A slump in carbon's price does not mean the trading scheme is a failure

The fall in carbon prices is short-term and businesses continue to invest in low-carbon technologies

James Murray
guardian.co.uk, Tuesday 10 March 2009 14.21 GMT

Just as the world's nosediving financial markets are having to defend themselves against the charge that it's the whole system that is rotten, not just a few greedy bankers, the still embryonic European carbon market is similarly engaged in a fight for survival as the price of a tonne of carbon plummets and environmental commentators line up to say "I told you so".
The speed with which the price of EU emission allowances (EUAs) has fallen from a high of €31 last summer to a low of around €8 last month lends plenty of weight to Julian Glover's recent assertion that the market is "in meltdown" and "failing in its purpose: to edge up the cost of emitting CO2".
But, with apologies to Mark Twain, reports of carbon trading's death have been greatly exaggerated. There remain flaws in the EU emissions trading scheme (ETS) but the charge that it has failed and actively encourages firms to pollute simply does not stack up.
The fall in carbon prices is the result not of the failure of the ETS, but the failure of the wider economy. The collapse in industrial output caused by the recession has led to falling emissions from many steel, aluminium, chemicals and power plants, leaving them with far more carbon allowances than they need. At a time when most businesses are cash-strapped they are happy to sell these excess credits and, as a result, supply of EUAs has outstripped demand, driving down prices.
It is by no means an ideal scenario. Carbon prices of under €10 have made it more cost-effective for some energy companies to burn carbon-intensive coal as opposed to cleaner gas, while the EUA glut has meant European firms no longer need to import carbon credits from emission reduction projects in the developing world to help cover their emissions, making it harder for those projects to attract investment.
But that is not to say the lowly price of carbon constitutes market failure, not least because the overarching cap on emissions has not been breached. Equally, that cap is lower now than during the genuinely disastrous first phase of the scheme when oversupply of EUAs was so severe prices fell to almost zero. Demand for allowances may have dropped but it has not collapsed altogether, and despite continued bleak predictions for industrial output the price of EUAs has stabilised at between €8 and €10 over the last couple of months and even crept back up to €11 last week.
Moreover, this is not a long-term issue. The emission caps are sacrosanct, meaning that as soon as industrial output recovers (and it will eventually) demand for carbon allowances will soar as firms buy more EUAs to cover their rising emissions. At this point a spike in the price of carbon is inevitable. And, if recent market whispers are accurate and cash-strapped plants in Eastern Europe are raising short-term funds by over-selling allowances they will only have to buy back later, then that price spike could be dramatic.
Most firms operating under the ETS know this and are planning for the price of carbon to recover to between €20 and €30 by 2012 and then rise steadily as emissions caps are lowered by 1.74% a year up to 2020. They also know that the number of free allowances will dwindle from 2012 onwards, forcing them to buy more EUAs at auction.
Regardless of the current low price of carbon, these factors are influencing investment decisions right now. Executives at Shell, for example, said recently that plans for a carbon capture and storage project in the Netherlands were informed by the expectation that the supply of carbon allowances will become constrained. Similarly, steel giant Corus has just completed a £60m upgrade of its plant in Port Talbot and is planning a wave of further energy-efficiency investments, which the company admits is driven in part by projections that the carbon price will head north. In this respect, the ETS is doing exactly what it set out to achieve: providing firms with a financial incentive to invest in low-carbon technologies.
None of this is to suggest the ETS is perfect. But while improvements to the scheme could and should be made, to suggest it is failing is not only inaccurate, it undermines a market that is reliant on confidence if it is to prove successful. It might not be perfect, but with the point at which global emissions must peak getting ever closer, and Australia, New Zealand, South Korea, Japan, and — most significantly —the US all planning to introduce their own cap-and-trade schemes, carbon trading is arguably the most important weapon we possess in the battle to cut emissions.
• James Murray is the editor of BusinessGreen.com