What we can learn from Europe’s cap-and-trade system

October 17, 2012

We know, we know. No one in Washington wants to talk about climate change. Neither Barack Obama nor Mitt Romney mentioned the subject in the second presidential debate on Tuesday. And there's a widespread belief that a cap-and-trade program to cut carbon emissions won't resurface in Congress anytime soon.


On the upswing. (AP)

Still, that hasn't stopped our friends on the other side of the Atlantic from tackling the issue. And there's a new report (pdf) out today from the analysts at the Environmental Defense Fund, looking at the track record of Europe's cap-and-trade system over the past seven years. Some of the lessons here are worth a closer look.

What Europe's cap-and-trade is. Quick history recap: Back in 2005, the E.U.-15 began implementing its Emissions Trading Scheme to curtail greenhouse-gas pollution from key industries across the continent. There was a hard cap on overall emissions that would grow steadily more restrictive over time, eventually expanding to cover industries like aviation. Companies would get a fixed number of pollution permits that they could trade with each other as needed.

How much Europe has cut emissions. Here's a graph from the report showing that emissions in the affected sectors have dropped 13 percent between 2005 and 2010. That's further than anyone expected even given economic conditions:

Since 2005, the E.U. economy has expanded slightly, though there was an obvious dip after the financial crisis (that's the blue line). But greenhouse-gas emissions in the covered sectors fell dramatically, by 13 percent (that's the purple line). It appears that Europe is starting to sever the traditional link between carbon emissions and economic growth. 

Overall, emissions in the E.U.-15 fell by 9.2 percent between 2005 and 2010. For comparison, U.S. greenhouse-gas emissions fell 5.3 percent during this period without any cap at all. This is far from a perfect comparison, however, since the two regions have different economic situations, different supplies of natural gas, different histories, etc.

Where Europe's cuts are coming from. Now, one thing the report doesn't delve into is where, exactly, those emissions cuts are occurring. If the cap is forcing electric utilities to clean up their coal plants and use more clean energy, that's one thing. But if the cap is simply driving Europe's manufacturers abroad to China, that doesn't do much for climate at all.

Fortunately, we can partly check this for ourselves. Data from European Environmental Agency's greenhouse-gas viewer suggest that the reductions in emissions between 2005 and 2010 have been spread out across multiple industries, with fuel combustion and the electricity sector falling the most, followed by manufacturing, construction, and "industrial processes":

How much the program costs. Not much, according to the report. One earlier study had found that cap-and-trade cost Europe just 0.01 percent of GDP between 2005 through 2007.* What about more recently? Well, there's this Greenwire article from 2010, which quotes a utilities analyst at UBS saying, "It does have an impact already, but it's rather tiny." Fair enough, but we'd like to see more hard data on this.

The Greenwire story does, however, explain that "not a single factory has moved out of Europe because of the ETS." So Europe's cap-and-trade program doesn't appear to be forcing companies to head for China just yet, though domestic steel producers keep warning that they'll flee the continent unless other countries start adopting their own carbon-emissions programs.

Flaws in Europe's program. Moving on, the Environmental Defense Fund report does detail some of the problems and flaws of Europe's cap-and-trade program. The ETS handed out far too many pollution allowances between 2005 and 2007, which caused carbon prices to collapse. At that point, companies had no incentive to make cuts or invest in low-carbon technologies. But European policymakers figured out their mistake and later tightened the cap.

Meanwhile, some electric utilities received free pollution permits and were able to earn "windfall profits" from their good fortune. That appears to have been an error, too. There's also the potential for fraud within the system. In theory, companies can get a pass on their pollution by buying carbon offsets—paying for projects elsewhere that reduce carbon, such as planting trees in Brazil. But these programs are often criticized for poor oversight (and some of them might have happened anyway). That needs to be reformed, too.

Europe's collapsing carbon market. One final thing to note: The ongoing euro zone fiasco and perpetual recession has posed a real challenge to the cap-and-trade program. Demand for pollution permits has withered, which means that European carbon markets are collapsing. Right now, there's little incentive for companies to invest in clean energy or new efficiency measures—why bother, when it costs so little to pollute? This isn't an immediate problem, since emissions are sagging anyway. But it could make it harder for companies to adjust to a future in which the carbon cap gets even tighter.

Still, the report is generally optimistic that European policymakers will work these kinks out. If Congress ever decides to get serious about tackling climate change, a cap-and-trade program is one possible way to deal with the problem. By that point, we'll have many years of experience watching Europe and learning from its early missteps. Meanwhile, California is launching its own cap-and-trade system in January 2013. So politicians there may want to pay close attention.

Related: Europe's a mess but it's meeting its climate goals

* Updated with an additional citation on cap-and-trade's costs.

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Dylan Matthews · October 17, 2012