Speaking at the recent British Institute of Economics Climate Policy Seminar, Boris Lagadinov of Sandbag, the Brussels and London based think-tank that addresses climate issues, gave an excellent summary description of the development of the EU Emissions Trading Scheme (ETS), its successes and shortcomings, and the prospects for remedying its defects in the 2020s, notably the status of Phase 4 (2021-2028) reforms and the overlap with other policies. The presentation is available online (at least to BIEE members), but the fuller version of his analysis is also readily available on the Sandbag website. It is an excellent exposition and I will not try to repeat its detail, but rather aim to concentrate on some of the lessons and implications discussed at the seminar and that we might draw from the ETS experience.

The broad picture is well known. The EU ETS has achieved compliance with its targets, largely as the result of initially very undemanding targets (a result of extensive industry lobbying) combined with recession-`induced falls in demand, but it has in the view of most commentators wholly failed to produce carbon prices that are likely to have any significant effect in reducing emissions, let alone incentivise the kind of transformative change that is required across the energy sector or more broadly in the economy or in lifestyle choices. In other words it provides no incentives for economy-wide decarbonisation.

Boris outlined the structural reform measures associated with so-called “backloading” and the creation of a Market Stability Reserve (MSR), but the scale of the surplus in the ETS stands at about 3 billion tonnes in 2016 and Sandbag expect this to rise to about 4 billion tonnes by 2020. In broad terms this is about a full year’s EU emissions, but about two years for emissions falling within the scope of the scheme. The reform proposals may be structurally sensible but the Sandbag analysis indicates there is no real prospect that they will lead to a significant increase in carbon prices any time soon.

In terms of fundamentals, the EU ETS is a highly oversupplied system. Emissions have fallen much faster than the “cap”, but it is quite clear that this has been entirely due to other factors, including the impact of so-called “overlapping policies” such as national policies for the power sector, and for energy efficiency. It is very hard to argue therefore that EU achievements in reducing emissions owe very much, if anything, to its flagship policy, the ETS.

For economists, for whom adequate pricing of the emissions externality is usually assumed to be one of the simplest and most efficient and effective policies, this is a difficult pill to swallow. In global terms the EU ETS was one of the earliest and is the world’s largest attempt at using price and market mechanisms to control emissions. But the outcome is that, in one of the largest players in the world economy, the carbon price is having little impact and playing little or no part in policy. And it now appears condemned to irrelevance for at least the next decade.

There is therefore a clear contrast between the lofty ambitions of Paris, which the EU (including the UK) have endorsed, and the reality of this core EU policy. And there are some clear practical and philosophical lessons to learn, both in the EU and for other regional schemes.

1. The first is the importance of being clear about objectives. The required level of long term global emissions reduction may be a clear target, but “region EU” contributions, defined over relatively short time periods were always at best a partial reflection of the real objective, which is to set in motion the massive changes required in moving to a low carbon economy. It was and remains the case that the long term objective requires very substantial transformative change, and that the incentive of a significant carbon price should be playing a major role in this. Failure of the EU ETS to deliver meaningful prices should therefore have been interpreted as an early signal that the short and medium term targets were far too slack and were certainly not consistent with EU ambitions to be a global leader on climate.
2. Cap and trade mechanisms are badly suited to the cumbersome and inflexible nature of much of EU decision taking, demonstrated by the slow and inadequate progress of MSR and related reforms. Cap and trade is intrinsically inflexible, given the need to provide participants with some degree of confidence in the rules and duration of the market. What is needed are policy instruments with the ability to adjust to events, such as the recession, over reasonably short timescales. Adaptive mechanisms permit a learning process. In this context using price directly as a policy instrument (through a carbon tax) could have been a much more effective policy instrument.

Unsurprisingly member states with high levels of ambition have developed their own policies. These include “floor prices” for carbon in order to support low carbon investments, but also other direct interventions. It has been claimed that, paradoxically, these so-called “overlapping policies” will in some instances give rise to implicit “costs of carbon reduction” an order of magnitude higher than the actual carbon price that would emerge even from a reformed ETS. Whatever the truth of this, the weakness of the ETS means that we are likely to see more rather than fewer “overlapping policies”.

These unilateral initiatives have also led on to further disputes over policy. It can be argued that they have undermined the carbon price and the ETS, and this finds its expression in one conventional view that additional measures do not decrease cumulative emissions, since they merely substitute for reductions that would otherwise have occurred within the EU ETS “carbon bubble”. Sandbag analysis of this argument, often described as the waterbed effect, and the growing scale of ETS surpluses, suggest that the waterbed myth is entirely fallacious, but that has not stopped the myth giving rise to some damaging public policy consequences.

One example was the objection on competition policy grounds to proposed closure of five coal power plants in the Netherlands, as part of a national agreement to move towards cleaner energy. Since this was to be done on the basis of an agreement between producers, it hit problems of competition law. The companies pleaded a “public interest” defence, namely reduction in CO2 emissions. However the Dutch competition authority concluded that the agreement was in violation of the cartel prohibition, arguing that the proposal would not reduce CO2 emissions, as claimed by the producers, since the redundant emission rights would be sold on the open market and would therefore only be relocated. In other words the “waterbed myth” was used to obstruct an “overlapping” policy that would have resulted in a real and immediate emissions reduction.

Inter alia this shows that the impact of policy failures can go beyond simple failure to achieve expectations, and can act as a barrier to other effective initiatives. Regular readers of my blog will be aware of my opposition to the UK’s exit from the EU, but the EU ETS has not proved to be a good example of successful EU policy. It may still be sensible for the UK to participate post Brexit, in the hope of its ultimate reform, but the UK will clearly need to continue its own policy initiatives, as it has to date.

There are numerous other issues for energy and decarbonisation policy that will spring from Brexit, and that is the subject of the next Climate Policy Seminar, on 5 April, when Anthony Froggatt of Chatham House and Owen Bellamy of the Committee on Climate Change are addressing the topic of 'Brexit and Decarbonisation'.

This opinion piece reflects the views of the author, and does not necessarily reflect the position of the Oxford Martin School or the University of Oxford. Any errors or omissions are those of the author.