With emissions falling amid the economic downturn, the price of carbon in Europe recently dipped below €10/tonne. Falling prices prove that carbon markets function on one level, but can they reduce carbon emissions in the long run?

In the long run, said the rehabilitated economist John Maynard Keynes, we are all dead. If the consensus among scientific experts is correct, then collective ‘death’ is accelerating, via climate change. So, if we accept climate change is the mother of all problems facing planet Earth, then action is needed now to curb harmful emissions. This much we know.

EU ETS Carbon Allowance (EUA) December 2009 futures contract settlement price Source: European Climate Exchange
Click here to enlarge image

However, a major mechanism for taking this action – emissions trading – has come under attack after the price of a tonne of carbon in Phase II of the European Union Emissions Trading Scheme (EU ETS) fell to a new low of around €8 ($10) last month, down from around €31/tonne in July 2008.

The fall in price reflects falling emissions and a rush in the selling of permits, raising around €1bn for cash-strapped, credit-crunched firms. So, as a price mechanism, the market appears to be functional; demand for permits has fallen, the supply has risen and – more importantly – carbon emissions are down.

So why is the power industry not entirely happy? Well, critics of the EU ETS argue that pollution is now too cheap, making renewable generation such as wind and solar power even less cost-competitive than the burning of fossil fuels.

We have seen this before, of course, following the collapse of the carbon price during Phase I of the EU ETS. In Phase II of the scheme, however, some of the permits have been auctioned, rather than ‘grandfathered’, i.e. given free to polluters.

What we are now seeing is the market reacting in part to falling emissions, rather than merely a heavy sell-off of permits, and the subsequent price plunge has exposed some of the flaws inherent within this particular market-based approach to carbon mitigation. The main criticism leveled at the EU ETS by power generators is that it does not offer any certainty, and without a clear long-term carbon price, they cannot accurately measure the payback time of an investment in a low carbon technology.

Vincent de Rivaz, chief executive of the UK arm of EDF, recently called for EU member states to revisit the ETS so that it offers a more certain carbon price. Tony Hayward, chief executive of oil major BP, said a predictable carbon price would “make vast numbers of alternative energy sources competitive.”

Governments, so goes the theory among some dissenters, should set a floor for carbon permit auctions to ensure power generators know the minimum they will have to pay to cover their carbon emissions each year.

Mark Lewis, an analyst at Deutsche Bank, told the news agency Reuters that a ‘reserve price’ for permits auctioned from 2013 would be a good way to offer stability, as would modifiying the rate at which the permit supply will decrease from 2020. The latter approach, said Lewis, would be “a very powerful policy lever because it means you can influence today’s supply by signaling a change to that reduction rate in the future.”

Reducing the supply of carbon permits is crucial to effective carbon trading because unlike ‘classic’ commodity markets, where lower prices trigger supply destruction, the supply of carbon is rigid and does not adapt to price changes.

That carbon dioxide is not a ‘classic’ commodity – it is a negative externality – begs the question whether it should not be traded, but taxed. Proponents of a carbon tax include none other than Rex Tillerson, CEO of ExxonMobil, who believes that it is “a more direct, more transparent and more effective approach” than a trading scheme, which, he says, “inevitably introduces unnecessary cost and complexity.”

The Achilles’ heel of the otherwise convincing case for a carbon tax is that politicians would be faced with the difficult challenge of setting the right price. Set it too high, and it would be economically crippling. Too low, and it would not achieve environmental objectives.

So it seems that the cap-and-trade approach is here to stay. Indeed, US President Barack Obama has proposed a cap-and trade scheme to launch in 2012 that would see 100 per cent of permits auctioned from day one, though possibly with both a price floor and price cap – effectively a tax.

The scheme could eventually be linked to the EU ETS, forming the central plank of new international climate treaty to replace the Kyoto Protocol after 2012, which is scheduled for agreement under the auspices of the UN in Copenhagen in December.

In the long run, a global carbon trading scheme may be more effective than 192 governments attempting to coordinate tax policy.