The European trading system has worked — and a new report details lessons for U.S. climate bill

Europe made a major commitment under the Kyoto protocol that U.S. conservatives have been telling us for years they would never achieve. It now seems clear they will meet their commitment under the terms of the protocol. It will become increasingly difficult for those who don’t want a U.S. cap-and-trade system to point to the European Trading System (ETS) as an obvious failure — as discussed in this June CP post. CAP’s Austin Davis has some lessons learned for U.S. legislation.

This week the German Marshall Fund of the United States released a useful new analysis of the European Union Emissions Trading System (EU ETS) designed to offer powerful and positive recommendations to U.S. policymakers as they debate the design of a potential cap-and-trade program.

The paper’s authors hail from a wide range of prestigious academic and the clean energy backgrounds: Michael Grubb, chief economist of the UK’s Carbon Trust and chair of Climate Strategies; Thomas L. Brewer, research director of Climate Strategies; Misato Sato of the London School of Economics; Robert Heilmayr of the World Resources Institute; and Dora Fazekas of Climate Strategies. Their premise for the report is straightforward:  While American opinion makers and policy makers vaguely know that Europe has a cap-and-trade system in effect, the lessons we can learn from it and its real and substantive benefits are too often ignored in our public debate. This report aims to fix that.

And the reason Americans should know more about the EU ETS is because it’s working. Since 2005, Europe’s cap-and-trade system has established a carbon market worth ‚¬40 billion (US$56.6 billion) annually and, despite initial stumbling blocks, has reduced emissions by 50-100 million metric tons of CO2 per year (or by around 2.5-5%). Simultaneously, European businesses benefit from Europe’s transition to a carbon-free economy since “the EU ETS has increased overall profitability in all participating sectors” while supporting a sizeable boom in clean energy jobs in spite of the global recession.

However, Europe’s multifaceted successes required Europeans to carefully evaluate their ETS and reconfigure it on the fly – uncertainties and tribulations that American consumers business can largely avoid. The Europeans divided their cap-and-trade scheme into three phases to provide pause for analysis and reevaluation; this allowed them, for example, to halt the unfortunate practice of European utilities whereby they passed almost all of the costs of carbon onto consumers, reaping huge windfalls from the ETS’s free carbon allocations. While Waxman-Markey effectively shields consumers from these abuses “by giving power sector allowances to distribution companies, which then sell these to generators and have an obligation to use the revenues in part to support energy efficiency programs,” this kind of acumen seems rare among American policymakers and rarer still in the public debate:

“Many U.S. analysts and politicians know about the EU ETS, but not the analysis that shaped it, the stages of its evolution, or what has been learned. Yet the history of the EU ETS is rich in lessons. This report presents some of these insights, with a particular focus upon the issues around allocation of emissions allowances, costs, competitiveness, and carbon leakage impacts of a cap-and-trade system.”

And those insights need to be on the tips of policymakers’ tongues. While aspects of the EU ETS still need reform – like its “much greater than originally anticipated” reliance on emissions offsets from the Clean Development Mechanism (CDM) in spite of CDM’s gross inadequacies in pricing, measuring, and effectiveness – this report provides extremely pertinent information at a crucial time in the domestic debate.

The report’s ten primary conclusions and recommendations are as follows:

1. Emissions trading works

Recommendation: Develop an emissions trading system that learns from and improves upon the EU experience.

2. Everyone will learn

Recommendation: Build in a capacity to strengthen the system if and as experience supports this.

3. Prices can be volatile and impacted by numerous unforeseen factors, which to date have reduced prices below expectations

Recommendation: Consider carefully the lessons from the EU experience on price volatility, around unavoidable uncertainties in emission projections, the contribution of other policies, and systematic tendencies to underestimate the abatement and innovation responses.

[JR:   The volatility problem can be dealt with through ‘price collar plus’ — though certainly because the 2020 target is too weak, U.S. emissions allowance prices are likely to stay on the low side.  That said, our Energy Information Administration has a much better handle on total US emissions than Europe had, which is one reason why they issued to many par myths and the price crashed.]

4. GDP impacts are small

Recommendation: Don’t let concerns about macroeconomic impacts dictate the environmental targets, Economic impacts have been consistently less than projected.

5. Industry can profit

Recommendation: Resist inevitable pressures from industry to maximize free allocation, but engage companies more constructively in designing and understanding the full implications of the system.

6. International competitiveness impacts are limited to a small number of industry sectors

Recommendation: Concerns about competitiveness impacts should focus on a few potentially exposed industries. For these, tailored solutions should be pursued.

7. Free allocation degrades efficiency and introduces risks either of windfall profits”¦

Recommendation: Design to minimize net impacts on the aggregate profitability of incumbent sectors, whilst boosting the profitability of cleaner technologies and innovators. Consider possible parallels between electricity production and upstream allocation to refineries.

[JR:  And that is the point of the US allocation scheme — see Robert Stavins: “The appropriate characterization of the Waxman-Markey allocation is that more than 80% of the value of allowances go to consumers and public purposes, and less than 20% to private industry.”]

8. “¦ or additional inefficiencies

Recommendation: A balance of free allocation between absolute and output-based should strive to minimize economic distortions as well as windfall profits. The balance between these two negatives should reflect each sector’s ability to pass through prices, its exposure to international leakage, and its potential for emissions abatement through radical innovation or demand reduction.

9. There is a compelling economic rationale to maximize auctioning

Recommendation: Maximize auctioning.

[JR:  Can’t argue with that.  Waxman-Markey makes what allocations are needed to get a bill passed, but over time the percentage auctioning rises pretty steadily.]

10. Unilateral border adjustments may be a politically appealing way to respond to domestic pressures from special economic interests, but they risk serious problems in the international trade system

Recommendation: Negotiate multilateral arrangements to contain or structure the use of border adjustments, focused upon minimizing emissions leakage, as and when specific problems can be demonstrated.

As an American, it’s difficult to avoid feeling embarrassed by successes of the EU ETS – in spite of its missteps – relative our complete failure to address climate change thus far. While Europe reaps the economic benefits from a clean energy transition and significantly reduces its carbon emissions, we have made almost no legislative efforts on either front. Whether the next report comparing Europe and America’s climate legislation is as one-sided as this one will be decided in the Senate during the coming months – and, hopefully, this paper will help make sure that we can hold our own.

6 Responses to The European trading system has worked — and a new report details lessons for U.S. climate bill

  1. Greg Robie says:

    …and then there is this reported view:

    If cap & trade “works,” does it work in a way that is relevant to what the science—and, more importantly, the trends in that science—requires; as initially envisioned? Does it lead to a systemic redressing of the economic injustice inherent to our “low context” society and its precept of what is sustainable economic activity?

    IMHO, if what is currently thought of as “profit” is accommodated by cap and trade, systemically, cap and trade does not work. Denial (and/or, as a subsequent guest post frames as a matter of ethics) withstanding, those who argue for “profitable” dynamics as a metric for assessing the viability of cap and trade and “working” are trapped in motivated reasoning. A carbon based—and dependent—economic model’s profit is systemically challenged to ever be scientifically green.

  2. Mike#22 says:

    As a self selected group, most readers of CP get the ethical case for GHG controls. That’s not America, though. As a country, we just aren’t ready to spontaneously pursue efficiency/renewables, and leave the carbon underground where it has been for the past millions of years. Few countries are. Especially given how effective companies are at marketing their products to consumers.

    The world’s nation’s leaders still have to get the job done. Enter Cap and Trade.

    The EU TS is undergoing constant revision and improvement. I think we are seeing something new and marvelous here. The future health of the biosphere has somehow been connected to tradeable allocations today. Their market is firming up steadily and soon to be harmonized with Kyoto Protocol CDMs.

    Is this stealth ethics? What is the difference in the end if the emissions are achieved? Especially if one considers that an efficient carbon market, funding sweeping chnages in our energy infrastrutcer, is the most efficient way to get this done?

  3. Greg Robie says:

    “The difference, relative to “stealth” and “orthodox” ethics, is that if what is accomplished by “stealth” is inadequate to the challenges of kilmakatastrophe the society is left up the proverbial Sh_t Creek without a paddle and will be trashed in the rapids of social chaos that will ensue —should that “if” come to be. IMHO, such is not much of an “if”—given the trend is the science— and reaching the 20% reduction of 1990 GHG emission by 2020 and 80% by 2050 as is currently scientifically/mathematically required to achieve no more than a 2° C rise in global average temperatures (and/or 350/350e).”

    BTW, “stealth ethics” is a descriptive term. Considering it, I find myself wondering what the systemic difference is between it and prohibition relative to effecting ethical behavior. Functionally, I feel they are similar. In any event, when the task is as challenging as what homo sapiens face regarding AGW, will either—should they be different—really “work?”

    In matters of ethics I find it instructive to remember that those from outside our low context greed/fear addicted social meme (3rd world elders) told, any who would listen in Rio in 1992, that the first world needed an ethical revival (though they called it a—from a liberal meme, un-politically correct—religious revival) if the world was to be saved. We have and have had one. It was/is global capitalism and its perceived profit grounded in the three “E”s (exploitation, extraction, and externalization). Turning a bit prophetic and trying to poorly pun, what profit is it to a person and/or a privileged elite if it gains the “gold” and loses the world?

    Regardless, don’t ethics have to be “religiously” lived to be, well, ethics?

  4. Shelly T says:

    A 2.5-5% reduction in emissions in four years doesn’t qualify as “working”. That’s the definition of “Not working.”

    [JR: The ETS was about meeting the Kyoto target — not reducing emissions in the last 4 years. true, many European countries mandated massive amounts of renewables and efficiency first — which is how they kept their emissions so close to the target — but that isn’t a fault of the ETS.]

    It would have to get up to 10-20% to qualify as actually making a difference.
    Serious conservation would do a lot more than cap and trade. Why not a big push for conservation rather than cap and trade? Or a real tax on carbon and then watch the conservation happen naturally.

    Cap and trade is a ridiculous scheme that won’t come close to doing enough, in time. It’s obvious.

    Is the goal of all of this to create wealth and jobs for a lucky few? Cap and trade might work for that. For reducing emissions, it’s a joke.

  5. Mike#22 says:

    Ah, don’t know where to start.

    First, a “Or a real tax on carbon and then watch the conservation happen naturally” is proven a non starter. Lots of American have excess wealth, and energy is already expensive. The only conservation going on is because of regulations like Energy Star and Cafe etc. (and yes, a neglible fraction of people building or living low carbon life styles. Good on them.) So the concept of “make energy expensive, dividend the tax, and people will foster a low carbon economy” has serious believability issues. Where is an example of wealthy communities faced with high energy cost going low carbon?

    “Is the goal of all of this to create wealth and jobs for a lucky few? Cap and trade might work for that. For reducing emissions, it’s a joke.”

    Three strawmen!

  6. Thijs Moonen says:

    Tiny mistake:

    …those who don’t want a U.S. cap-and-trade system to point to the European Trading System (ETS) as an obvious…

    ETS stands for Emmissions Trading System instead of European Trading System thus EU EMS