Saving the Scheme (giving EU ETS a bit more institutional clout)

The swings in the EUA price have been recently so large that they have provoked panic headlines in the financial press. The very advocates of market mechanisms are now washing their hands of it.

A touch of reasonableness. The scheme is a year old and the problem it seeks to address is highly complex. Did we expect zero volatility and a perfect allocation first time round? Get real. If we accept an artificial market, we have to accept it will take time to get it right. The idea is that it’s worth it.

One noted economist[1] explained that the scheme has run aground because it is too complicated. Well, how about a simple system?

The simplest system would be a carbon tax levied on industries on their total fossil fuel usage – fixed at Euro 5 per tonne of CO2, and rising Euro 5 per year for the next fifteen years. It would avoid all the gaming and cheating, all the market abuse by behemoth utility companies, all the lobbying on allocation amounts, and the fluctuations in price which caused so much panic. It would allow investors to incorporate carbon prices accurately into their financial projections.

It does not have the bite of the current system which punishes marginal use rather than overall use, but it’s simple.

But just listen to the howls of protest from economists who are wedded to the market and who despise taxation!

If we do want to stick with a market mechanism, however, I think we can learn from the mechanisms used to keep economies as a whole in balance. The central bank has a target inflation rate sets interest rates from time to loosen or tighten the economy. Critically, the board of that bank will make regular announcements giving signals to the market of its intentions and expectations. And the president of the bank is a respected figure, to some degree independent of politicians, and people listen to her or him.

But imagine the central bank only set interest rates every three or five years, imagine there was no board or president of it, imagine it had no political independence. There’s the EU Emission Trading Scheme for you.

So this is what we need:

(i) A president: Not some half-time EU bureaucrat, but someone with an intellect like a laser, with top quality communication skills, the guts and muscle to fight his corner, and a lot of respect: a leader.

(ii) A board: a few wise women and men who have a firm, clear, mandate to govern the scheme independently of short-term political and corporate interests

(iii) A clearly communicated medium and long term target market price, and regular signaling by the board of this

(iv) Quarterly reporting of emissions so that we aren’t taken by surprise

(v) The equivalent of an interest rate which the board can flex from time to time. For example a coefficient between the number of allowances to be submitted per tonne of CO2 emitted and the tonnes of CO2 actually emitted. If the scheme is too loose and the price too low, then the board will increase the coefficient to, say, 1.05, effectively tightening the market a little

With this institutional reform there is a good chance EU ETS will start to deliver a stable framework, allowing companies to invest in cutting their CO2 emissions.

[1] John Kay, Financial Times

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