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The European emissions trading scheme (ETS) was launched with great fanfare last year. The idea was to require certain energy-intensive industries to have a permit for each ton of greenhouse gases they emitted. Each industry would be allocated a certain number of permits. If they needed more, they would have to buy them; if they were able to cut emissions below their allocation, they would be able to sell them. The idea seemed wonderful in theory—a "market-based" way to reduce emissions. In practice, the market has been a roller-coaster, reaching record highs of over €30 per ton before collapsing to just €11 last week. <?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />
What caused the precipitous collapse in price was the early reporting by France, the Czech Republic, Estonia and Holland that their emissions for 2004 were not as high as their allocations, along with the announcement by Spain that it had exceeded its allocation, but not by as much as thought. Traders reacted immediately on the assumption that other countries would make similar announcements, although this is likely to be premature, and the fear of a market glut drove prices down. To understand what happened we need to think about what the market price of an emissions permit actually represents.
A price is essentially information. At its simplest, the price paid for a permit represents merely the cost of undertaking the activity for which the permit is granted. Permits have been auctioned in the past at least partly to establish the true level of such costs. However, when permits are traded, extra information is added that changes the price from a mere reflection of the cost. Scarcity value is the most obvious example: when the market believes permits will be scarce, their value increases. If there will be enough for everyone who wants one to get one, no scarcity value will be added. Thus a rise or drop in price will reflect the market's greater emerging knowledge about the actual level of scarcity involved.
Prices can rise or drop quicker when speculation is involved and traders are essentially gambling that scarcity will be greater or less than the market as a whole believes. Wide price fluctuations, therefore, inevitably represent a lack of complete information about the nature of the market. Political uncertainty or lack of transparency related to the market merely lessens information available and therefore contributes to market uncertainty (this should be borne in mind when considering demands to keep emissions information secret).
With this in mind, we can look at the history of the European emissions market. When it was first mooted, there were fears of high prices imposing massive extra costs on industry that would be passed on to consumers. Eurocrats rushed to reassure the market this would not be so. For example, in October 2004 Spain's Cristina Narbona  took to the airwaves to angrily deride a KPMG projection of prices in the €15-20 range as "false"—if also asserting that such prices would indeed be cause for panic—insisting instead that €5-6 was the reasonably anticipated price.
What happened next needs to be understood in the context of the national allocation plans. It is widely agreed that European member states, not wishing to see their national industries suffer, submitted overly generous allocation plans to the European Commission. The exception was the UK, which was serious about its commitment to reducing emissions. However, on seeing that its allocation plan handicapped British industry by essentially requiring them to purchase foreign credits, the UK government took the Commission to court to try to get its allocation plan replaced with a more generous one.
Meanwhile, the market price swiftly reached KPMG's estimate and then surpassed it. Traders were worried about the emissions associated with a forecast (and actual) cold winter and bid up the price. Large companies with large allocations therefore found themselves sitting on a gold mine. At the same time, the cost of the permits drove up energy prices. A study by UBS Investment Bank, for instance, found that most of the energy price increase in Europe last winter was due to the cost of emissions permits. This prompted calls from environmental groups for windfall profit taxes and other measures to remove the "unearned" value of the permits from the hated industries.
This is important. When traders do not have the information to act rationally they have a tendency to act irrationally, on hunches or gut feeling. In a politically charged market such as the carbon permit market, traders will also react to statements by major political players. Environmental groups demanding tighter allocations or auctions, for instance, will cause traders to take this political risk into account, the implied increase in scarcity almost certainly driving the price up.
The recent market dive has also been the result of incomplete information. The countries that have reported surpluses on allocation are not major emitters. The major emitters like Germany and the UK are due to report on May 15. It is possible that they will not have the same surpluses, which may cause the market to rebound slightly. On the other hand, it is also possible that they will report emissions lower than allocation, in which case the market will collapse completely.
What does all this mean? First, even at the current market price it suggests that cutting emissions is more expensive (at least twice) than the scheme designers supposed. Unsurprisingly, this has had an effect on energy prices. Proposals to tighten allocation plans would probably cause the price to rise again, reflecting a much higher economic cost of reducing emissions than envisaged. Proposals to auction rather than grant permits would presumably see a very steep rise in the market price, as industries are forced to pay for things they do for free now. Energy prices would skyrocket.
Meanwhile, it should be remembered that the ETS covers only about 40 percent of all emissions in the EU. Report after report from the European Commission confirms that overall few countries are anywhere near their reduction targets, hence the symbolic importance of the ETS. If other sectors, such as aviation, were to be brought within the ETS then the market would probably react as it did in 2005, bidding the price up in lieu of information about how easily the new sectors could reduce emissions. This would in turn have an effect on the sectors already within the scheme. The market is still feeling its way; expansion to include other sectors would increase uncertainty and result in further volatility at a crucial stage.
This all suggests that speculators who have offloaded permits at the current price are reacting to the high cost of emissions reduction. They are guessing that member states and the Commission will be unwilling to impose further restrictions that would send the price up higher.
This supposition would also be confirmed if the major emitters also report emissions below allocation next week. The price would collapse, because it would prove that member state governments were unwilling to restrict emissions by means of tighter allocations; there would be no scarcity value whatsoever to the permits.
So has anybody won from the ETS? Overall, emissions are not reducing and the high costs of the ETS suggest it will not be used to reduce emissions further unless governments are willing to slow economic growth (which is unlikely). Consumers have seen energy prices rise, then fall, for seemingly no reason. Industries, while at one point benefiting from a bull market, have seen millions wiped off their values by the recent collapse and may see yet more value disappear. Politicians and greens cannot claim vindication as the cost of emissions reduction in the event of (perceived or actual) scarcity has been revealed to be much higher than they thought, while companies are experiencing the volatility of an uncertain market and consumers have paid the price.
It should also be mentioned that volatile markets are particularly prone to manipulation by the unscrupulous. Enron recognized the potential volatility of carbon markets when it lobbied hard for their introduction in the United States. Badly structured markets where transparency is lacking are to the rogue traders like pheromones in the insect world.
One final note: the ETS is most emphatically not an example of market failure. The uncertainties are all a result of government action—inadequate allocation plans, misunderstanding of how much it would cost to reduce emissions, political risk associated with demagoguing special interests and lack of transparency. The fatal conceit led European governments to think they could design a market to produce the outcome they want. Surprise, surprise! They were wrong.
Iain Murray is a Senior Fellow at the Competitive Enterprise Institute.