Carbon Goes Subprime

European Union (EU) carbon trading proponents are finding support for their market-based emission trading scheme (ETS) in freefall like the market price of carbon in the EU. This unanticipated consequence of the ETS really should not have come as a surprise.

Free Allowances

The ETS, often described by EU regulators as the world’s most advanced market-based approach to reducing carbon emissions, liberally distributed carbon emissions allowances to industries proportional to their pre-ETS emission inventory when the EU economy was in full swing. Subsequently ratcheting down the number of allowances will, in theory, increase the value of those allowances, and their market price should rise. The anticipated effect is to increase the cost of coal-fired generation, for example, and to subsidize less-carbon-intensive, yet more expensive, renewable energy.

This free-market approach to managing an unpredictable power supply market may work well in a rising market when the thirst for power can’t be satisfied. What the ETS designers failed to consider is that during a recession, the demand for power slows, leaving a glut of allowances on the market and quickly falling prices. Allowances that were highly prized last year might as well be sold on eBay as just another depressed asset.

Vincent de Rivaz, CEO of the UK arm of Électricité de France, the French-owned utility, suggested at the January World Economic Forum in Davos, Switzerland, that politicians and regulators need to reexamine the ETS and confirm that the system is working as designed. "We like certainty about a carbon price, [but] the carbon price has to become simple and not become a new type of sub-prime tool which will be diverted from what is its initial purpose: to encourage real investment in real low-carbon technology," he said.

Self-Preservation

Adam Smith preached that the market’s "invisible hand" would cause an individual business to respond to a market stimulus in a way that maximizes its own self-interest, and private enterprise’s response to the ETS is no exception. The run on the emissions allowance bank began when surplus allowances were dumped to beef up sagging balances sheets and pump up cash flow to the tune of about $2 billion over the past couple of months. This sell-off has pushed the market price of carbon down over 60%, from about $40 a metric ton on July 1, 2008, to less than $16 today. Bloomberg suggests that these lower prices will be the norm throughout 2009. One carbon market report painted a happy face on the news by noting that 2007 was "a tremendous year of growth for the carbon market," which had a 170% year-on-year increase in trades.

Predictably, environmentalists are heavily criticizing the unintended consequences of the ETS for delivering more windfall profits to business than to climate change mitigation. "This [ETS] was not designed as a scheme to give corporations cheap short-term funding options in the face of a credit crunch meltdown where banks are not lending, but that appears to be what’s happening," said Mark Lewis, a carbon analyst at Deutsche Bank in an interview with The Guardian on Jan. 27. When the stock market plunges, the price of carbon must be allowed to follow, or there is no free market trading in carbon. Otherwise, the ETS becomes a carbon tax in disguise.

On Jan. 30, The Guardian quoted Henrik Hasselknippe, global head of carbon at Point Carbon, as saying, "Recession in Europe is bringing a slowdown in manufacturing meaning less production and less emissions. Companies are doing exactly what is the rational thing to do in these circumstances, which is to sell if they are long on credits. It is right that if they are emitting less[,] then they do not need the credits so much and the price of carbon will fall." A market-based approach to carbon allowances means there will always be winners and losers.

Collateral Damage

Why should the U.S. be interested in the EU carbon market? As worldwide stock and money markets operate 24/7, so will the carbon market. Just days after his inauguration, President Barack Obama was called on by Brussels to establish a joint carbon trading scheme modeled on the ETS. Stavros Dimas, the EU environment commissioner, is pushing for a global carbon market by 2020. He characterizes the Copenhagen meetings scheduled for late this year, which are to produce a successor agreement to the Kyoto Protocol, as our "last chance" to negotiate a united approach to controlling global warming. Dimas has produced a draft policy white paper that suggests that a 30% reduction in 1990 levels of carbon emissions by 2020 will cost developed nations a cool $225 billion a year.

I won’t be surprised if carbon cap-and-trade legislation were debated by Congress this year. However, I see few reasons why the U.S. should consider adopting the ETS approach given its recent market gyrations. Also, the chances are nil that any proposed U.S. carbon trading scheme will be as generous as the EU’s in its initial distribution of allowances. That disparity would put U.S. businesses at a disadvantage from the start.

The political fallout from a global carbon market would be palpable. How does the president convince voters that shipping boat loads of money to the EU is good for the U.S.? This undesirable situation would occur regularly when our industries grow faster in good times, have a dearth of allowances, and would be obliged to purchase allowances from EU firms that will continue have more than they need. That’s a stimulus package we should avoid.