The Lessons of Europe’s Carbon Trade

The EU has demonstrated that a multinational cap-and-trade scheme can reduce carbon-dioxide emissions at least cost, and that the economic side-effects are not serious. Whatever the system's flaws, these lessons are the important ones to keep in mind.

FLORENCE – As the Cancún climate change summit approaches, discussions about the viability of carbon trading systems is intensifying. The world can look to Europe as a model that is not only up and running, but that works.

In 2005, the member states of the European Union became the first to create a cap-and-trade system covering roughly half their CO2 emissions. They remain the only countries that impose a price for carbon upon a significant part of their economies. With the EU’s Emissions Trading Scheme (ETS) half-a-decade old, three broad lessons can be drawn. 

First, the system works. The ETS has achieved its objective of reducing emissions by the required amount at least cost. Emissions have been reliably estimated to be 3-5% lower in the ETS’s first three years, owing to the carbon price. This is a modest amount, but the initial ambition was also modest.

More importantly, the cap on emissions is being tightened over time – by 11% for the second period, from 2008 through 2012, and by 1.74% annually from 2013 on – so that the required reductions will increase in the future. While it is impossible to prove that firms have reduced emissions at least cost, the necessary conditions for doing so exist.

Firms can readily compare their cost of abating an extra ton of emissions with the cost of the allowance required if that ton is released into the atmosphere. A well-functioning allowance market – with broad participation and pricing that reflects underlying fundamentals – reveals this latter cost.

The second lesson is that the side-effects of the ETS are few. The expectations of extremists among advocates and opponents of carbon pricing have been disappointed in equal measure. The former expected transformational technological and social change, while the latter darkly predicted weakened competitiveness and job losses, even recession.

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The readily observable fact – to the consternation of both sides – is that the carbon price has produced no far-reaching economic changes in Europe. Trends that existed before 2005 continued thereafter. Production and employment increased in the first years of the program, and there was no observable effect on imports and exports.

The only trend that changed was carbon emissions, which fell. The financial crisis in late 2008 brought recession, but no one has blamed carbon pricing. The fact is that the European economy has been affected more by sub-prime mortgages in the United States than by a carbon price in Europe.

The reason for the absence of noticeable side-effects is worth noting. Producers that are subject to the cap-and-trade scheme have many ways to adjust production, and, not surprisingly, they do so when faced with higher prices, including a new price on carbon.

Some of these adjustments are little more than “leak-plugging,” or paying more attention to emissions. Others involve small changes in industrial processes, such as the use of inputs that emit less carbon in steel and cement production, as well as large ones, such as a changeover within Europe to lower-carbon manufacturing facilities.

A typical example is the increase in electricity produced by gas-fired generating plants rather than coal-fired plants. In such instances, the output purchased by consumers is the same, and the additional cost is imperceptible. The explanation is one that applies to all of us. When faced with higher prices, we make small adjustments in our use of the affected items, but otherwise carry on as before. Producers find ways to continue making the goods that consumers want, but with fewer emissions.

The third broad lesson from the ETS is that multinational emissions-trading regimes can be constructed. A little-noted feature of the ETS is that it is more akin to 27 linked national cap-and-trade systems than to one big centrally administered system.

The EU, after all, is composed of sovereign states that jealously guard their prerogatives while occasionally yielding some aspect of sovereignty to central institutions for mutually agreed-upon purposes. Moreover, the differences among member states in economic circumstances, exposure to market institutions, and commitment to climate-change policy are significant.

These differences may not be as great as they are on a global scale, but they are similar, and bridging them to accommodate individual EU member states required no small amount of negotiation and compromise. But it was done – a demonstration of the feasibility of multi-national carbon trading that has enormous implications for the construction of a global trading regime.

While the ETS is often criticized and sometimes characterized as a failure, a sense of perspective is always required. As is true of all public policies, textbook perfection was not achieved. Mistakes were made but they have been or are being corrected.

Many find the system lacking in ambition, but the important point is that a mechanism for achieving bolder reductions is in place. The real problem is one of political will, not of institutional mechanics. And, compared to the US Senate’s failure to enact anything at all, Europe’s achievement looks pretty good. It has demonstrated that a cap-and-trade system can reduce CO2 emissions at least cost, that the side-effects are not serious, and that multinational cap-and-trade systems can be constructed.

Whatever the ETS’s flaws, these three lessons are the important ones to keep in mind.