EU climate credibility just hit zero

New EU instruments with regards climate change policy prove that European politicians are more concerned with pleasing vested interests than tackling the issues they claim are so important

The green lobby has its tentacles rooted within the EU
Carlo Stagnaro
On 8 July 2013 10:54

Is it possible to kill a policy by trying to save it? On July 3rd 2013 the European Parliament voted in favour of the Commission’s proposal to “backload” 900 million carbon allowances, in order to sustain the carbon price—that has been sinking at or below euro 4 per ton CO2 for several months now—by withdrawing (actually, postponing the release of) a huge amount of allowances.

The move has been welcomed by green activists, renewable producers and utilities who received part (or all) of their certificates for free, but it exposes both the flaws of Europe’s carbon market, and its underlying political agenda. To understand why, we have to see how the system works in the first place and what the alternatives could be.

The EU Emissions Trading Scheme (ETS) has long been regarded as the major success in European environmental policy. By establishing a pan-European carbon market, it is claimed that the EU has introduced a market-based, cost-effective tool to deal with climate change.

Many objections may be raised. Market-based policies to address such complicated issues as those involving emissions can be divided in two broad categories: price instruments (such as a carbon tax) and quantity instruments (such as a cap and trade scheme).

Under the former, the regulator sets a price for the pollutant (ideally equally to its marginal social cost) and the market—i.e., economic agents who have to pay in proportion to their own emissions—will find the corresponding, “optimum” amount of emissions. Under the latter, the regulator sets a cap to the amount of emissions that can be emitted, and a corresponding number of permits is issued. Market agents will have to surrender a number of permits equal to their own cap by the end of the period (say, one year). If they emit less, they can sell the extra-allowances to other subjects who weren’t able to cut their emissions as much.

In this way, the burden of cutting emissions is shifted where its marginal cost is lowest, and the market finds the “true” price of allowances. In perfect conditions, the two systems are equivalent: an optimal carbon tax will lead to an amount of emissions equal to the optimal cap set under a cap and trade scheme, that, in turn, would price emissions at the same level as the optimal tax.

Unfortunately, our world is not a perfect one, and regulators lack the information to make an optimal decision. Therefore, the choice between a carbon tax and a cap and trade scheme is a practical one: under conditions of uncertainty, which one is more likely to deliver the expected results? Economists hold that a price mechanism is better when the marginal cost curve is steeper than the marginal benefit curve, while a quantity mechanism is better in the opposite situation. This depends on the long-term consequences of a sub-optimal choice as well as on the need to minimize the subsequent adjustment costs.

When dealing with climate change, it is easy to see that a carbon tax would be a more effective instrument than cap and trade (of course under the bold assumptions that we have to “do something” about climate and that unilateral action makes any sense at all). In fact, the marginal cost curve of abating emissions is quite steep, insofar as it requires the flow of emissions that are produced annually to be immediately decreased. On the other hand, the marginal benefit curve is less steep, as it does not depend on the flow, but on the stock, of carbon that builds up in the atmosphere year after year.

Despite these commonsensical suggestions that came from virtually every climate economist, the EU decided to implement a cap and trade scheme. A feature of the cap and trade scheme is that it is very much exposed to the vagaries of the economic cycle.

Emissions depend by and large on energy consumption, which in turn depends on the performance of the economy. If the economy goes bad—as with the recession in Europe—emissions will fall, because factories will produce less and both people and goods will travel less. But since the amount of allowed emissions was (and necessarily has to be) fixed in advance, their price will go down.

The reason is very intuitive: recession, not climate policy, is driving down emissions. The fact that the price of allowances goes down does not prove that the cap and trade scheme is flawed: it only shows that it is properly working in this respect. If supply of a good whatsoever is fixed and demand falls for exogenous reasons, its price must also fall.

At least, it must fall under market conditions. But then, politicians came in. They realised that the price wasn’t “high enough” (with respect to what?) and introduced the “backloading” measure. Actually, in a first vote the Parliament rejected backloading, but then it passed it with minor modifications, under enormous pressures from both the Commission and powerful vested interests. The result is almost paradoxical.

From the point of view of the mechanism, backloading consists of changing the cap. Price will (and already did) go up, of course. What really matters, however, is that the underlying idea is that politicians know what the “true price” of carbon is. But if they know the “true price,” then it makes much more sense to introduce a carbon tax: remember, a cap and trade scheme is all about discovering the optimal price!

From the point of view of European credibility, backloading should be a major reason of concern. It shows that rules can be changed at will, regardless to how strong the initial commitment was. It is almost irrelevant that the Parliament allowed the Commission to withdraw a limited (but not low) amount of emissions “only once.” Breaking the rules implies a very high, sunk cost the first time you do that: but once you have taken the step, everybody understands that you are willing to cheat—and will behave accordingly. This is like a flag waved at lobbyists: it suggests that, if they are persuasive enough, nothing is out of reach.

Finally, from the point of view of environmental policies, this vote should be a major reason of concern. It suggests that designing good mechanisms to achieve long-term results—which is supposedly the goal of climate policies—is less important than meeting short-run objectives, such as keeping the price of carbon high enough to please those that politics has picked as must-be winners.

The short-run consequence of backloading allowances will be most likely to sustain prices, consistently with its objective. But its long-run effect might be that of killing the residual credibility of European climate policies.

Carlo Stagnaro is Research and Studies Director, at the Instituto Bruno Leoni a free-market think-tank in Turin, Italy.

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