes, but I think there’s a lot of overly optimistic talk about having a common market. Europe is pushing for a common market by 2015. That’s optimistic. What we’ll see is a number of domestic markets forming, which over time will link together, in the meantime providing fundamental similarities—i.e., the caps are similar, an allowance is equivalent to a ton of CO2, and the mechanisms are comparable. If you have those similarities, then you can arbitrage between the two systems and ultimately they’ll come together.

Carbon is a bit like currencies in Europe. We used to have a number of different currencies and now we have the Euro. Eventually there was a conversion, but before that different currencies had different values, and people made money on arbitrage. That’s what will happen with international carbon trading, until people sort out the differences between schemes.

 

Fortnightly: What lessons should we learn from Europe’s experience developing a carbon market? How can we avoid a price collapse like what happened in the ETS?

Scowcroft: The essential element is that the initial allocations must be made on the basis of good knowledge of what the actual emissions are. That was the fundamental problem in Europe. To a large extent no one had accurate data on what emissions actually were, and the allocations were made on assumptions. Before emissions trading, CO2 emissions were published by companies, but it was done by the environmental department. If it was within 10 percent, everyone was happy. But when you think about the value of CO2 allowances, the CFO will say 10 percent isn’t good enough. We have to be more accurate, and that was the biggest lesson that came out of it. You can’t make proper allocations unless you have proper data. Otherwise what happened in Europe will occur in America.

There was a similar collapse in the sulfur market in the United States. It’s a feature of policy-driven markets. I don’t think the ETS price collapse was unexpected, but its size was unexpected.

If you start out with a good understanding and projection of what emissions are likely to be, you will have a good allocation.

Another important point: When you move to full auctioning the company will decide what its exposure is going to be. The company will decide how much to emit, and then it will go out and buy allowances to cover that amount. But with free allocations, America will have something like what we saw in Europe—negotiation of what emissions are and what they will be.

So your fate is in your own hands. Or rather, you’ll negotiate your fate based on data.