Why Europe’s Carbon Market Collapse Won’t Kill Cap And Trade

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For carbon markets across the world, it was the best of times, it was the worst of times.

Plummeting European Union carbon prices following a key EU vote seem to demonstrate in the clearest terms that cap and trade is doomed to fail. After all, “if carbon trading can’t make it in Europe, it can’t make it anywhere,” said Bryan Walsh of Time.

But declaring the death of carbon markets and cap and trade policy over Europe’s struggles is a knee-jerk reaction which overlooks significant developments for carbon trading around the world – ones which could ultimately rescue the EU and cement cap and trade as a global climate change solution.

What Went Wrong In Europe?

First, some background on Europe. The EU’s Emissions Trading Scheme (ETS) launched in 2005 with a common price on a ton of carbon emitted anywhere across the EU. It’s the oldest and largest carbon market in the world, and started out with prices around €25 Euros per ton – a level that encouraged heavy industry and electricity generation to shift toward clean energy.

But an overly generous allowance policy that gave businesses free permits has combined with the stubborn economic recession to create a glut of surplus allowances and kneecap EU carbon prices. Allowances sold for as low as €3 Euros per ton in early 2013, and the EU proposed a “backloading” solution to delay the sale of 955 million allowances from 2013-2015, roughly half annual emissions.

Backloading Fails, Everyone Freaks Out

Backloading was intended to force prices back up and keep them relatively stable while the EU restructured the carbon market to address allowance oversupply, but the measure was narrowly defeated Tuesday and permit prices fell 40% to an unprecedented low on the system’s futures exchange, threatening the €54 billion program.

“The ETS will almost certainly collapse,” said analyst Kash Burchett. “Prices will sink very low, potentially below €1 per ton and liquidity will dry up.” So if the EU ETS goes, it’s game over for cap and trade, right? Wrong.

While the EU carbon market absolutely must reduce its glut and boost prices to function in the short-term, backloading was just the first step proposed to reform the system’s inflexibility, and key EU policymakers have said they will introduce long-term fixes to save the ETS.   

A Pan Asian-Pacific Carbon Market?

Looking beyond the EU, however, multiple carbon markets are underway around the world, learning lessons from ETS oversupply and linking to each other to create larger markets. In fact, these new cap and trade systems could one day revitalize the ETS in ways internal reform cannot, by creating access to new allocation demand.   

Australia launched a national A$23/ton carbon tax on large emitters last year, and plans to start a national cap and trade market system with a floating price and links to the EU ETS in July 2015.

This system, in one of the world’s most carbon-intensive economies, could become the cornerstone for a massive Asia-Pacific carbon market. Australia has announced it will work with China to jointly develop the two countries’ respective systems with an eye toward long-term linkages, and Australia is working toward links with both New Zealand and South Korea’s fledgling markets.

China Is Key

As noted by several Australian observers, China might just be the lynchpin to international carbon market success. China is the world’s largest carbon emitter, and recently stated “the increasing dangers presented by climate change measured against the inadequacy of the global response requires a more focused and urgent initiative.”

To that end, China is launching cap and trade pilot programs in seven major manufacturing cities ahead of an expected 2020 national emissions trading system launch. These seven pilot programs alone will cover up to 1 billion tons of emissions by 2015 and will make China the world’s largest carbon market outside the EU.

China previously signed a financing deal with the EU to develop an emissions trading link with the ETS, and has pledged to move forward even if the ETS collapses. “China has pledged these targets to the international community to deal with climate change,” said Xie Zhenhua. “No matter what happens to our economy, we cannot make any change.”

North America Does Its Part

So we can count China and Australia in on ultimate international linkages, but what about the US? Even though our national emissions reduction policy amounts to little more than nibbling around the edges, regional cap and trade markets are growing strong, and form the core of a North American carbon market projected to “more than double” in value to $2.5 billion in 2013.

The Regional Greenhouse Gas Initiative (RGGI) has been in operation across the Northeast US for six years, and may net $2 billion in revenue by 2020. Unlike the ETS, RGGI has taken steps to readjust its carbon allocation budget to match lower emissions due to natural gas, clean energy, and recession. In fact, allocation prices may more than double due to the 45% allowance cut.

While RGGI is America’s oldest carbon market, its impact could be dwarfed by the new kid on the block – California. The Golden State’s cap and trade system sold more than 23 million allocations for nearly $300 million in November 2012, and a second auction in February 2013 exceeded analyst expectations while raising another $176 million.

California has also formally approved a linkage to Quebec’s carbon market through the Western Climate Initiative, and the two systems could start trading as soon as January 2014. More than 425 companies operating in the two systems will soon be able to buy and sell interchangeable permits, which could increase the overall market 20 percent.

Emissions Reductions: On The Right Side Of History

To be clear, the collapse of carbon prices in the EU’s ETS is bad for climate policy, no matter how it plays out. And, many challenges lurk for carbon markets around the world. But dooming cap and trade as a policy measure simply because the first established international system didn’t anticipate how emissions trading would play out and couldn’t adjust to market changes is shortsighted hyperbole.

Hope springs eternal in these fledgling global markets, set in much more carbon-intense nations, in every corner of the globe. As each market matures and links with others while applying lessons learned, the overall ability of cap and trade systems to absorb individual shocks will improve, and the potential to flatten emissions while delivering real economic benefits will only grow.

Carbon emissions reduction policy is on the right side of history. If the EU ETS can survive on life support until other systems can realize their potential, this emergency may one day be seen as merely a speed bump on the road to a low-carbon world.