Avoiding Europe's Carbon Trading Missteps

Early carbon trading efforts flopped because regulators created too many credits and gave them away for free. Washington wants to do better
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The Berlaymont Building, a modernist, glass-fronted structure in the center of Brussels, is home to the European Commission—the European Union's executive branch. Nicknamed the "Berlaymonster" because of its dominating position in a wealthy neighborhood of the Belgian capital, the building is bustling with policymakers from the European Union's 27 member states on most days. But over the past three years, the Commission's offices have welcomed guests from further afield. U.S. officials have made repeated visits to tap Europe's knowledge of carbon trading to help them develop a similar scheme—one that is now working its way through Congress.

The Americans certainly came to the right place. Since its inception back in 2005, the EU's Emission Trading System has become the world's largest cap-and-trade carbon scheme with a 2008 market value of $90 billion, according to consultants Point Carbon. That compares to a mere $240 million value for the Northeast's Regional Greenhouse Gas Initiative, currently the largest mandatory scheme in the U.S.

Both plans set a limit, or cap, on total emissions. Companies then need a permit or allowance for every ton of greenhouse gas they emit. If a company has more permits than emissions, it can sell the excess permits on the open market. Based on a bill passed by the House of Representatives on June 26, the U.S. system would follow a similar recipe.

Lost Investment Incentive

But as the European experience reveals, the details are crucial. To avoid repeating many of the Old World's mistakes, analysts reckon the U.S. must create a strict cap on carbon credits and make sure that consumers, not companies, are the main beneficiaries of the system for allocating the permits. Long-term CO2 price stability, as well as regulatory and popular support for greenhouse gas cuts, also helps win over the often-skeptical business community.

It took Europe some time to learn these lessons. In fact, Europe's first crack at carbon limits and CO2 trading was a complete flop. Officials in Brussels overestimated the current level of emissions and set a cap that was too high, which created too many allowances. Then they compounded the mistake by giving most of the allowances away.

The miscalculations provided a windfall to the companies that received the free permits. The companies sold the excess permits at prices that went as high as €30 ($42) per metric ton in May 2006. The oversupply of permits then caused the market to crash—to just 2 euro-cents (3¢) by the end of 2007. That removed any incentive for companies to invest in green-energy projects or clean technology programs. Even worse, the policy didn't make a dent in European greenhouse gas emissions over the three-year time period.

Now, the European Commission is fixing its mistakes. First up is a tighter cap on emissions—and on the number of permits. From 2013 (when the third phase of CO2 trading begins), total allowances for all industrial sectors, including power, chemicals, and other energy-intensive industries, will be reduced by almost 2% per year until 2020. That comes on top of similar cuts imposed since 2008, which have eliminated most of the excess carbon permits from the market. In total, the cutbacks are expected to bring a 21% reduction in greenhouse gas emissions compared to 2005 levels by the end of the next decade—the largest cut by any region worldwide.

Craving Price Stability

Brussels also is pulling back from granting free CO2 allowances for companies. Starting in 2013, one-fifth of all credits will be auctioned to the highest bidder, with a particular focus on the energy sector. Utilities, such as France's EdF (EDF.PA) and Germany's E.ON (EONGN.DE), have been criticized for increasing customers' electricity prices because of carbon trading despite companies receiving CO2 credits for free.

Auctioning is expected to curtail these windfall profits, and will be expanded to more than 60% of the European trading scheme by 2020. "Europe realized free allowances distorted how the carbon market worked," says Olivier Lejeune, an analyst at consultants (New Carbon Finance) in London.

The steps will help create what energy-intensive companies desire most: long-term CO2 price stability. Knowing that carbon emissions will carry a stable, and stiff, price, makes investments in low-carbon technologies or energy efficiency more economically competitive and less risky. "To make capital-intensive investments, companies need less [price] volatility," says Colette Lewiner, global energy, utilities, and chemicals leader at consultancy Capgemini (CAPP.PA).

For sure, the Europeans still haven't fully cracked the art of carbon trading. Critics say the main benefactors have been financial players such as Britain's Barclays (BCS) or Goldman Sachs (GS), which actively trade CO2 credits. Others question whether the European scheme has even led to reductions in overall greenhouse gases.

Here to Stay

But there's no question the European scheme has been vastly improved, and that the U.S. is learning from the EU's mistakes. However, according to Andreas Arvanitakis, a senior analyst at Point Carbon in London, Congress still has a ways to go. While the proposed U.S. legislation doesn't create too many permits, it does hand out 85% of allowances for free—a key problem that Europe has now solved. "Many of the concessions made [in the congressional climate change bill] just haven't been consistent with ideal cap-and-trade regulation," Arvanitakis says.

Supporters of the U.S. plan argue that this isn't as bad as it sounds, since consumers, not industry, are the main beneficiaries of the free permits. For instance, while the bill does hand out 30% of the permits to regulated utilities, the permits don't go directly to the actual electricity generators. Instead the permits go to the companies that distribute the electricity. Those so-called local distribution companies are under strict orders to return the value of the handout to customers to help the customers cope with higher energy bills.

Problems remain, but with global leaders putting their weight behind cap-and-trade, carbon trading looks like it's here to stay. To harness market forces to tackle global warming, Europe's initial missteps—and its moves to correct them—should help the U.S. cuts its carbon footprint.

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