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Friday, 31 January 2014

The carbon mountain: Dealing with the EU allowance surplus

It’s not news that the EU emissions trading system (EU-ETS) is in trouble. A build-up of surplus emission allowances has caused dangerous instability in the carbon market and a plunge in prices since the economic slump in 2008 began (See Figure 1, courtesy of David Hone).

Figure 1, courtesy of David Hone

The discussion at the All Party Parliamentary Climate Change Group’s (APPCCG) meeting on the 28th of January centred on the causes and consequences of the EU-ETS allowance surplus. The majority of speakers at this session had a background in the discipline of economics, so inevitably the exchange of views was… frank.  The panel were in agreement that EU-ETS is in crisis; but can and should it be saved?

Emissions trading schemes, of which EU-ETS is a canonical example, are an attempt to allow market forces to correct the so-called ‘market failure’ that is carbon emission. From the point of view of a classical economist, the participants in carbon emitting industries do not naturally feel the negative effects their activities cause to the environment. Emissions trading forces carbon emitters to ‘purchase’ the right to pollute on a market. In effect, they pay to receive permits (or allowances) to emit a certain level of emissions. If they do not reach this level of emission, the excess can be sold back onto the market, allowing others to make use of it. The prices of permits are determined by market forces, so cannot be fixed by the EU. The quantity of permits is within the control of the EU, and this is where the problem lies.

James Cameron, Chairman Climate Change Capital
In the aftermath of the 2008 slump, a surplus of allowances began to build up, leading to a crash in the price of allowances. Many commentators blame EU economic forecasting for this problem, as the recession and consequent reduction in economic activity was not factored in to the EU-ETS control mechanism. Criticism has been forthcoming for the economic models used, and some go as far as to liken the mismanagement of EU-ETS to the ‘wine-lake and butter-mountain’ days of the 1980s, where the Common Agricultural policy was allowed to consume over 70% of the EU’s budget. Perhaps the models are too simple - James Cameron, a speaker at the APPCCG event, spoke of the ‘premium on simplicity’ that exists in creating policy. Maybe that approach has extended itself into the mathematical models used to predict the performance of EU-ETS, rendering them over-simplistic?

Personally, I see things a little differently. It’s clear that economic models are often far from perfect; however, I’m not sure that’s where the problem lies. In the implementation of policy, decision makers have to draw on the implications of many separate models; for instance, they must consider the GDP growth of EU member states, their adoption rate of new energy efficiency standards and the relative industrialisation of their economies. To my mind, the greatest source of error is in the gaps and interfaces between these economic models. Policy makers must make decisions on how to interpret the way economic predictions will interact with one another, and these interpretations are always subject to value judgements. What we need is a more joined-up approach.

Climate science has long used ‘macro-models’ to incorporate a variety of physical processes into their predictions, an approach that could be adopted by economists as well. While the first economic macro-models may not achieve even a fraction of the accuracy of climate models, that is not to say they cannot be improved through collaboration and quantitative criticism. Perhaps now is the time to make a start?

This blog is written by Neeraj Oak, Cabot Institute.

Neeraj Oak

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