Market data

What about the market? (Source: Financial Times)

As part of the latest budget the UK government announced its intention to introduce a price floor for the emissions market. It is hoped that this move will encourage low carbon investment by disincentivising regulated entities from emitting at current levels.

How this proposed unilateral measure will interact with the EU ETS remains to be seen. The purpose of emissions trading is to give polluters the discretion to decide whether to buy more EU emissions allowances (EUAs) in the market or invest in greener technologies, depending on which avenue is more cost-efficient. Having to pay a pre-set price for EUAs effectively removes this choice and distorts the emissions market as the cost-benefit calculation has already been performed by the regulator.

A tax by any other name…

The effect of the carbon price floor would be akin to that of a tax on emissions, since it would guarantee a minimum price level which UK polluters would have to pay to the government irrespective of the real market price of EUAs. It has not yet been clarified how this would operate in conjunction with trading under the EU ETS; one option would be to require polluters to make up the difference between the market price and the minimum set price. This would provide the UK with a hybrid tax-trade approach to emissions reductions, whilst the other EU Member States remain wedded to the EU ETS only.

A key advantage of a carbon tax over a trading system is the guarantee that the revenues from the former accrue to the national government rather than to polluters. This makes it more likely (at least in theory) that the money will be spent on low carbon initiatives rather than simply being reinvested in the polluters’ business or helping to boost their profits. The flipside is that regulated entities do not enjoy the cost-balancing flexibility associated with emissions trading. A proposed EU-level carbon tax was in fact rejected by industry in the 1990s.

Design issues

A cap-and-tax system could work well to reduce emissions if appropriately designed. Specifically, the price would have to be set at a level which is neither excessively high (so as not to seriously stall productivity) nor woefully low (which would be of little help in motivating polluters to reduce their emissions).

Of course, the price level would also have to take into account the fluctuations in the emissions market and would thus have to be crafted in a way which allows for any requisite adjustments.

What hope is there left for the market?

The proposed hybrid system makes the regulator’s job easier as it removes the uncertainty associated with fluctuations in the market price of CO2, which has recently fallen to around €12/tonne. This has been caused by overallocation of EUAs to polluters and decreased levels of productivity due to the difficult economic climate.

On the other hand, the whole point of having a market in emissions is that the price level is left to be freely valued by supply and demand, as with conventional markets. A cap-and-tax system would enable the UK government to artificially manipulate the price of EUAs and thus unilaterally interfere in the EU-wide emissions market as national environmental policy dictates. This is concerning as it undermines the very notion of market freedom on which the EU ETS is premised.

Either one or the other

Paradoxical as it may seem, if the EU emissions market is to function effectively, some level of price volatility is in fact desirable in order to incentivise entities engaged in emissions trading for investment rather than compliance purposes to take part. Tying the EU-wide price of carbon to Member State national environmental policy sends out the wrong signals as it strongly suggests that the market may not be genuinely free.

The UK government may be rightly concerned about the adequacy of the market price for carbon as a tool of environmental policy aimed at achieving emissions reductions. However, it cannot have it both ways without significantly diverging from the uniformity of the EU ETS.

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