Recent headlines proclaim "deep trouble" in the European cap-and-trade system for greenhouse gases, evidenced by the decline in allowance spot prices from over $25 per metric ton of carbon dioxide in June 2008 to about $3 this month. Although many press articles have referred to an "oversupply" of emissions permits, suggesting some kind of intrinsic imbalance, the markets are clearing just fine. It's just that the price is lower than forecast.
Whether this represents trouble or not depends on what you think the goal of the program should be. If the goal is to ensure that emissions in the covered industrial sectors are no higher than the emissions caps, then the program has worked just fine. It just didn't have to work very hard since much of the decline in emissions relative to projections was driven by the multi-year economic crisis. A sputtering EU economy lowered industrial activity and consumer energy demand, and this drove down allowance demand and prices. This makes compliance easier for the remaining emitters just at the time business and consumers are suffering most. This counter-cyclical property might be seen by some as a feature, not a bug.
On the other hand, if you think the goal of climate policy should be to provide stable cost effective long-run incentives to lower emissions relative to what would otherwise occur, then the ETS price plunge is a cautionary tale. First, it illustrates the importance of the design details of the carbon market. The ETS law included no provision to restrict automatically the number of allowances when prices get low. Efforts to withhold allowances failed when, not surprisingly, coal-dependent states balked at the proposed stringency in an economic downturn.
Second, the price volatility shows that the ETS hasn't really fixed the market failure in which fossil energy prices don't reflect their full social costs, including environmental damages. Economists widely advocate a price signal on carbon that would include those external costs, as best we can estimate them, in fuel prices through a carbon tax or a cap-and-trade system. The ETS illustrates one key drawback of a poorly designed cap-and-trade system: fluctuating allowance prices and abatement incentives. Price volatility makes no sense if you're trying to internalize an external cost because there's no reason to think the social cost of carbon fluctuates over the short run, much less drops by 90 percent over five years.
Third, the ETS illustrates the potential for laxity in one carbon market to erode abatement incentives abroad. For example, the Australians plan to convert their carbon tax to an ETS-linked permit program in July 2015. The prospect of linkage to the ETS lowers the expected Australian carbon price well below the current tax of about $25 per ton of CO2. To be sure, low prices in the ETS just amplify the investment-depressing effect of the broader uncertainty around a policy so incompetent one wonders if they'll go through with it.
Finally, the ETS experience reveals the limitations of framing the environmental success of a climate policy solely in terms of emissions levels. Many environmentalists are more comfortable with an emissions cap than a carbon tax because the cap provides more environmental certainty. However, the lower-than-predicted ETS allowance price has made it unexpectedly easy for utilities to fire up coal-powered plants and delay investments in cleaner natural gas and renewables, and this could set back climate efforts in the EU for years.
The fits and starts of the EU carbon market suggest the potential advantage of an enduring and credible incentive to reduce emissions through a carbon tax. Even if the EU had set a tax at the lesser of the estimated damages from emissions and the public's willingness to pay, it would surely have been greater than the current ETS price, suggesting that the policy with the greater environmental certainty has foregone the opportunity for greater environmental benefits.
Policymakers should expect the unexpected and do what they can to establish a climate policy that is robust to changing economic conditions at home and abroad. Compared to the EU's current approach, a modest predictable tax would be more robust to shocks, solidify the payoffs of investments in new technologies and emissions reductions, cost less (especially if the revenue is used wisely), and ultimately do more to protect the planet.