Lawmakers Act to Raise European Carbon Price

By Emil Dimantchev

In mid-December, the European Parliament approved a measure to support the European carbon price. Following two years of discussions and an initial rejection of the proposal, lawmakers reached a broad majority in support of the so called ‘backloading’ plan. This will now allow the EU executive to temporarily withdraw emission permits from the market. Dubbed “a turning point for the market” by legislators and “a confidence boost” by analysts, the move will likely help revive the European carbon market, at least in the short term.

The trouble with EU climate policy

High carbon investments continue to be economical in Europe, despite the continent's ambition to limit global warming below 2˚C. This is partially due to the fact that the EU has failed to set a binding emission target for 2030, on the back of resistance from coal-reliant Poland. The other main reason is the fall of the European carbon price which dropped from around 30 euros in 2008 to single digit levels in 2013. A result of the financial crisis and Europe's unexpectedly strong growth in renewables, the low carbon price reflects the fact that EU's aim to limit emissions to 20 percent below 1990 levels is too easy to meet. Low carbon prices and a lack of emission targets beyond 2020 have left investors little incentive to promote low-carbon technologies. The EU thus risks locking its energy infrastructure in highly emitting technologies which are inconsistent with the its ambitions to limit global warming below2˚C. Recognizing this, policy markets have been scrambling to find ways to increase the carbon price.

Backloading: a step in the right direction

By implementing backloading, European regulators will withdraw permits equivalent to 900 million tons of CO2 over the next three years and reintroduce them back into the market in 2019 and 2020. This is expected to increase carbon prices from around €4 ($5.49) currently to €6 ($8.24) next year and €8 ($10.99) in 2015. Prices will however likely drop again towards the end of the decade as the withdrawn permits return to the market. Backloading will therefore have little effect in the long term. The measure’s most important effect lies with the policy signal it sends to emitters.

Having taken action to boost carbon prices, policy makers reaffirm their backing for carbon trading as a climate policy instrument. Participants in the EU ETS now have more confidence that the market will continue to operate as a key EU policy rather than be discarded as a failed experiment. A higher certainty for the continuation of the scheme will probably have an impact on investment decisions as well, although one that is difficult to quantify. Backloading therefore supports the market in the short term, buying time for policy makers to make structural amendments to the EU carbon market.

Carbon markets evolve towards flexible supply

The intervention in the EU ETS mirrors a similar move by regulators across the Atlantic. The nine states operating the first U.S. carbon market, the Regional Greenhouse Gas Initiative (RGGI), decided in February to reduce the cap in the market by 45 percent. The RGGI carbon market was previously oversupplied, but analysts now expect emitters to be short of permits, leading to an increase in the carbon price.

The measures implemented in Europe and RGGI exemplify that the common carbon tax vs. cap-and-trade debate is a false dichotomy. Policy makers can put a price on carbon, which is determined by a market, but not allowed to deviate beyond desired ranges. California adopted this concept by incorporating price floors and price ceilings in the design of its carbon market. In the EU, the debate will continue on how to implement long lasting structural reform of the carbon market. Currently, one of the front-running options is to put in place a flexible supply mechanism which can adjust supply depending on changes in demand.

These changes reflect the evolution of carbon markets. Putting a price on carbon may not only be about reducing emissions at the least cost anymore. By managing supply, regulators can use carbon markets to send price signals that help incentivize energy markets along the path of decarbonization.

Emil Dimantchev is a carbon market analyst at Thomson Reuters Point Carbon. The views expressed in this article are his own, unless stated otherwise. Follow Emil on Twitter. 

Photo Credit: FMJ Shooter, Flickr