Europe’s Carbon Market Collapses–Should We Worry?

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First, a quick recap: The whole idea behind a cap-and-trade regime is that the government sets a nationwide cap on greenhouse-gas emissions and then auctions off (or hands out) tradable pollution permits to companies. The price of the permits depends on supply and demand, and, as in all markets, there’s not necessarily a “correct” price. Countries generally prefer that the price of carbon doesn’t rise too sharply and crush the economy, but other than that, there’s no reason to fix prices. As long as the cap is set at scientifically sound levels and keeps ratcheting down each year, then prices should adjust accordingly, emissions should go down, and the system should work.

So I’m not sure I entirely agree with James Kanter of The New York Times that it’s a problem that, in Europe, permit prices for carbon have collapsed. Back in 2005, prices dropped to zero because the EU set the cap too loosely and handed out more permits than companies even needed—that was a real flaw, and it still hasn’t been totally patched up. This time around, though, permit prices are plummeting mainly because a global recession has scuppered economic activity across Europe, and companies are polluting less. They’re also using more natural gas and less coal. None of that is a concern per se. Carbon emissions are, after all, still going down.

Indeed, this might even be an advantage of having a cap-and-trade regime instead of a carbon tax: During recessions, emitting carbon becomes cheaper under a cap (because fewer people are doing it), so companies can postpone decarbonization projects until the economy starts booming again and they can spare the extra funds to do so. On the downside, however, falling permit prices do cause investments in renewable energy to shrivel up, something less likely to happen under a steady carbon tax. It’s not immediately obvious which would be a better outcome. This might bolster the case for a price floor in a cap regime—a sort of hybrid approach.

Ezra Klein also delved into the price issue recently when he wrote: “Cap and Trade makes dirty energy more expensive. The better the bill, the pricier dirty energy becomes.” That’s not quite right, either. Granted, a tighter cap will typically lead to pricier permits (as supply gets restricted), but the relationship isn’t ironclad. Again, from an environmental perspective, what mainly matters is that the cap is set correctly—ideally, a U.S. cap would follow the recommendations of the IPCC and follow a path to reduce emissions 80-90 percent below 1990 levels by 2050. But it also helps if Congress finds ways to make it cheaper for companies and households to meet those targets—by, say, upgrading the electric grid or rejiggering utility rules to make waste-heat capture and efficiency upgrades more viable. Both of those things would lower permit prices, but so what? Cranking up the price of dirty energy isn’t an end in itself.

Incidentally, this is the main thing that differentiates a carbon tax from cap-and-trade. With a tax, we know in advance how much it will cost, but aren’t sure what emissions level will result. With a well-enforced cap-and-trade regime, we know the maximum level of emissions we’ll get, but aren’t positive how much it will cost to get there (that’s one rationale for well-designed safety valves to create a bit more price certainty, though open up too many valves and you’ve eviscerated your cap). Both can have unexpected side-effects, as we’re seeing in Europe, but that doesn’t mean the problems are fatal.