The chronicle of a crisis foretold: Price bubbles in the EU's CO2 emissions trading scheme

It's clear that that the EU's Emission Trading Scheme (ETS) is fundamentally flawed, argues the EESC's Marcin Nowacki

By Marcin Nowacki

Marcin Nowacki is a member of the Employers' Group of the European Economic and Social Committee

06 Dec 2021

As the EU grapples with rising energy prices and business leaders carefully assess the European Commission’s Fit for 55 climate roadmap presented by the European Commission in July, we must state loud and clear that the CO2 Emission Trading Scheme (ETS) is flawed.

Both energy companies or industrial concerns and ordinary consumers are likely to pay a huge price for emission reductions.

By the end of 2030, carbon dioxide emissions in the EU are set to be reduced by 55 percent from 1990 levels. The Fit for 55 package provides a detailed analysis of the European Union’s carbon output and identifies the region’s most challenging sectors and corresponding plans to decarbonise.

Buildings, industry and mobility are identified as the key problem areas in terms of the EU’s CO2 emissions, together comprising almost 50 percent of the total. That is why the Commission proposed strengthening carbon pricing within the EU by extending the Emissions Trading Scheme (ETS) to include maritime transport, buildings and road transport and to introduce a new Carbon Border Adjustment Mechanism (CBAM) for selected sectors.

The need to reduce emissions and move away from coal and fossil fuels while delivering a genuine energy transition is an irrefutable argument in the fight against global warming, but there are doubts as to whether the CO2 reduction mechanisms adopted in the EU might pose a serious threat to the competitiveness of the EU economy in relation to China or India.

At present, the market for emissions allowances, based on cap-and-trade principles, has become speculative and is slowly spiralling out of control in terms of supply and demand. Price bubbles are forming. This situation calls for a proper reform of the current EU-ETS to contain energy prices and avoid a global energy crisis, similar in nature to the financial crisis of 2010.

"At present, the market for emissions allowances, based on cap-and-trade principles, has become speculative and is slowly spiralling out of control in terms of supply and demand. Price bubbles are forming. This situation calls for a proper reform of the current EU-ETS to contain energy prices and avoid a global energy crisis, similar in nature to the financial crisis of 2010"

According to Marek Lachowicz, economist and author of a newly-released report on the EU ETS, the European Union Allowances (EUA) in the trading scheme can be improved, but the biggest problem is that the European Commission is unable to see cracks in the faltering ETS system.

Indeed, the system does not work in accordance with the idea of a free market, because its underlying mechanisms, (Stabilisation Reserve Mechanism and Linear Reduction Factor) artificially limit the supply of allowances. Why? Because, although it is assumed that deficit installations would be able to buy allowances from surplus installations, this is not the case.

A second group of purchasers has entered the system, namely the financial institutions, which are free to exploit the fact that some of the purchasers of EUAs (the energy sector and manufacturing companies) need them for their economic activity.

That flaws the system. Investors bear no risk and installations have to buy EUAs at any price. It can be assumed that financial investors treat emission allowances as a similar speculative asset to oil. EUA futures prices fluctuate in a way similar to traditionally speculative oil or gas contracts.

Lachowicz's analysis leads to the conclusion that a bubble is forming on the ETS market, precisely due to the unequal position of buyers. Even a short-term price drop will not affect it - sooner or later there will be another bubble. More worryingly, forcing installations/companies to hold cash in reserve in the event of an increase in the price of allowances limits the real ways in which they can reduce their CO2 emissions.

Unfortunately, the European Commission does not seem to be concerned and wants to extend the system to new sectors, which pose a real threat to the competitiveness of the EU.

"Taking into account the enormous costs for society and the little achieved in terms of emission reductions, one has to wonder whether this instrument, combined with the equally dubious carbon adjustment mechanism, should be the foundation instrument of the EU's energy transformation"

The reduction in the number of free allowances for aviation and the extension of the system to include maritime transport, along with the carbon border tax, would increase the prices of goods imported to the EU, which may lead to tariff wars with the rest of the world.

The COVID-19 pandemic and the current situation in many industries have shown the danger of basing supply chains on imports of essential raw materials and intermediate goods. One example is the automotive industry, which is being forced to shut down production and cut jobs because of the shortage of semiconductors.

At the same time, energy-intensive companies might relocate their production outside the EU. This could be true also for companies in the supply chain of raw materials (e.g. steel) which are at the core of EU competitiveness.

Some might argue that the EU may try to compensate for the increase in the price of raw materials by increasing the price of exported products (mainly technology), but we should be mindful that the technological advantage which Europe had over Asia two-to-three decades ago has largely been eroded.

In the event of an international crisis, the EU's potential technological advantage will be irrelevant if it is not supported by the necessary raw materials.

Transporting raw materials from abroad may also wipe out any emission reductions we have managed to achieve thanks to the ETS.

The Commission argues that extending the ETS will boost efficiency. However, a number of studies have shown that the annual reduction in emissions achieved by the ETS ranges from half a percent to just one percent.

Taking into account the enormous costs for society and the little achieved in terms of emission reductions, one has to wonder whether this instrument, combined with the equally dubious carbon adjustment mechanism, should be the foundation instrument of the EU's energy transformation.

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