Economics and politics - comment and analysis
12. May 2016 I Will Denayer I Ecology and Growth, Economic Policy, Europe

Why the market approach fails to lower greenhouse gas emissions. Part 2: the failure of the EU Emissions Trading System

I explained in the first part that we urgently need a comprehensive strategy in order to realise steep cuts in greenhouse gas emissions. According to economic orthodoxy, the introduction of carbon markets is the most effective way to accomplish this (see here). In fact, a carbon tax is an indefinitely better instrument – a carbon tax is much simpler and can be highly effective. The problem with carbon markets is that it is impossible to set a price that stands in a realistic relation to the damage that GHGs produce. Prices cannot be determined by demand and supply because pollution is not an ordinary commodity (its description of a commodity is fictitious – see below). Aside from that, markets are characterised by power relations, just as any other social institution, and they fail to reckon with the preferences of fictional actors (future generations). Let’s have a look at the ETS. We will explain carbon taxes in part 3.

  1. The EU European Union Emissions Trading System

The European Union Emissions Trading System (ETS) is the biggest CO2 emissions trading scheme in the world. It set an overall legal limit on CO2 emissions of over 11.000 power stations and factories (‘installations’) within 30 countries and accounts for almost half of the EU’s CO2 emissions. Each ‘installation’ receives permits to pollute which are called European Union Allowances (EUAs). The rest is up to the market: the scarcer these permits become, the more their prices rise. This makes pollution more expensive and encourages the reduction of emissions. Installations must report their CO2 emissions and ensure that they hand in enough allowances to the authorities to cover their pollution. If emissions exceed what is permitted by its allowances, an installation must purchase permits from others. Conversely, if an installation performs well, it can sell its leftover credits. In theory, this allows the system to find the most cost-effective way of reducing emissions without significant government intervention – which is always the neoclassical red thread.

How did the ETS work out? The price of allowances increased more or less steadily to a peak level in April 2006 to about €30 per tonne CO2 – according to many economists this is the minimum threshold for the trading system to become effective. Subsequently, prices dropped and never recovered. In May 2006, prices fell to under €10 per tonne. One year later, in March 2007, allowances were traded for € 1.2 per tonne before dropping to almost zero. In Phase II, the carbon price increased to over €20/tCO2 in the first half of 2008. It then dropped, first to €13/tCO2 in the first half 2011 and eventually to € 6.76 in June 2012. In January 2013, the EUA price fell to a phase II record low of € 2.81 – ten times too low to make a difference (see here).

Figure 1


Figure 1: evolution of carbon price per tCO2 compared to carbon taxes according to Helm. Source: Bloomberg.

Did the ETS reduce CO2 emissions? According to the European Commission, in 2010 GHGs from big emitters covered by the scheme had decreased by an average of 17,000 tonnes per installation, a decrease of more than 8% since 2005. Emissions from installations covered by the scheme fell by 11.6 per cent in 2009 (a drop of 246 MtCO2e), having fallen by around 5 per cent in 2008. However, as Oscar Reyes from Carbon Trade Watch writes, the figures need to be set against falls in production of electricity and industrial goods of 13.85 per cent in 2009 as a result of the financial crisis (see here and here). Germany consumed 4.8 percent less energy in 2011 than in 2008. This also made the prices of EUAs fall as industry required less allowances. The allocation of ETS permits was 159.5 MtCO2e higher in 2009 than the actual level of emissions (as Reyes says, this is roughly equivalent to the annual emissions of Spain (see here)).

The system did not function because the cap was much too high. This has always been the problem. Figures for 2010 show that emissions rose by over 3.5 per cent in 2010, compared to 2009 levels. The allocation of permits under the scheme was 3.2 per cent (57.4 MtCO2e) higher than the actual emissions measured from the ETS installations. The ETS miserably failed to deliver a consistently rising carbon price necessary for long-term, low-carbon investment. The third phase of the ETS will run from 2013 to 2020. The stated aim is to achieve a 20 per cent reduction in greenhouse gases by 2020 compared to 1990 levels (see here). As Reyes writes, this falls a long way short of what climate science suggests is needed to create significant impacts (see here).

According to UBS Investment Research, the ETS cost $287 billion through to 2011 and had an ‘almost zero impact’ on the volume of overall emissions in the European Union.  According to the UBS research, the money could have resulted in more than a 40% reduction in emissions if it had been used in a targeted way, e.g. to upgrade power plants (see here – see also Ellerman and Convery in Pricing Carbon on this (here)). The World Wildlife Fund also found that there was no indication that the ETS had influenced longer-term investment decisions. The ETS has failed to reduce emissions. What it accomplished instead was that it rewarded major polluters with windfall profits, while undermining efforts to reduce pollution and achieve a more equitable and sustainable economy (see here, here and here). This is a direct consequence of the market approach.

All of this has very well been documented. Companies have consistently received generous allocations without having the obligation to cut emissions (see here). According to Reyes, power companies gained windfall profits estimated at €19 billion in phase I and up to €71 billion in phase II (see here). For the most part, this resulted in higher shareholder dividends. Very little of the ‘profits’ were invested in transformational energy infrastructure. The third phase of the ETS still significantly subsidises industry. Energy companies successfully lobbied for an estimated €4.8 billion in subsidies for Carbon Capture and Storage (CCS) and biofuels. There was lobbying everywhere (Reyes gives concrete examples here and here). The final agreement contained a surplus of pollution permits for the cement sector that rewards the continued use of dirty and outdated production methods.

Energy-intensive industry routinely received extremely generous allocations of permits – a structural surplus of between 20 and 30 per cent in the case of the steel sector (our competitive steel that needs protection from China’s ‘excess’ capacity, who’s government has the temerity to intervene in the economic process (see here)). Oscar Reyes and Denny Ellerman and Frank Convery (see here) estimate the value of this over-allocation to industry in phase II of the ETS at €6.5 billion (mainly for steel and chemicals) (see here). As if this is not already beyond belief, rules governing the entrance of new actors to the scheme resulted in generous awards of free certificates for hard lignite plants, which contributed to a ‘dash for coal’ in German power production. All of this – remember – in order to fight climate change.

What did the population get from the ETS? Higher prices. Reyes writes that fossil fuel refineries and the steel sectors routinely passed on the entire “cost” of EUAs – which they received for free – to consumers. The windfall profits received by these sectors in the first phase of the scheme were estimated at €14 billion. When the third phase of the ETS was announced, full auctioning was heralded as being around the corner and, with it, the end of subsidies. However, by the time the Directive was agreed upon, industry had clawed back most of its free permits. Such is the power of lobbying (see here and here).

Several researchers made the point that even if ETS’s caps would be tight, this would still only encourage the cheapest emissions reductions and would not lead to transformational changes in energy, industrial production and transport. Of course, the caps were nowhere tight. This is the reason why the scheme had so little impact on emissions. Even when, in 2011, Germany closed eight nuclear power plants and demand for coal power increased as a consequence, the falling trend of prices for EUAs did not reverse. In fact, it is worse: CO2 prices also fell because billions were spent on renewable energy (especially in Germany). This lowered the demand for allowances and thus their price and allowed coal to become more competitive. Perversely, the ETS sped up climate change.

Figure 2


Figure 2: Cumulative total anthropogenic CO2 emissions from 1870 in gigatonnes of CO2 and corresponding temperature anomalies relative to 1861-1880. RCP stands for representative concentration pathways in climate modeling. This figure shows the gravity of the situation. There is no time to lose. Source:

Why did the ETS fail so spectacularly? Reyes’ overall conclusion leaves little room for doubt: ‘(T)he ETS is at the mercy of a complex interaction of state and corporate power. Those with the loudest voices have successfully pushed for rules that allow them to escape their responsibility to change industrial practices (…) (T)he history of emissions trading is littered with evidence that it helps companies and governments to pre-empt and delay making (…) structural changes. It is a fundamentally flawed system, setting up a system of property rights for continued pollution, and transposing environmental objectives into the kind of cost-benefit trade-offs that led to the problem of climate change in the first place’ (see here and here for similar conclusions).

  1. The fundamentalism of the market approach

A carbon tax would solve many problems and would potentially be extremely effective. But many issues need to be rethought: these questions are not primordially technical, they are inherently political. Karl Polanyi distinguished in the 1940s between ‘embedded’ and ‘disembedded’ economies. The latter arose with the commodification of labour and land and finalised when markets for goods, labour, land and capital became ‘autonomous.’ Instead of the economy being embedded in social relations, social relations became embedded in the ‘all-encompassing’ economic system.

Polanyi explains that this ‘great transformation’ took place during the years 1750–1850 in England (see here). This society was unprecedented in its extreme radicalism. It required the complete commodification of labour, land and money, a venture that Polanyi considered impossible. According to him, they cannot be commodified: ‘the postulate that anything that is bought and sold must have been produced for sale is emphatically untrue in regard to them’ (see here). The radicalism of laissez-faire liberalism lay in its attempt to treat labour, land and money as if they were commodities. Self-regulating markets would maximise outcomes.

Laissez-faire liberalism produced such catastrophic results that very fast protective legislation had to be introduced to deal with its excesses (at least at home and for example not in Ireland where more than a million people perished during the Famine – a direct consequence of laissez-faire (see here)). At home, even the most conservative, anti-social, forces rebelled against it. The project of the liberals was not economically (or socially or politically) sustainable for any length of time. After Word War I, market fundamentalism made another fateful bid to restore the self-regulation of the system by eliminating ‘interventionist’ policies in the spheres of world trade and monetary policy. The result was the collapse of the global economy and the rise of fascism and totalitarianism.

Today, we once again live through a retrograde era. Market fundamentalism made its third fateful attempt to organise societies on the basis of the miracles of ‘unrestrained markets’ and nothing else, certainly not governments, social concertation or democracy. Market fundamentalism led to an authoritarian, corporate state. Now almost everything needs to be fundamentally rethought, up to the most elementary level. Was Polanyi right (or mostly right) when he spoke about ‘the great transformation’? Is the value of a cow equal to the market price of her meat? Is the value of a human equal to the ‘price’ of his labour? Why do we think that carbon markets, which deal with pollution that no one wants, function like markets for products that are produced for sale? The fundamental barbarianism is that if everything has a price, nothing has intrinsic value.  Those who think that the fight against climate change is a question of technological advances or social engineering (the dominant paradigm, by far) are deluding themselves.

You can read in part 3 about carbon taxes. A carbon tax is absolutely essential if we want to lower GHG emissions. Aside from the technical side, there is the normative argument that governments have the right to regulate economic behaviour. They have the right to tax companies out of the market if they pollute too much. This is, of course, easily said in a world in which many multinationals are much more powerful than many states. This is nonetheless what needs to happen. Since historically just 90 companies are responsible for two thirds of global CO2 emissions, we know where to start (see here).