Europe Acts to Fix Its Crippled Carbon Market

After months of wrangling, a vote in the European Parliament is bringing relief to the EU’s stricken Emissions Trading System (ETS), the world’s first and largest cap-and-trade program.

The vote shows the political will to address the oversupply of allowances (permits to emit carbon) that has led to unsustainably low carbon prices.

On July 2, Members of the European Parliament (MEPs) voted in favor of a "backloading" proposal which would withhold hundreds of million of permits.

Pulling back available permits to balance supply and demand (in order to raise prices) is exactly what’s been needed, but a previous vote caved to industry interests, which convinced them that higher carbon prices risked the bloc’s competitiveness. 

That move collapsed carbon prices by another 45%, to €2.63 ($3.38) per ton of carbon dioxide, and led many to question whether Europe remains committed to the program – its flagship climate change policy.

However, that price collapse triggered intense debate and a renewed effort to save the market.

“This is a good decision by the European Parliament and is an important step forward for climate change policy,” says Ed Davey, the UK’s climate change minister. “We need a stable carbon market so we get more certainty for investors so emissions reductions can be achieved at the lowest cost possible.” 

Carbon allowances have lost 75% of their value over the last four years as Europe’s economic downturn, and the faster-than-expected development of renewable energy capacity has reduced demand for allowances from emitters.

As the world’s first market, it did not have rules that would come into play when demand drops. The lack of the ability to reduce the supply of allowances led to a glut.

Last year, the European Commission proposed to ‘backload’ 900 million allowances, holding them back until later in the decade. This would push prices up, giving time for structural reforms to the system to be introduced.

“This is a reassuring signal for industry and international observers – many of whom have recently adopted their own emissions trading schemes – that the EU remains committed to decarbonizing Europe’s economy in the most cost-efficient way,” says Hans ten Berg, the Secretary General of Eurelectric, which represents Europe’s electricity sector.

“Today’s positive vote is a much needed step in the right direction, but it is nevertheless only a first step. We urge the Commission to continue down this path of strengthening the ETS in the long run by proposing more significant structural reforms.”

The backloading proposal still needs to clear several more hurdles, although analysts say last week’s vote was the toughest. Traders expect the Commission to begin withholding allowances next year.

Structural reforms, however, are likely to be years off, given the drawn-out processes involved in European policy making. Elections next year to the European Parliament are likely to slow deliberations, and most observers don’t expect reforms to be agreed until 2017. But last week’s vote shows there is political will to fix Europe’s carbon market, say participants.

“The ‘yes’ vote should provide a short-term boost to carbon prices and confirms the EU’s commitment to the success of the ETS and to implementing the long-term improvements that are still needed,” says Thomas Rassmuson, a Founding Partner at CF Partners, a risk advisory and investment firm specializing in renewables and commodities.

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