Europe's system for cutting CO2 emissions is working well

Cambridge, USA - According to the Massachusetts Institute of Technology, despite a rocky beginning three years ago the European Union’s ’cap-and-trade’ system has operated well and has had little or no negative impact on the overall EU economy. A key finding of the review is that everything does not have to be perfectly in place to launch similar systems. Could it be that the Europeans got it right?

The new report released by the Pew Center on Global Climate Change examines the European Union’s Emissions Trading Scheme (EU ETS) offering a realistic assessment of the system’s initial objectives and outcomes. The report, The European Union’s Emissions Trading System in Perspective, by A. Denny Ellerman and Paul L. Joskow of the Massachusetts Institute of Technology, examines the development, structure, and performance of the system to date.

Main findings of the report include:

  • Accurate data on baseline emissions is needed to create an effective trading system that results in sufficient emissions reductions;

  • Suppliers quickly factor the price of emissions allowances into their business decisions under a cap-and-trade program;

  • Price volatility can be reduced by allowing banking and limited borrowing of emissions allowances;

  • The relationship between allowance allocation, allowance markets, and the unsettled state of electricity regulation must be understood and addressed to avoid unintended consequences; and

  • The linkage of 28 separate trading programs in the EU ETS provides a valuable prototype for a globally linked carbon market.

The report finds early concerns with the EU ETS are being addressed and the program’s trial period has provided important lessons about the creation of new emissions trading schemes. In fact, the system has worked much as it was envisioned - it established a European-wide carbon price; caused businesses to incorporate this price into their decision-making; and created the infrastructure for a multi-national trading program. In addition, emission reductions were realized in some covered sectors which underscore the system’s initial benefits.

"This important public policy experiment is not perfect, but it is far more than any other nation or set of nations has done to control greenhouse-gas emissions-and it works surprisingly well," said A. Denny Ellerman, senior lecturer in the MIT Sloan School of Management, who performed the analysis with Paul L. Joskow, the Elizabeth and James Killian Professor in the Department of Economics.

While it remains a work in progress, the EU ETS affords many important lessons for policy-makers and major stakeholders to consider when developing appropriate short- and long-term measures to limit greenhouse gas emissions.

The report helps address key cap-and-trade concerns in the U.S. and internationally, including over-allocation, price volatility, and excessive "windfall" profits.

"The EU has done more than any other nation or set of nations in limiting GHG emissions - and the implementation of their cap-and-trade system has been a key part of their efforts," said Pew Center President Eileen Claussen.  "The EU’s experience with emissions trading offers valuable lessons for Congress as they work to craft a sensible cap-and-trade program for the U.S."

For years, the United States has operated highly successful cap-and-trade systems for emissions of sulfur dioxide and nitrogen oxides. Based on a national emissions cap, facilities that emit those pollutants receive a limited number of emissions permits, or allowances, for a given period. Facilities that emit more than their allowed limit must buy allowances from facilities that emit less. Markets for trading allowances operate smoothly and facilities have reduced their emissions significantly.

Despite such success, setting up a U.S. cap-and-trade system for CO2 emissions has proved challenging. Carbon emissions are so central to energy consumption that the idea of imposing a policy to limit them raises serious concerns. Could putting a price on carbon emissions lead to serious economic effects? Might the outcome be the equivalent of energy rationing? Such questions loomed large during recent Congressional deliberations on the now dead climate-change bill proposed by Senators Lieberman and Warner.

Already, the EU ETS is far larger than either of the U.S. programs for sulfur dioxide and nitrogen oxides. Further, the EU ETS operates internationally. Allowances are traded by facilities in 27 independent nations that differ widely in per capita income, market experience and other features. As a result, "I think the EU ETS has a lot to tell us about how a global system might actually work," Ellerman said.

What are some of the lessons to be learned from the European experience? First, it shows that the economic effects-in a macroeconomic sense-have not been large.

Second, allowing "banking and borrowing" will make a cap-and-trade system work more efficiently. Within the EU ETS, facilities can bank (save some of this year’s allowance for use next year) or borrow (use some of next year’s allowances now and not have them available next year). Many facilities took advantage of the opportunity to trade across time. But they always produced the necessary allowances within the required time period. Concerns that facilities would postpone their obligations indefinitely have proved unwarranted.

A third lesson is that the process of allocating emissions allowances is going to be contentious-and yet cap-and-trade is still the most politically feasible approach to controlling carbon emissions. In a cap-and-trade system, those most affected-the current polluters-receive some assets along with the liabilities they are being asked to assume.

Finally, the MIT analysis shows that everything does not have to be perfectly in place to start up. When the EU ETS began, the overall EU cap had not been finally determined, registries for trading emissions were not established everywhere, and many available allowances-especially from Eastern Europe-could not come onto the market. The volatility of prices during the first period reflects those imperfections.

"Obviously you’re better off having things all settled and worked out before it gets started," said Ellerman. "But that certainly wasn’t the case in Europe, and yet a transparent and widely accepted price for CO2 emission allowances emerged rapidly, as did a functioning market and the infrastructure to support it."

According the Ellerman there are also lessons Canada can take away from the EU ETS.  In April 2007 the federal government announced the development of a credit trading program.  So far the program does not require hard caps and is based on carbon intensity instead of total emissions.

Ellerman, among many other experts, points to the success of the EU ETS and establishment of hard caps on reducing overall emissions without economic consequence and suggests this may be a good structure for Canada. 

A report released in January, 2008 by the Canadian National Roundtable on the Environment and the Economy (NRTEE) also found that a cap and trade system for Canada would be a viable method for reducing greenhouse gas emissions.  (See article Report of the National Roundtable Points the way to change)

According to Point Carbon, a leading analyst of carbon markets, a Canadian cap and trade system could also serve as a link between a US and EU system, and would provide incentive for all three regions to work together to reduce greenhouse gas emissions.

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