This post initiates a series that will examine emerging problems in the European Union’s carbon market—by far the world’s largest—and the broader policy implications of those problems.  We turn first to the recent collapse in the value of European Union Allowances (EUAs), each of which represents the right to emit one ton of greenhouse gases within the EU’s annual emissions caps.  Since the second half of 2008, the price of EUAs has dropped precipitously—from over €30 ($38) per ton to below €8 ($10) per ton. While in recent weeks the price has increased again slightly, and currently stands near €12 ($15) per ton, the overall pattern is of a decline in price.  What is behind the drop, and what does it mean for the health and sustainability of the EU’s Emissions Trading Scheme (ETS)?

For some market observers, the decline evinces a market working properly, with supply and demand finding a new balance.  Some point to sharply declining industrial output in the EU, which has left many emitting facilities long on EUAs, driving prices down.  As noted by Hernkir Hasselknippe of Point Carbon, an energy consultancy, the rational response for companies in this position is to sell credits.  “If they are emitting less then they do not need the credits so much and the price of carbon will fall.”  Other observers see the declining value of EUAs as a manifestation of the credit crisis, with holders of EUAs eager to sell them to raise cash.  Notwithstanding decreased demand for EUAs, current trends suggest that the total volume of EUAs traded within the EU ETS will continue to grow significantly this year.  According to Point Carbon’s projections, the volume traded in the ETS in 2009 could reach 3.8 gigatons of CO₂ equivalent this year, up from 3.1 gigatons in 2008.

Other market observers, however, attribute the decline in the value of EUAs at least in part to ETS design flaws.  A recent Deutsche Bank analysis identifies two problematic features of the ETS:  first, that the EU has fixed the supply of EUAs through 2020 (the end of the third commitment period in the EU ETS, for which legislation was just enacted); and second, that many EUAs to date have been provided to emitting facilities free of charge, leading to a glut.  Due to these factors, the Deutsche Bank analysts contend that the real prospect of future EUA shortages, as the EU emissions caps decline, are inadequately reflected in today’s EUA prices.  These analysts are also concerned that sustained price weakness for EUAs in the months leading up to the U.N. Copenhagen Conference in December 2009 could call into question the viability of the EU ETS as the foundation for a post-Kyoto Protocol global emissions trading system.

The recent volatility in the price of EUAs has also reanimated the longstanding debate between supporters of cap-and-trade mechanisms (such as the EU ETS) and advocates of a carbon tax.  The latter see the sudden decline in the value of EUAs as further evidence that an emissions rights trading system would not work well in the United States.   As this argument goes, the emissions allowance values are inherently unpredictable and can fluctuate wildly, making long-term business planning much more difficult than under a carbon tax.  These critics also contend that a cap-and-trade mechanism provides emitters with an undue interest in maintaining the market value of emissions allowances, an asset they hold.

For further information about this topic, please contact Akin Gump.