Is Europe's carbon emissions trading system working?

Carbon trading has been getting a tough press recently, but reports of its demise are very much exaggerated, says Simon Wilson.

Why is carbon trading in the news?

Last Thursday the European Commission ordered a suspension of spot trading in carbon emissions under the European emissions trading system (ETS), after it emerged that cyber thieves had stolen millions of euros worth of allowances. Heavy polluters (typically firms) need the credits to meet their overall emissions targets and they pay to get them. So the allowances are valuable. Recently, there's reportedly been a series of "phishing" expeditions in several countries, culminating in the theft of about €7m-worth from the Czech registry last week.

How big a problem is this?

Exchanges on which EU emissions allowances (EUAs) are traded including ICE Futures Europe, Nasdaq OMX Commodities Europe, and the London-based LCH.Clearnet were all obliged to cease trading to allow regulators to investigate. But although spot trading ground to a halt, companies were still able to deal in futures contracts, which account for the vast bulk (about 80%) of the emissions trading system's volume. Moreover, the amounts stolen are not huge, compared to an annual total of €90bn traded last year. Even so, it's hardly great news for carbon trading in general, and Europe's ground-breaking ETS in particular (the biggest such system in the world, covering 10,000 industrial installations in 30 European nations). Worse, this latest problem is hardly an isolated one.

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What else has gone wrong?

Last year scammers in Germany and Denmark abused the ETS as part of a massive carousel-style VAT fraud. Before that (last spring) it emerged that the Hungarian government had "recycled" some cheap carbon credits from non-European emitters and resold them on the European market. That legal loophole was swiftly shut down amid market turmoil. Taken together with recent cyber thefts, this sort of stumble gives fresh ammunition to critics of the ETS. European business has sometimes complained that Europe's ETS unfairly penalises heavy industry here, compared with more lightly regulated firms in China, India, and even the US. Meanwhile, some environmentalists think carbon trading is (in the words of a recent Friends of the Earth report) a "high-risk, irresponsible and dangerous" distraction from more direct ways of cutting emissions.

So why bother?

Proponents argue that putting a price on carbon emissions is the best way to give emitters an incentive to cut emissions. And so far Europe's decision to start the world's first large-scale cap-and-trade scheme has proved a qualified success when it comes to shifting attitudes. The exact impact of the trading scheme is hard to quantify, but its fans point to the fact that power companies across Europe have moved significant production of electricity from coal to gas in recent years. The resulting emissions are between a third and a half the amount of carbon per unit of electricity produced. As Martin Lawless, the global head of environmental financial products at Deutsche Bank, put it this week in a conversation with MoneyWeek: "In Europe, people no longer debate whether carbon should have a price; they debate what the price of carbon should be".

So what is that price?

The price of emitting a tonne of carbon has been in the $12 to $15 range for the past year or so. This is the cost of an EU emission allowance (EUA). The cost of a certified emission reduction (CER), under which European firms are allowed to buy in ("offset") emissions allowances from UN-certified developing world emitters, is a bit lower. This CER system, according to critics, has particular potential for abuse notwithstanding the fact that European firms and traders buy CERs in good faith, and the system is rigorously policed by both the UN and EU authorities. Last week the EU announced that offset credits for certain gases would be ended from 2013.

Where does it go from here?

In terms of the overall goal of reducing warming by cutting emissions of heat-trapping gases, it's still early days for carbon trading. In the first (2005-2007) phase of the EU scheme, prices collapsed after too many free permits were issued, denting confidence in the market. In the second phase (2008-2012) the ETS has stabilised. That's despite the global recession, which sent the price tumbling again, and in spite of the much-publicised teething problems that are arguably inevitable in any new financial market.

The real test will come in the third phase (2013-2020). Emitting firms will then be obliged to buy far more of their permits at auction. To date, the ETS has proved a qualified success. The question now is whether the clear pollution price signal sent by a carbon market will foster a global shift towards a low-carbon economy over the next decade.

Who else is trading carbon?

Europe's is by far the biggest ETS. Its trading system is based on allocating firms a carbon allowance (gradually ratcheted down under successive phases) and forcing them to buy extra permits from cleaner firms if they want to emit more. New Zealand has a similar domestic scheme, Australia is likely to introduce one next year, and the Chinese and Japanese governments are exploring similar market-based schemes. In America, a federal cap-and-trade scheme proposed by President Obama was rejected by Congress last year. But California, the world's eighth-largest economy, is introducing its own in 2012. At least 11 other US states and three Canadian provinces are in discussions about joining it.