When setting up a new business there are a number of processes that tend to be followed, one of which can best be described as evaluating the business response to a series of ‘what if’ scenarios. Adopting such a process is crucial to the long-term viability of a business as it enables the business to accommodate various ‘what if’ factors.
Unfortunately, it seems that the ‘what if’ scenario of a global recession was not factored into the development of the EU Emission Trading Scheme, for if it were we would not have the current uncertain and conflicting reactions to the plunging allowance price.
When oil prices sharply reversed last summer, having peaked just shy of $150/bbl and then dragging the entire energy complex lower, climate policy makers remained remarkably upbeat over the carbon market’s prospects even though there was a strong price correlation between energy and allowance prices. Analysts believed the allowance price would not unduly suffer, with most forecasting an average 2009 allowance price between r30 and r40/t, compared to r35 to r40/t before the oil price reverse.
And even as the year began, with oil prices down $100 in just six months, a succession of analysts still sought to reassure that the carbon market would not be severely impacted by the worsening economic downturn. But if these words were meant to provide some psychological price support they failed. In February, after a few days of testing strong psychological support at r10, the benchmark December ‘09 EU allowance contract finally slumped into single digits and now looks more likely to continue testing new lows than retrace its recent losses.
As weak as the energy complex is, compared to last summer, it is not the energy complex that has been the main driver of lower carbon prices since the turn of the year, although it is certainly a contributory factor. Instead the main price driver is the economic downturn. With industry reducing production output to conserve costs it is producing less emissions and thereby has a surplus of allowances, which are being sold back into the market to reap some much needed revenues. The consequence of this aggressive industrial selling is a rapidly falling carbon price.
When the EU ETS was conceived it was as a free market. The European Commission believed there should be no constraints on the carbon price, arguing that the carbon price should reflect the supply and demand of allowances, which Brussels would effectively regulate through its allocation of allowances. This, it reasoned, would limit carbon price volatility and thus not undermine clean energy investment that is mostly based on the carbon price.
But it is not volatility that worries policymakers and investors; it is a crumbling carbon price that has forced numerous companies to re-evaluate their clean energy investment projects. The carbon slump could also have ramifications at this year’s pivotal UN climate conference in Copenhagen, with a question mark now hanging over the long-term viability and integrity of carbon trading as an emission reduction mechanism.
Unsurprisingly, the growing response to the carbon price slump has been the call for a price floor, with proponents arguing that intervention may be necessary to ensure the EU ETS drives emission cuts amid the severe economic downturn. But the Commission rejects these calls, holding to its belief that a free market must remain free from intervention.
While the Commission should be applauded for resisting market intervention it is partly the Commission’s mismanagement of the scheme, through the overly generous allocation of free allowances to industry, that has created the current problems. If it had stress-tested the scheme against a potential severe economic downturn the scheme would probably have had a more conservative allowance allocation policy.
Few would disagree that a price floor would provide the market with more certainty on the downside and would stop the cap-and-trade scheme from being discredited as an emission reduction and green economy investment vehicle. But equally, it is right that the limitations of a cap-and-trade scheme are made transparent now, and before the carbon trading proponents seek to sell in carbon markets as the primary mechanism for achieving a global green economy.
It is now clear that without any interventions, ie through providing an implicit or explicit price corridor, a carbon market will not reliably provide the requisite price signals for future clean energy investment. This is not slur on free markets; it is simply a fact that in a free market the price can move, in theory, between zero and infinity.
Some proponents of an EU ETS price floor argue that it could be implemented by setting a minimum auction price for allowances, with member state governments buying the auctions back if the price fell below the minimum price level. Others believe that carbon prices should be maintained within a price corridor through a flexible distribution of allowances, arguing that the use of price corridors in cap-and-trade schemes would encourage other regions to introduce them as part of a new global climate deal.
Unfortunately for the pro-market interventionists, a member state agreement has already been reached on the third phase of the EU ETS, commencing January 2013, and the EU ETS is too entrenched in European policy to be backtracked. Some analysts believe that a price floor would not only be technically very difficult to implement, it might even be impossible in today’s political economy because governments would need to find the money for it.
The problem faced, therefore, is straightforward; the market needs some downside price certainty, ideally provided by a price floor, but should remain free from intervention. And the solution is also straightforward.
According to respected energy economist Dieter Helm, the most efficient way to introduce a price floor is through a carbon tax, and he is right. A carbon tax would resolve the problems of a falling carbon price, as derived by the carbon market, and could be set for a long-term period thus providing investors with some much needed long-term price certainty.
Carbon trading is still in its infancy and if it is to mature the market has to learn from its mistakes. While cap-and-trade schemes will continue to play an important role in climate change mitigation the current economic downturn has illustrated the shortcomings of relying on a free carbon market. The only way to guarantee the twin objectives of investor certainty and emission reduction incentives is through carbon taxation.
That being so, the new challenge for policymakers is to merge the taxation and trading mechanisms to provide an efficient and effective carbon abatement market mechanism.
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