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When the European cap just never seems to fit

Despite rock bottom trading prices, the European Parliament is determined to make a go of the carbon emissions trading scheme despite less than wholehearted support from the UK.

The headlines are screaming. The European carbon emissions trading scheme (the EU:ETS) is in an “existential crisis”. According to the Economist magazine, its allowances are now “below the level of junk bonds”. A New York Times editorial crows that Europe has conceded its leadership role on climate.

The “crisis” has been caused specifically by the European Parliament’s decision to reject by just 19 votes a proposal to remove temporarily some of the oversupply that has overwhelmed the market for permits to emit carbon dioxide.

Conversely, you could argue that the scheme is meeting one of its main goals. It was launched in 2005 as a cap-and-trade system, with the intention of setting an absolute limit upon the total amount of emissions across the European continent emanating from power stations and from heavy industry.

This is precisely what has been achieved. It may not have changed attitudes to industrial energy efficiency. Or even the merit order for electricity plant. But at least in one way the EU:ETS is a cause for celebration. After all, when initially conceived at the start of the century, few external observers outside Europe thought that 28 countries could really co-operate so effectively, to ensure almost total compliance with inventories and assessments. On the back of it, a whole new breed of carbon traders emerged.

Free trade of allowances

The traders’ commercial interests ensured that genuine free trade of allowances across national borders could, and did, take place. In the initial months, trading prices were recorded of around €35 per tonne of CO2 emitted. Today the price has fallen to less than one-tenth of that figure. Indeed, with the marketplace moribund, trading desks are losing staff fast.

What went wrong? The simple answer is: the fault wasn’t with the trade. It was with the cap. The cap has simply been too generous. Up until this year, it was the role of each sovereign government to decide how many allowances were distributed to their heavy industry. Some (including the UK) were pretty strict. Other governments were not. This matters in a system where an allowance bought in Prague or Rome had the same worth as one bought in London or Stockholm.

Over-supply was already obvious when the banking crash took place. Given a decline in demand for heavy industrial activity, their need to hold quite so many allowances diminished, much as their requirement for liquidity grew. Many permits changed hands, moving from heavy industry to electricity generators at ever decreasing prices.

Why did the generators want to own as many allowances as possible? Because although initially permits were given away free to participants, increasingly the generators in particular were being forced to acquire theirs via auctioning. And allowances have no expiry date. Once obtained, they can be held in reserve until needed.

With more and more allowances flooding into an already over-supplied market, the law of supply and demand led to the exponential price collapse. The motion defeated in the European Parliament had been intended to hold back 900m allowances for six years, in the hope of stabilising prices.

It did not succeed, because multinational heavy industry lobbied against the principle of changing the rules mid-game. For obvious reasons: they prefer lower prices. This vote effectively reduces the trading system itself to a minor nuisance, as trading prices are forecast to stay at or around £2.25 per tonne for the rest of the decade.

Many free market commentators celebrated. That is certainly not how most of British industry perceives it. Few commentators understand that, from last month, it is irrelevant to those manufacturing in Britain what the EU:ETS trading price is elsewhere in Europe.

Effective trading price

For British manufacturers the effective trading price is £16 per tonne this year, increasing each year subsequently. This is because our Chancellor has unilaterally introduced a “floor price for carbon,” which ensures there is a minimum price paid in Britain, regardless of the trading price on the Continent. The lower that traded price, the more the extra differential between the prices paid in Britain and those elsewhere in Europe. And the more our industry is placed at a competitive disadvantage.

It is a point that the UK government was making very plain to all UK MEPs. Practically all LibDem and Labour MEPs listened. In contrast almost the entire 25 strong contingent of Conservative MEPs – with four honourable exceptions – voted to increase the differentials between UK and Continental prices, to our detriment. Had they voted as the Government requested, the proposals for backdating would have passed, with the relative damage to our industry reduced.

The saga may not be over. Later this summer the European Parliament is set to consider alternative options to reinvigorate the trading scheme. There is a determination among many (although far from all) European governments to make the scheme work. But it will not be easy.

I fear that some of those rejoicing took delight in doing down anything concerned with helping the environment. Whether they are equally pleased with deliberately decreasing business opportunities in Britain, it is nonetheless what these ill-informed cheerleaders have achieved. This is no time for celebration.


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