The Failure of Emissions Trading

While European leaders have long pretended to show global leadership on climate change, lecturing the rest of the world to take drastic action, our own emissions have in fact been steadily rising. In Part One of this series, we documented how Germany and the UK rigged Kyoto to start in 1990 instead of 2005, when the treaty went into effect, so that it could count entirely unrelated reductions made in the early 1990s. The reality, however, is that emission reductions of the EU-15 stand 6.2 percentage points short of its 8 percent target, despite the fact that the European Environmental Agency counts highly questionable carbon offsets and Russian 'hot air' to claim something closer to the opposite.

But if Europe did not reduce its emissions, then what happened to the €100 billion it spent on its much-touted Emissions Trading Scheme? The answer, we show in this second article, is fraud, rent-seeking, price volatility, abuse, and inefficiency. Worst of all, the ETS threatens to trap Europe into a high-carbon energy infrastructure for decades to come, greatly increasing the risk of climatic disturbances and the cost of future action.

Today, the Scheme stands no longer as a model for the rest of the world, but as a warning of what happens when we attempt to make fossil fuels more expensive through complicated regulatory schemes, rather than making clean energy cheap through limited but direct government support for innovation.

Perverse Incentives

On January 1st, 2005, the EU ETS went into effect to much fanfare and clamor from European leaders and mainstream environmentalists. As the cornerstone of the EU's efforts to meet its Kyoto targets, the ETS was the world's first serious cap and trade regime for greenhouse gases. It was also one of Europe's biggest mistakes since World War II.

EU emissions did not decline, but actually rose by 1.9 percent during the first three years of the ETS, according to the Institute for Energy Research and figures from the European Commission. The UK economy, for example, actually recarbonized as renewable energy production fell.

A report by Sandbag, a UK-based climate campaign, concludes that by the end of Phase II of the Scheme in 2012, the ETS will have reduced emissions by a mere 0.3 percent. Worse still, even these minimal reductions will depend on highly questionable CDM credits. Domestically, Sandbag does not expect any abatement until at least 2017.

But the ETS did not just fail to reduce EU emissions -- it actually created a perverse incentive to increase them. It is now clear that a small number of Europe's most carbon-intensive industries made windfall profits after lobbying successfully for an over-allocation of permits, essentially getting paid to do nothing.

According to Sandbag, the ETS:

fruitlessly gives away public assets currently worth €14 billion to industries taking no corresponding environmental action. Were this not sufficient affront to European citizens, as electricity consumers we are also obliged to bear the costs of this giveaway: the same permits are bought up by power companies to make up their shortfall and these costs are passed through to their customers.

Criminals and bankers reaped the financial gains paid for by unsuspecting European taxpayers and consumers -- who collectively forked over between €46 and €146 between 2005 and 2008 alone, according to an analysis by the Taxpayers Alliance. Over the same period, the German power company RWE, Europe's largest emitter, received a $6.4 billion windfall.

The steel and cement sectors, which lobbied most violently against the scheme, are estimated to gain some €2.3 billion and €1.8 billion, respectively, during Phase II of the scheme. The 10 most over-allocated companies in 2008 managed to somehow quadruple their allocation surpluses by 2009, up to 119Mt from 33Mt. Over the five years of Phase II, these 10 companies alone stand to gain some €3.4 billion in emission permits. Projected into the future, these firms have accrued so many surplus allowances that they could afford to grow their emissions 50 percent by 2020.

It has also become clear that the ETS is beset with fraud. According to Bloomberg, some 400 million metric tons, amounting to 7 percent of the total amount of carbon traded within the Scheme, are entirely fraudulent. Europol - Europe's transnational criminal investigations unit - announced that:

criminals have gamed the EU's Emissions Trading System for a cool $7.4 billion in purloined tax revenues. [...] By the time volume peaked last May and early June, Europol investigators say, up to 90 percent of the trade in some European countries was totally bogus.

The authors of the Sandbag report conclude:

Far from being a competitive disadvantage, the EU ETS appears to have helped subsidize these industries as the recession entered full swing. This not only represents a total perversion of the environmental purpose of the ETS, but potentially violates WTO rules prohibiting state aid.

Jumping Ship Left and Right

Rapidly, a consensus is emerging among experts that the ETS has been a dramatic failure. In a recent report, Harvard economist and international trade expert Richard Cooper has pointed to the Scheme's price volatility, its vulnerability to abuse and its failure to achieve any meaningful emissions reductions. In response to these findings, Elaine Kamarck, a former senior policy advisor to Vice President Al Gore, has described carbon trading schemes like the ETS as "costly and ineffective."

In his foreword to an influential report by Open Europe, Max Andersson - who is a Member of Swedish Parliament for the Green Party - warns that "real environmentalists should be very skeptical indeed of the EU's record on this area ... It will do practically nothing to fight climate change." Similarly, Sandbag concludes that:

With emissions now below the level of the cap, the cap has become a trap - guaranteeing high level of emissions into the future rather than working to deliver reductions ... Despite the promise of much more aggressive Phase III caps we find that on-going availability of cheap offsets could allow Europe's domestic emissions to grow a staggering 34 percent from current levels by 2016.

The 2008-'09 financial crisis and the subsequent recession and drop in emissions has led to another huge surplus of carbon permits. Since these surplus permits will be carried over into Phase III, the present recession has the ironic result of raising the total amount of emissions that can be made during Phase III, practically rendering the final cap obsolete.

As a result, even George Monbiot, one of the world's most fervent environmentalist journalists, has acknowledged that the ETS will "remain completely useless." According to the researchers at Open Europe, "it is likely that a majority (if not all) of the "reductions" which are being made as a result of the system will take place outside the EU."

The mainstream U.S. media outlets are now also turning against the ETS. The Washington Post stresses that carbon trading schemes are "complex and vulnerable to lobbying and special pleading." According to the Wall Street Journal:

Not only does the taxpayer carry the cost of any cap and trade scheme, but their money also provides profit for a whole new industry: the carbon trading sector, the middlemen who make the system work.

The Collapse of Green Neoliberalism

The problem with the ETS is not just that it has failed to work until now - and that somehow we will be able to make it work with some makeshift adjustments in the future. The real problem with the ETS is that emissions trading is a structurally unsound way of tackling the complex problem of climate change to begin with.

The idea of 'cap and trade' was born out of a Baptist-bootlegger coalition of sorts, between environmentalists on the one hand and neoliberal policy makers on the other. While environmentalists focused on limiting emissions through the imposition of a cap, the neoliberals focused on internalizing the social cost of climate change into the price of carbon.

Bringing these two seemingly disjointed worldviews together, European governments bought the policy prescription sold by neoliberal American greens like Al Gore. But it turned out that the system could not deliver the stable carbon price it had promised - much less the technology innovation expected to magically flow from carbon pricing. The inevitable consequence of trying to raise fossil energy prices resulted in furious industry lobbying, the spectacular over-allocation of permits, and thus the crash in the Scheme's carbon price from €33 to just €0.20 per ton.

Even the carbon traders were disappointed. Bloomberg and the Institutional Investors Group on Climate Change have warned that the "European Union's carbon trading scheme hasn't provided the needed long-term price signal for investors to switch away from carbon-intensive technologies." Likewise, Carbon Trust & Climate Strategies has argued that "the EU ETS offers very little encouragement for investment in lower carbon technologies."

In their seminal 2007 paper, The Wrong Trousers, Gwyn Prins and Steve Rayner already observed that the idea of creating an entirely superficial market from scratch - and expecting it to work smoothly towards the ends envisioned by its 'social engineers' - is completely absurd. The idea that the 'invisible hand' of the carbon market will automatically guide private investors to clean energy alternatives remains wishful thinking at best and misguided idolatry of market magic at worst.

In his most recent book, the environmentalist author Clive Hamilton rightly slams the green neoliberalism that underpins the idea of carbon trading, arguing that: "It is an irony that environmentalists generally have more faith in the market system's ability to find a way to accommodate environmental restrictions than the upholders of free markets in the business press and conservative parties."

It has become overly obvious by now that the problems associated with the ETS are not just 'teething problems' that will be resolved once the initial 'experimentation phase' is over. The problems of emissions trading are structural. The bottom-line is that while markets may be great tools for efficient allocation, they are a highly ineffective at bringing about transformation.

"In the final analysis," argue Prins and Rayner, "cap-and-trade cannot deliver the escape velocity required to get investment in technological innovation into orbit, in time. That calls for something else."

This is the second article in a three-part series on the Twilight of European Climate Leadership:

Part I: Cancun Can't
Part II: The Failure of Emissions Trading
Part III: How Europe Can Escape Groundhog Day