Cap-and-Trade is Faltering in Europe, But the Problem Isn’t What You Think It Is

The last couple weeks have seen a steady stream of news articles heralding the near-death of Europe’s cap-and-trade system. The basic story is straightforward. After the European Parliament declined to effectively tighten the emissions cap in the continent’s Emissions Trading System (ETS), prices for emissions permits plunged. Since high permit prices are required to drive serious energy-system transformation, many people have concluded that the ETS – and by association cap-and-trade more broadly – is bust.

Some analysts have responded by pointing out that low prices don’t signify failure per se. They’re correct up to a point. The goal of a cap-and-trade system is supposed to be to drive emissions down to preset levels at the lowest possible cost. If achieving those goals turns out not to require much effort, then carbon prices are supposed to fall, signaling to the energy system that it ought not work too hard. That’s what’s happened in Europe: a weak economy has reduced emissions already; the cap-and-trade market is telling power producers not to push too much more. Indeed this is a great feature of cap-and-trade, because it makes the system countercyclical, lowering costs when the economy is it its weakest.

But this analysis alone shouldn’t be satisfactory. The European experience is revealing (or, depending on your previous beliefs, reinforcing) a basic problem with cap-and-trade.

The problem underlying the European predicament is that politicians apparently don’t want to do all that much about climate change, at least not if they’re going to pay a price with voters. Alas cap-and-trade makes climate-change curbing effort highly visible: the more you’re trying, the higher the price of permits is, and the higher electricity prices rise as a result. Roger Pielke has pointed out repeatedly that consumers really don’t like this sort of thing. And as David Victor has argued, that makes politicians inclined to pursue policies whose costs are hidden rather than clear. The current experience with the ETS gives both of their arguments some reinforcement. The fundamental problem in Europe right now isn’t that cap-and-trade is a technically flawed mechanism; it’s that politicians don’t want to act strongly on climate change. And the fact that acting strongly through cap-and-trade is likely to inflame political opposition means that the centrality of the ETS to European policy doesn’t help if implementing an ambitious policy is your goal.

Would the same thing that’s happening in Europe have happened had cap-and-trade been implemented in the United States? The Waxman-Markey bill mandated a 3 percent emissions cut from 2005 levels by 2012; that would have been met with a zero carbon price. And it is extremely unlikely that U.S. policymakers would have stepped into push up carbon prices. In principle, though, this would have been mitigated by two features of the U.S. system: a long time horizon (targets were set through 2050) and permit banking that should have created an incentive to hoard permits today for use later, pushing up near-term carbon prices and driving near-term investments. Whether that dynamic would have actually happened the way I’ve described would have depended strongly on how credible people thought that system was; any threat that it would be weakened or scrapped would have reduced the incentive to hoard and kept carbon prices low.

What should all this teach us? One thing it should do is reinforce that a serious and transparent carbon price may be much tougher to pursue that clumsy and less cost-effective carbon policies. It also suggests, though, that in crafting a carbon policy, it may make sense to make lots of the tough decisions at once -- a la Waxman-Markey with its targets through 2050 -- rather than forcing politicians to repeatedly do things that voters dislike (e.g. tighten or extend emissions targets, as the European scheme ultimately requires). Alas these two lessons work against each other, since forcing larger numbers of difficult decisions to be made up front makes a policy less likely to be adopted in the first place. All of this suggests that, if we’re going to get serious about climate change, it will likely take considerably more than just carbon pricing in order to succeed.