EU Carbon Market Crashes

Published July 1, 2006

The European emissions trading scheme (ETS), launched with great fanfare last year, has been a rollercoaster, with prices of permits reaching record highs of more than €30 per ton before collapsing to below €9 on May 12.

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 firms needed more, they would have to buy them; if they were able to cut emissions below their allocation, they would be able to sell the permits. The idea seemed wonderful in theory–a “market-based” way to reduce emissions–but in practice it has proven chaotic.

What caused the precipitous price collapse 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 by less than expected. Traders reacted immediately, on the assumption that other countries would make similar announcements, and the fear of a market glut drove prices down.

The countries that first reported emissions below allocated levels are not major emitters. The major emitters, such as Germany and the UK, reported their emissions later, on May 15. They did not have the same surpluses of allocation, which caused the market to rebound somewhat, moving above €15 after nations such as Italy and the UK announced less-surprising emissions reports.

Scarcity Changes Price

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 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 simple 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.

Speculation Creates Confusion

Prices can rise or drop more quickly 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.

This helps explain the history of the European emissions market. When the plan was first proposed, 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 denounce as false a projection by the international financial analysis company KPMG of prices in the €15-20 range, insisting instead that €5-6 was the reasonably anticipated price. This denial, however, had the effect of confirming that the projected prices would indeed be cause for panic if they proved true.

Governments Cooked the Books

What happened next arose from 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 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 found most of the energy price increase in Europe last winter was due to the cost of emission 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. The increased risk of new strictures almost certainly created a fear of coming scarcity, driving the price of permits up further.

System’s Flaws Exposed

All this activity suggests that even at the current market price, cutting emissions is at least twice as expensive as the scheme’s designers supposed. Unsurprisingly, this has pushed up 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 envisioned.

Proposals to auction rather than grant permits would presumably cause a very steep rise in the market price of fuel, as industries face being forced to pay for things they do for free now. Energy prices would skyrocket.

Not Working as Expected

The high cost of the permits suggests the ETS will not reduce emissions unless governments are willing to slow economic growth further, which is unlikely.

Consumers have seen energy prices rise, then fall, for seemingly no reason. Industries 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 of allocations has been much higher than they promised, while companies are experiencing the volatility of an uncertain market and consumers pay the price.

It should also be noted 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 rogue traders like pheromones in the insect world.

It is important to recognize that the ETS is most emphatically not an example of market failure. The uncertainties have all been results of government action: inadequate allocation plans, misunderstanding of how much it would cost to reduce emissions, fears of adverse political action by demagogic special interests, and lack of transparency. The fatal conceit of central planners led European governments to think they could design a market to produce the outcome they wanted. Surprise, surprise! They were wrong.

Iain Murray ([email protected]) is a senior fellow at the Competitive Enterprise Institute. This article first appeared on May 11 at Tech Central Station,, and is reprinted with permission.