Italian free-market think tank in new report:

"Replace emission trading scheme with a carbon tax"

If the European Commission wants to stimulate "green growth", as its official policy states, then the Emission Trading System (ETS) is the wrong instrument. That's one of the major conclusions of a new study from the prestigious Italian free-market think tank Istituto Bruno Leoni (IBL). The authors, Stefano Clò and Emanuele Vendramin, argue that a carbon tax would be much more suitable to the goals of the EU's green growth agenda than an emission trading scheme. The ETS is the EU's flagship climate policy instrument, but it is widely criticized for being ineffective.

The EU is trying to pursue a price goal through a quantity instrument (c) The Australian

At first sight it might seem to be paradoxical: the premier Italian free-market think tank Istituto Bruno Leoni (IBL) has just released a report that comes out against emission trading and in favour of a carbon tax. Emission trading, or 'cap-and-trade' is, after all, a market-based instrument, one that was especially designed to achieve emission reductions with minimal interference in the free market process. It was successfully used to reduce NOx and SO2 emissions in the US in the 1990s, and was adopted by the EU starting in 2005 to reduce CO2 emissions under the 1997 Kyoto Protocol.

The EU's Emission Trading Scheme (ETS), which is about to enter its third phase in 2013, is by far the world’s largest greenhouse gas emission trading scheme, representing more than 80% of the global carbon market. Despite the fact that the Kyoto protocol encouraged the instrument of emission trading, no other major country or region followed the EU's example in setting up a cap-and-trade system, although some local schemes are in operation, such as in New Zealand and in some States in the US.

In Europe, the ETS has consistenly come under heavy criticism ever since it got started. Many studies have concluded that the ETS has so far failed to provide incentives to market players to invest in reduction emission technologies. It is also generally accepted that many participants managed to pocket 'windfall' profits under the scheme. The main problem with the ETS at this moment is the low price of carbon allowances. The CO2 price in the ETS collapsed to zero at the end of the first trading period (2005-2007) as a result of overallocation. In the current second phase (2008-2012), carbon prices initially rose, only to collapse again when the recession broke out. Prospects for the upcoming third period (2013-2020) are uncertain, but if the system is not changed, prices are not likely to rise to a level that will be sufficient to stimulate new investments in low-carbon technologies.

Hence, an intense debate has started up in Brussels how to 'fix' the ETS. One measure that is being discussed is the so-called 'set-aside', which would take a number of allowances out of the carbon market to drive up the price, but it is by no means certain whether this will be adopted. Other proposals that are being discussed are to increase the EU's CO2 emission reduction target from 20% to 30% in 2020, or to establish a carbon price floor. This last is what the UK government has said it will do. Climate Commissioner Connie Hedegaard announced in April that she is preparing an assessment of the ETS which should be ready by the end of this year.

Green jobs

In this great ETS debate, the new IBL report takes a clear stand. It concludes that the EU's climate policy goals would be much better served by scrapping the ETS altogether and adopting a carbon tax.
In a telephone interview with EER, co-author Stefano Clò, who wrote his PhD on the EU ETS and now is a research fellowat the University of Tor Vergata in Rome as well as consultant at the Italian consulting firm RIE (Energy and Industrial Research), explains why he and his RIE colleague Emanuele Vendramin, came to this conclusion. It is not, he says, because there is necessarily wrong with the cap-and-trade instrument as such. The problem is rather that in the current political context the ETS cannot do what the policymakers want it to do.

When the ETS was first established, Clò notes, the goals it was meant to serve were much different from now. “At the time the EU wanted to be world leader in reducing CO2 emissions. It expected other countries to follow its example. That did not happen, however. The EU is pretty much alone and it knows it won’t accomplish much on its own in terms of reducing global emissions. Accordingly, its priorities have shifted. The EU now wants above all to promote low-carbon technologies, to create 'green jobs' and stimulate the 'green economy'. But the ETS is not the right instrument to achieve these new goals."

What is needed to stimulate “green growth", says Clò, is a relatively high price for CO2 emissions. But a

"If your primary goal is to stimulate 'green' investments, then a carbon tax makes much more sense than a cap-and-trade scheme"
cap-and-trade scheme, he points out, focuses on the quantity of CO2 emissions, not the price. "The carbonprice in the ETS will always be uncertain and volatile. That's in the nature of the scheme. And political intervention will only make this worse. A carbon tax, on the other hand, is perfectly designed to raise the price of CO2 emissions. It can grant price stability at a lower administrative cost than the ETS."

Clò acknowledges that a disadvantage of a carbon tax is that it does not guarantee a reduction in the quantity of emissions. Companies may continue to emit if they are prepared to pay the price. "But", he adds, "if your primary goal is to stimulate 'green' investments, then a carbon tax makes much more sense than a cap-and-trade scheme."

Discrimination

Clò notes that it's not just 'Brussels' that has adopted a 'green growth' agenda. The EU member states also pursue numerous energy and climate policies that interfere with the functioning of the ETS. Subsidies for renewable energy are the most obvious example – they tend to depress the carbon price, as greater renewable energy production leads to lower CO2 emissions, hence lower demand for CO2 permits. Another example are policies to stimulate energy efficiency. But even a decision like the German nuclear phase-out has a direct impact on the carbon market: it drives up the CO2 price.

A carbon tax would have another advantage over the ETS, Clò points out. It would eliminate the 'discrimination' that now exists between sectors that are subject to the ETS and other sectors, such as transport, agriculture and housing, which are not part of the scheme. "What you see is that the electricity sector is over-regulated: it is subject to the ETS and to all sorts of other conflicting policies. By contrast, other sectors are under-regulated. A carbon tax would apply equally to all CO2 emissions."

The measures that are currently being discussed in Brussels to 'fix' the ETS, are unlikely to solve the underlying problem, says Clò. On the contrary, they will probably only make matters worse. "The

"What you see is that the electricity sector is over-regulated, other sectors are under-regulated"
problem for market participants is not so much that the carbon price tends to fluctuate. They can deal with that. The problem is the uncertainty created by political interference. Now they are discussing a set-aside - removing emission rights from the market - or a national carbon price floor as in the UK, but this type of intervention will only increase regulatory uncertainty. It is undermining the market."

Clò believes it is quite likely, despite the failure so far of the ETS, that the EU will persist with its cap-and-trade scheme. "It may be too-strategic-to-fail", he says. In that case, he has some advice to offer EU policymakers. "If you are going to intervene at all, do it in a transparent, predictable manner. Establish a central authority, a bank, that can operate independently of political intervention. Reduce permits on the basis of clear rules. Set clear long-term targets. It would still be a second-best solution, but at least it's better than what is going on now."


"Is the ETS still the best option?" No, says IBL

The IBL Special Report "Is the ETS still the best option?" provides a harsh critique of the functioning of the ETS. It acknowledges that the ETS represents "a milestone" in international climate policy and is a success as far as trading activity is concerned: traded volume within the system doubled every year until 2008 and increased even in the crisis year 2010. In 2010, the market value of permits traded within the ETS reached $120 billion.

But the authors, Stefano Clò and Emanuele Vendramin, note that the ETS "caused many inefficiencies and market distortions". In the first phase of the scheme, from 2005 to 2007, the carbon price collapsed to zero as a result of overallocation of allowances. In the second phase (2008-2012) the recession again led to a collapse of the price after a promising start. However, since this time participants are able to carry over their permits to the next trading period, the price has not fallen to zero but is hovering somewhere around €6 or €7 per ton after a high of €30 in June 2008. The report also notes, incidentally, that not all companies were able to profit from the overallocation of permits: the power sector had to buy permits, whereas the manufacturing industry had over €5 billion in surplus allowances. Thus the ETS had an anti-cyclical effect and partly shielded the industry from recession and credit crunch, says the report.

Unlevel playing field

An important shortcoming of the ETS in the first two phases is that companies and sectors faced very different requirements across Europe, depending on how national authorities implemented the scheme. "This unlevel playing field has distorted competition, creating undesirable economic consequences at the expense of effective EU common market integration", says the report.

Thus, for example in Germany the sectors covered by the ETS (i.e. the power sector and heavy industry) had to do more than the non-ETS sectors (i.e. the rest of society) to help Germany meet its Kyoto target. By contrast, in the Netherlands the ETS sectors were even allowed to increase their emissions while the rest of the country had to reduce them. On average, ETS sectors had to do less than the non-ETS sectors: "Member States preferred to protect national industries by setting soft ETS caps and shifting the emissions reduction burden on the non-ETS sectors". Incidentally, these non-ETS sectors are generally not subjected to any binding climate policy, thus in effect the burden of compliance falls on society as a whole.

So how effective was the scheme? Not very, says IBL. The authors have calculated when during the first two trading periods the carbon price was sufficiently high to stimulate coal to gas switching in power production. The answer: only for about one-and-a-half years in the total period, corresponding to just 1.6% of emissions.

Free-riding

But one could argue that all this is history, in a way. The question is, what can we expect from the upcoming trading period? Some lessons have been learned, say the two researchers. For example, the ETS cap will now be set at a centralised level by the European Commission to avoid free-riding and protectionist policies at the national level. And the cap will be reduced each year in a gradual way.

Still, the authors do not believe that the ETS will do what it is supposed to be doing in the third phase, namely stimulating investment in low-carbon technologies. The main reason, according to them, is that "too many political and economic uncertainties affect the ETS in the third trading period." They note that as a result of this political intervention, "analysts have little clue about the future trend of the EU carbon price and they continue to adjust their forecasts". Thus, "market operators do not know whether investing in low-carbon technology will be a profitable strategy."

The IBL researchers point out that the EU by trying to adjust the ETS cap in order to increase the carbon price, is betting on the wrong horse. The EU is trying "to pursue a price goal through a quantity instrument", they say. By doing so, Brussels is changing the rules of the game. On top of "being administratively costly and politically unreliable", this strategy is "not efficient", they argue, because the chosen instrument is not the most suitable for the given purpose.

The alternative they put forward is to opt for a carbon tax. This, they say, is "a non-distortionary instrument" that will grant "price stability", which will stimulate investments. It will be less subject to political manipulation, it will lead to "harmonization among economic sectors" (everyone will be subject to the same rule). Moreover, it will have a positive impact on public budgets, not an unimportant argument these days.

The authors concede that what a carbon tax cannot do is guarantee lower emissions. However, they argue that since European emissions represent only a negligible part of global emissions, the reduction of European emissions cannot impact significantly on the trend of global emissions anyway. Their conclusion: "fixing a carbon price in order to reach an industrial goal (fostering diffusion of low carbon technologies) would appear to be a more effective strategy than fixing the quantity of emissions in order to reach an environmental goal (the emissions reduction target)."