Are carbon markets an effective way to address climate change?

This article interrogates some of the most important claims to avert the repercussions of man-made climate change and deliver much-needed greenhouse gas (GHG) reduction put forward by proponents of emissions trading. It will do so by analysing the effectiveness of the European Union’s Emissions Trading Scheme (EU ETS) in terms of emissions reduction (through the newly created commodity of carbon credits) while incorporating this in a broader discussion of market-based environmentalism.

By Adela Putinelu

Climate change has been described as the greatest collective action problem the world has ever faced (Barrett 2008: 257). In the search for regulatory solutions which would mitigate the effects of global warming, emissions trading has become the most favoured policy instrument.

If we are to envisage a more sustainable future and a transition away from today’s fossil-fuelled economies, it is imperative that we seek to understand the EU emissions market in terms of its aims, and propose ways to overcome its current failures.

So how does the EU ETS work? The central point of the Kyoto Protocol was to establish a global market in GHG emissions by means of three flexible mechanisms:

1. Emissions allowance trading between registered polluters
2. The clean development mechanism enabling offset trading in the form of emissions credits between Annex 1[1] countries and developing countries
3. Joint implementation allowing high-polluting Annex 1 countries to invest in mitigation projects in transition economies, such as Eastern Europe.

Taken together, these were intended to deliver effectiveness (real GHG emissions decrease), efficiency (low-cost solutions for individual polluters) and equity (cash and technology transfer from the industrialised world to the rest).

The EU ETS is currently the largest market in emissions trading. States propose levels of permitted pollution and the European Commission negotiates around these levels before allocating permits. Since the EU is registered under the Kyoto Protocol as a single ‘country’, there is a ‘bubble agreement’ whereby allowances  vary to reflect different national circumstances in industrial output, with some countries receiving a surplus of allowances and others a deficit.

Tightening the cap of permitted levels of GHG emissions renders pollution more costly, with the intention of pushing industry to a transition away from fossil fuels and towards investment into cleaner technologies. To ensure ‘least cost compliance’, directive 2004/101/EC creates the conditions for member states to use credits generated by emissions reduction projects within the ETS market.

The pilot, phase I, ran from 2004–2007, followed by phase II in 2008–2012 (coinciding with the Kyoto commitment period). The ETS draws its model from the apparently successful US cap-and-trade scheme for sulphur dioxide in the 1990s (Castree 2009).

The EU ETS covers electricity generation and the main energy-intensive industries

One of the most contentious points in the ETS model was the initial allocation of allowances set in directive 2003/87/EC. This stated that 95% of allowances in phase I and 90% in phase II would be given for free to industrial polluters. Although various governments initially advocated ‘benchmarking’ as the principle of allocation, ultimately ‘grandfathering’ was favoured in the majority of the national allocation plans.

Grandfathering is a method of allocation based on installations’ historical emissions shares according to their sector, whereas in benchmarking some index of historical activity or capacity is multiplied by a uniform emissions-rate standard to determine allocations to individual installations (Ellerman and Buchner 2007: 78). However, debate rages over each method of allocation and its subsequent effects on the market’s economic efficiency.

For example, it is thought that grandfathering favours big industrial polluters, undermining the ‘polluters pay’ rule whilst failing to encourage investment in clean technologies through adequate incentives. This could, in turn, undermine the efficiency and overall effectiveness of the trading scheme as it may not ensure GHG reduction according to the least-cost principle (Chernyavs’ka 2008: 15).

The free allocation of allowances for industrial polluters has been described as the largest instance of the creation and regressive distribution of property rights in history (Gilbertson and Reyes 2009: 10). As the opportunity cost of allowances is incorporated into power prices in countries with liberalised energy markets, the largely free allocation of allowances means that power generators receive a windfall profit since their compliance costs are far less than their revenues generated from increased consumer prices.

When the overall loose cap, which in most cases exceeds overall emissions, is taken into account, the scheme primarily translates into profit-making opportunities for industrial polluters. While most allowances are used for covering existing emissions, the cost of buying extra pollution permits is being passed to consumers, effectively bypassing any incentive for systemic change (Lohman 2006: 90).

For example, the Czech energy giant CEZ, which received a third of the country’s permits, was able to sell its allowances in 2005 when the price was high and buy them back when the market collapsed – investing the profit in coal production while energy prices for consumers increased. In the UK, the ‘big six’ electricity generators receive around $1.2 billion each year in windfall profits from the ETS.

he industry is able to pass the marginal costs onto consumers, giving a massive boost to the industry’s profitability (Lohman 2006: 91). Moreover, according to the European Environment Agency,[2] there was an increase of 2.8 per cent in CO₂ emissions in the EU 27 in 2010 from energy production-related fossil fuel combustion.

Learning curve or regulatory deadlock?

So far there has been a wide gap between environmental rhetoric and reality in the EU ETS. Stemming from the divorce between economic theory and complex reality, the current regulatory framework and the market design of the EU ETS have faced serious shortcomings (Spash 2010). Some argue that carbon markets like the EU ETS, which were advertised as a means for incentivising and providing finance for a transition to a fossil fuel free future by the derivatives traders and neoclassical economists who created them, have had exactly the opposite effect (Lohman 2009: 1073).

In their decade of existence, these markets have offered new means for the heaviest polluters in fossil-based industries to delay structural change while also providing supplementary finance for these industries. As investment is used interchangeably as a short-term, money-making venture and as a foundation for a secure future, the ‘savings’ of the carbon trading market are achieved by putting off technological change and long-term investment in a  future without fossil fuels.

Thus, by encouraging ingenuity in inventing measurable equivalences between different types of emissions and various types of offsets rather than by fostering innovation to reduce dependence on fossil fuels, the overall effectiveness of this type of market-based environmental policy is questionable (Lohman 2006).

Framework failure

The 2012 Carbon Trade Watch report indicates that although the currently low market value of carbon has led the general public to believe that the EU ETS is not working, it is not the market as such that has failed but rather the policy framework. We must go back to the initial aims of the policy to assess this claim. Who has profited most? Did the regulatory framework succeed in circumventing what the market was initially created for, that is, achieving emissions reduction in the most cost-effective way?

While the ‘free market environmentalism’ theory – which holds that carbon trading is efficient in internalising the costs of environmental externalities (Castree 2009: 199) – has some validity when judged against the success of the US cap-and-trade of sulphur dioxide, there is an enormous gap between environmental theory and practice in the EU (Castree 2009: 203).

Whether the problems associated with the EU ETS are inevitable features of institutional learning or are due to drivers outside of policymakers’ control (such as oil prices), it might be the case that these are all inherent problems in the business-friendly approach of most EU states. The text of directive 2003/87/EC is easily interpreted as a compromise between the urgency to meet targets set out in the Kyoto Protocol and the interests of the different member states – and thus the big capital interests behind them.

Ultimately, the intricacies and range of interpretations outlined above resulted because of  the failure of the Kyoto Protocol to stipulate a degree of uniformity in rules of allocation, caps to be set for each member state and the methodology for constructing national allocation plans (Chernyavs’ka 2008: 17).

In an effort to reconcile the regional logic of emissions trading with its regulatory logic, complex struggles and negotiations between EU policymakers, member states and industry have taken place (Bailey and Maresh 2009: 7). The market mechanism per se is not the problem but rather the regulatory deadlock in which the market seems to be trapped thanks to European policymakers’ unwillingness to put pressure on the big fossil-fuelled industries for the sake of a more coherent and effective scheme which would diminish corporate influence over the design of the carbon market.

Favouring fossil fuels?

The form of carbon capitalism which has emerged has been driven by the interests of the big industrial polluters. As such, the EU ETS has bowed to corporate self-interest from the very beginning. Some would argue that even the most conservative estimates of the windfall profits enjoyed by intensive fossil-fuelled industries at the launch of the carbon market raise a question mark over the political accountability of the EU ETS (Sijm et al 2008: 123).

Structural deficiencies have been perpetuated in phase II, with the issue of windfall profits remaining unaddressed in the European Commission’s directive, the overall cap set only marginally lower and grandfathering remaining the practice although policymakers are well aware of its associated drawbacks after the disastrous effects of the phase I pilot (Castree 2009: 204).

Both market environmentalists and climate justice movements are calling for systemic change. The latter, comprising organisations such as Climate Justice Action, Climate Justice Now! and Third World Network, campaign for equitable environmental policy but are increasingly criticised over their apparent misinterpretation of cap-and-trade schemes and faulty economic analysis (Hahnel 2012: 142).

Market environmentalists on the other hand suggest that only a ‘learning by doing’ approach will deliver much-needed GHG reduction – both in terms of economic efficiency and equity. They reiterate the need for improved cap-and-trade schemes, whereas climate justice movements are warier of emissions trading and call for a rapid transition away from fossil fuels.

Advocates of current ETS models regard GHG control as a ‘pro-growth strategy’ offering positive financial returns for investors. One such example is to be found in the Stern Review (2006), which emphasises the great opportunities for banks and the financial sector in funding pollution reduction. But if we consider pollution control as defensive expenditure we could argue that this adds nothing to human welfare and should not be a sign of societal progress. The transaction costs inherent in these markets should not be interpreted as a source of economic growth but rather a loss to society (Spash 2010: 16).

Does it work?

Intense corporate lobbying against governments’ favoured idea of a carbon tax and the desire of the EU to fill a power vacuum after the US withdrew from the Kyoto Protocol in 2001 saw the EU making a U-turn and adopting a cap-and-trade policy. Subsequently, the EU enjoyed a leading role in climate change negotiations while its proposed emissions trading scheme increasingly attracted attention as a model for a global cap-and-trade system.

But concerns about the practical implementation and effectiveness of the current scheme, the failure of the US (the world’s largest per capita emitter of GHG) to establish a national cap-and-trade programme and the fundamental ethical critique of the legitimacy of carbon commodification indicate that the future of emissions trading is far from certain (Perdan and Azapagic 2011: 6052-6053).

With little incentive for investing in clean technologies, a timely transition away from fossil fuels seems unlikely. With the market-based policy tool of emissions trading preferred on grounds of economic efficiency (although this is subject to debate), environmental policy will not address the challenge of behavioural change while the goal remains to seek new investment and financial opportunities (packed in green discourse and delivered to the public in the form of pro-growth strategies).

Structural deficiencies in the EU ETS cannot be understood as part of an institutional learning process so long as the EU policymakers remain unwilling to learn from its failures.

This article was first published in the Institute of Public Policy Research (IPPR) journal Metis. It aims to provide students with the opportunity to engage with the policy process and gives them a unique platform to express opinions, critiques and solutions.

About the author:
Adela Putinelu is an MA student in International Development: Politics and Governance at the University of Manchester


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 [1] Annex 1 countries are defined as industrialised countries and those in transition to industrialisation.

[2] European Environment Agency (2011), ‘Why Did Greenhouse Gas Emissions Increase in the EU in 2010?’ EEA analysis in brief, 2011. Available at

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