Is the EU carbon trading market oversupplied?

Any fledgling market is prone to nasty shocks, but the EU's emissions trading system was hit exceptionally hard last week. Shortly after reaching a record price of €31 a tonne, the price of carbon-emission permits plummeted by more than 50% to €14 a tonne.

The collapse was caused by news that several EU countries had emitted less carbon than expected last year. Traders now fear the market is oversupplied with permits and that the price could fall further as other countries report their emissions over the next week.

The crash comes after long-running concerns about the way the permit system operates. Permits are allocated on a national basis and given without charge to carbon emitters, such as factories and power stations. If a firm produces less carbon than it has permits, it can trade its excess permits with companies that have exceeded their allowance (and would otherwise be fined €40 a tonne).

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As the FT points out, "supply of these permits should be less than demand for them; otherwise there will be no reduction in carbon pollution". The EU has got its sums wrong and handed out too many permits for this year and next, which will undermine the market.

"But it is not too late to tighten the system for 2008-2012", when the market widens to include Japan, Canada and Russia. There are also calls to auction the permits instead of initially handing them out free after a report from IPA Consulting found power firms may make a £1bn windfall profit from overgenerous allocations.