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How much longer can European politicians keep the emissions trading scheme on life support?

The EU Emissions Trading Scheme is like a cargo ship stranded on a beach. Expected to play its vital part in an international carbon economy, it is grounded on the hard economic realities facing Europe. It sits there looking lonely and pointless thanks to the failure to secure an international deal. Instead of lucky locals picking over crates of consumer goods, there are big businesses and financiers making handsome profits at the expense of poor consumers. Instead of an insurer picking up the bill, families get higher electricity prices. Too many manufacturing workers play the role of the crew, and will be looking for a new job.

The whole point of emissions trading is supposed to be that politicians do not have to set the carbon price. If they know the right carbon price, they can use a carbon tax instead and there is no need to accept the additional costs of this policy – like employing talented people to trade carbon, instead of doing something else. With emissions trading, in theory, they can just decide the amount of carbon dioxide they want Europe’s economies to emit and the right price will come out to fit emissions within that cap.

Unfortunately, it does not quite work out like that. The problem is that demand is hard to predict. It is hard to know how difficult companies will find it to cut emissions. And politicians are not very good at predicting booms and busts in the wider economy either. With supply completely fixed that leads to wild fluctuations in the carbon price. It is similar to the situation in a highly-regulated housing market like we have here in Britain. We get booms and busts, because it is hard to build more houses in response to new demand.

So far, we have seen collapses. In the first phase, as it became clear that emissions allowances were oversupplied and everyone had more than they needed, governments had a lot of freedom to decide the quantity of allowances available. That meant they had been given a licence to print money for their companies at others’ expense and pretty much everyone took that opportunity except Britain. We picked up the £1.5bn bill. Then, in the second phase, the recession led to another collapse. The price can just as easily spike up though and that could cause huge economic disruption. Politicians are talking about how the recession means that the cap is not tight enough and they might respond to that and step in with a tighter cap just before the recovery starts in earnest, leading to a shortage of allowances.

When the price is so volatile it makes the scheme much less efficient in cutting emissions and creates uncertainty, which exacerbates the cost to business. As the prominent climate economist William Nordhaus has put it, a “high level of volatility is economically costly and provides inconsistent signals to private-sector decision makers”. The government’s response here is to fix the price. That will not make the scheme effective in encouraging new generation. Renewable energy already gets generous subsidies under schemes like the renewables obligation and the feed-in tariff. Potential nuclear plants face formidable construction risk even with guaranteed electricity prices.

Even if it did work, without other countries following suit it will not cut emissions overall, thanks to the way the emissions trading scheme works. Other emissions, in other countries, will fit under the cap instead. There is a lot of money in the ETS for special interests. ArcelorMittal has enjoyed €1bn worth of surplus allowances in the last two years as steel production has fallen in the recession. Energy companies have made billions in windfall profits as a result of getting valuable allowances for free. Our carbon market sustains the dodgy “clean development mechanism” in the developing world.

Even criminals are making a fortune. Europol announced, in December 2009, that governments had lost €5bn to carousel fraudsters – using the ETS. And, more recently, the whole market had to be suspended for a while thanks to repeated thefts. The price is paid by consumers – residential and business – stood at €15.6bn in 2010. For consumers, in the UK for example, the burden was about £75 a family. And that is just for a rotting failure of an ETS. At the medium term target price of £30, that cost would be more like £175 a family for the same emissions. The cost to families is tough enough. It hits the same poor and elderly families – who depend most on benefits and, therefore, makes it harder for governments to control public spending.

But at the same time energy intensive industries are not going to stay here with the ETS and other climate policies driving up the cost of energy. Special deals for specific industries might help limit the exodus, but that isn’t going to be a secure basis for long term investment. Tens of thousands of jobs are at risk, in the UK alone. Any hopes that economies like ours can be rebalanced away from a reliance on financial services are compromised. The plan was to link the ETS into a single carbon market that would span the developing world. There are specific provisions in the legislation to make that happen.

Similar provisions were in the cap and trade bills they tried to pass in the United States. With the failure of cap and trade in the Senate, that dream of a global carbon market is dead. With so many other pressures on their economies and the finances of their citizens, how much longer can European politicians keep the emissions trading scheme on life support?

Matthew Sinclair is director of the Taxpayers’ Alliance, a UK campaign group, and author of the book Let them eat carbon

Public Service Europe, 17 August 2011